In 2024, a range of macroeconomic market forces are set to significantly influence limited partners (LPs) private market strategies. A new interest rate regime will recalibrate the required returns for risk assets, specifically challenging traditional leveraged buyout (LBO) models that face the highest capital costs in over a decade.
Further, with uncertainty around the recovery of the exit environment and tight credit conditions, the pace of new commitments across private market asset classes will likely continue to experience headwinds. These factors, coupled with the Federal Reserve’s ongoing inflation measures, massive excitement and adoption of AI, and geopolitical unrest, contribute additional themes to allocators’ playbooks in the new year.
In a tighter exit environment and uncertain market landscape, the liquidity options, blind pool risk mitigation, and J-curve benefits the secondaries asset class offers become highly attractive to LPs seeking to increase or maintain their private market allocations with less risk and more liquidity. In the first nine months of 2023, secondaries funds raised a record $68.1 billion across 39 vehicles, outpacing all previous years except 2020.
With almost 60% of LPs eyeing commitments to secondary funds next year, the asset class continues to hold an important corner in allocator’s portfolios. While the secondaries market will likely experience robust demand into the new year, these assets can add complexity to a portfolio, requiring investors to build effective data management strategies, deploy new technology, and consider new reporting workflows.
Source: Pitchbook – Global Private Market Fundraising Report Q3 2023*Note: 2023 data only through Q3
The number of private market funds in the market has experienced a notable decline, dropping roughly 50% year over year in the second quarter of 2023, signaling a flight to quality. LPs are directing their capital commitments to a smaller set of private equity fund managers, with many conducting more thorough portfolio evaluations and selectively re-upping with managers they believe can deliver superior performance.
With less than 50% of allocators planning to increase their general partner (GP) relationships in 2024, private equity firms nurturing their LP relationships via top-tier reporting, communication, and analysis capabilities can gain a competitive edge. Further, emerging managers must demonstrate exceptional institutional readiness and operational proficiency to attract LP capital.
Leveraged buyouts are undergoing a significant shift in today’s high interest rate environment. Debt has become more expensive, leading to a record high average yield of 11% on loans to companies acquired by private equity firms during Q3. As a result, buyout investors are contributing more equity from their own funds than ever before. This year, equity contributions have averaged around 51%, crossing the 50% threshold for the first time since 1997 and marking a significant departure from the 41% average experienced over the past decade.
Despite equity contributions driving the debt-to-earnings ratio to a 13-year low, rising debt costs mean interest payments consume a larger slice of earnings. This exerts considerable pressure on the cash flows of companies involved in leveraged buyouts, particularly those with high debt-to-equity ratios. As a result, buyout managers must concentrate on driving revenue growth and enhancing operational efficiency as key levers for generating returns and outperformance.
Further, in this environment, LPs need to have an effective system in place to accurately assess the extent and distribution of leverage within their portfolios to better understand their managers’ ability to navigate a high interest rate environment.
In recent years, negotiations over fund terms have emerged as an increasingly important issue between LPs and GPs. According to PEI, unsatisfactory or lack of key man clauses remains the biggest point of disagreement going into 2024, reflecting an ongoing trend of LPs pushing for protection of their commitments. Management fees and carry structures also continue to be top of mind for allocators, especially as fund sizes continue to grow.
While fund terms have historically been GP-friendly in private equity and venture capital markets — especially for experienced managers — LPs have started to gain the upper hand in negotiations over fund terms in recent months. As many GPs feel the pressures of a tighter fundraising environment, conceding to LPs’ fund term requests has and will likely continue to offer a valuable strategy for securing new commitments.
With market conditions poised to affect the return profiles of private market asset classes, co-investment opportunities offer LPs an avenue for enhancing returns and reducing management and carry fees — roughly two-thirds of LPs say they are open to co-investment opportunities in 2024.
By securing direct positions on a portfolio company’s cap table, LPs often acquire larger stakes than possible through their fund investments, opening the door to increased profit shares. However, this heightened potential for returns comes with greater risks. Co-investments typically lead to more intricate portfolios, as LPs must navigate the complexities of managing specific company exposures and assets, a task that becomes even more challenging in growth and venture sectors where many funds invest in the same businesses.
This complexity demands efficient systems for aggregating exposures across all funds, and ultimately, LPs equipped with advanced technology are best positioned to effectively manage these risks and capitalize on co-investment opportunities.
As LPs prepare for the challenges of the coming year, effective portfolio monitoring becomes paramount for understanding value creation drivers, identifying exposures, and making agile investment decisions. Learn more about Chronograph LP here.
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