WTT: Can Private Markets Normalize?

(upbeat music) In this What's Ted's thinking, can private markets normalize? I post a question of whether private equity will ever be able to recycle capital fast enough to support successive fund raises without strain. The answer I'm afraid is no. In a world dominated by short-termism, does it seem odd that private equity holding periods are getting longer? Public market investors trade faster than ever and social media dopamine hits are relentless. Yet private equity portfolio companies are now held for more than six years on average. Private equity professionals don't have different genes than other investors, they face a structural problem. Too many portfolio companies cannot find a buyer. A year ago, I asked the question, when will private markets normalize? At the time, I argued that expectations for a surge of capital returning from private equity exits were premature. That assessment proved correct. While exit activity increased, it remains far below what would be required for private markets to recycle capital fast enough to support successive fund raises without strain. I've continued to think about weather normalization as possible this year. Once again, the answer is no, not yet. I'm starting to wonder if the answer is no, not ever. Viewing private equity through a supply and demand lens helps explain why. On the purchase side, growth remains robust. On the exit side, supply overwhelms demand. Supply and demand for purchases. Over the past decade, the total unrealized value held by global private equity funds has tripled, rising from approximately 1.1 trillion to 3.2 trillion. For this to happen, private equity markets had to expand on both the capital and opportunity fronts. Demand for private equity has searched as institutional allocations arose, motivated by a long history of strong returns. In addition to tripling deployed capital, private equity firms now sit on another 1.2 trillion dollars in dry powder. Looking ahead, further growth in demand seems likely. Pools of capital that are under allocated to private markets, most notably private wealth, insurance companies and sovereign wealth funds, are continuing to increase exposure, supporting ongoing purchase activity. The supply of companies willing to sell to private equity is also substantial. In the US alone, roughly 87% of businesses with more than $100 million in revenue are privately owned, representing more than 19,000 companies. This universe of potential targets provides abundant raw material for private equity firms to own many more businesses. Both demand for private equity exposure and the supply of acquisition opportunities are well-positioned for growth. Supply and demand for exits. Exit activity tells a different story. While investors have a strong desire to exit portfolio companies, buyer demand has not kept pace. The private equity business model relies on finite life funds with successively larger ventages. LPs have limits on the capital they can deploy. When capital is tied up in existing funds, it constrains commitments to future ones. This dynamic explains the industry's push towards new pools of capital, private wealth in particular. The math of capital recycling can be complex, but the conclusion is straightforward. Everyone wants exit activity to accelerate. The bottleneck lies on the demand side, the buyers of private equity back businesses. Private equity exits investments through three primary channels. Sponsor-disponsor transactions, IPOs, and sales to strategic buyers. Sponsor-disponsor activity should pick up this year. The industry has endured a prolonged bid-ask spread as rising interest rates made sellers reluctant to accept lower prices while buyers waited for exceptional deals. After several years of strong economic performance, operating results have allowed values to grow into prior marks, narrowing the spread, and enabling more transactions. The IPO market remains unattractive for most private companies. Being the CEO of a public company once carried aspirational status. Today, most CEOs prefer to stay private. With abundant private capital and fewer perceived benefits to being public, IPOs have lost much of their appeal. Absent meaningful regulatory reform, it's difficult to imagine a wave of private equity backed IPOs large enough to materially improve exit volumes. The most underappreciated bottleneck lies with strategic buyers. According to Baining Company, strategics historically accounted for 60% of private equity exits. Yet, while private equity purchase activity tripled over the last decade, strategic acquisitions remain roughly flat. Whether measured by transaction count of about 700 a year or dollar volume, $250 to $300 billion a year, strategic demand has not kept pace with the growing supply of private equity owned businesses. As a result, private equity currently holds 29,000 unsold companies representing $3.6 trillion in unrealized value. Many withholding periods exceeding five years. Implications for the industry. Private equity owned businesses continue to grow in number and size, but demand from IPOs and strategics has not and likely will not keep up. This means that more companies will have to remain within the private equity ecosystem. The end of the private equity bottleneck is not insight. Instead, the industry may be heading toward structural change, including the following. One, changes in fund structure. Finite life funds are poorly suited to an environment where exits outside the private equity ecosystem are limited. Liquidity solutions, such as secondaries and continuation vehicles, will grow, but they do not solve the fundamental shortage of external exit demand. Two, changes in LP portfolio construction. Based with longer holding periods, LP will reduce commitments and rethink portfolio strategy. Topics I explored in reconstructing private equity portfolio construction for the post-distribution drought and private equity investing in 2030 last year. Three, changes in GP fortunes. The ecosystem cannot support the thousands of funds operating today. Winners and losers are already emerging. The top 10 funds captured 36% of all capital raised in recent years, while more than one third of funds that do close are on the road for two years or longer. A shakeout appears inevitable. And four, changes in LP/GP relationships. Although many GPs face a business problem, most LP's do not. Unlike after the GFC, LP's are not materially overextended in private. However, alignment erodes when a GP becomes a zombie. The problem of undermanaged or unmanaged assets will grow. I can't recall a time when the range of potential outcomes for the private equity industry was wider. One thing is certain. Without a dramatic and sustained increase in exit demand from IPOs or strategic acquires, normalization will remain elusive and change is coming. Thanks for listening to the show. If you like what you heard, hop on our website at capitalislecators.com, where you can access past shows, join our mailing list, and sign up for premium content. Have a good one, and see you next time.