No. We argue that after macro conditions helped propel the private investment industry to temporary heights, today’s environment has ushered in a “back to normal” era.
For more on this topic, please see Andrea Auerbach, “CA Answers: Are Venture Returns About to Cycle?” Cambridge Associates LLC, May 25, 2022.
Let’s back up a bit. In the COVID-19 period (defined as July 2020 through June 2022), all facets of the US private investment “ecosystem” were in overdrive. During that two-year period, US buyout, growth equity, and venture capital funds raised $1.0 trillion, while $1.6 trillion was invested in US-based private equity and venture capital companies. The healthy, but not quite record-breaking, fundraising was driven in part by private investments’ strong, but largely unrealized, headline performance, and further supported by the more than $550 billion of limited partner distributions over the period. Notably, two-thirds of the distributions were received in calendar year 2021, twice the annual average since 2012. Overdrive, indeed.
Post-COVID, driven by geopolitical stress, high inflation, rising interest rates, and as of late, bank failures, the private investment asset classes are now in a shoulder season. Following a quick and dramatic reaction in the public markets in mid-2022, private market activity began to moderate, and valuations started to reset. In 2023, the environment has cooled down further. Transaction volumes have halved, fundraising activity is down, distributions have slowed, and returns are falling on the back of declining valuations. Recent vintage year pooled returns for US private equity and venture capital funds have already dropped by an average of 1,600 basis points (bps) and 2,000 bps, respectively, over the last nine months alone. Funds raised since 2017 likely have material exposure to investments made at the height of the COVID-19 period, when valuations were peaking. While these vintages have years to go before performance is final and might ultimately be positive contributors to a program, this degree of return contraction portends a long road ahead for many COVID-era private investments.
The private investment industry is returning to basics, incorporating the now-known unknowns and macroeconomic information into asset selection, underwriting, and valuation. Dry powder is no longer considered easily replaced and thus is being husbanded accordingly. From a private equity perspective, the prevailing (COVID-era) “growth at any price” approach has been replaced by one focused on profitable growth, with value creation plans grounded in fundamentals. Venture capitalists—plagued by public tech sector woes and now a banking crisis—are waving goodbye to tourist investors who were dominating investment activity during COVID-19 and focusing on shepherding their portfolio companies to the other side of this moment intact. Valuations across the asset classes are coming back down toward long-term averages and expectations.
Once low interest rates are stripped away and return enhancers (such as commitment and net asset value loan facilities) are removed, the task of generating an authentic private equity or venture capital return falls to those who can successfully help deliver strong operating performance for their portfolio companies and then profitably harvest them. While the industry has returned to a focus on fundamentals, the constantly evolving nature of private investing requires managers to seek ways to improve their approach to value creation to be better positioned to earn a competitive return for investors in the future. This “next generation toolkit” often includes enhancing asset identification and selection, increasing focus on key strategies or sectors, building specific and scalable operational capabilities, incorporating diverse perspectives for better decisions, and seeking appropriate capital structures. Managers that have been resting on their laurels may not be ready for current market conditions; choose your partners wisely.
Andrea Auerbach
Global Head of Private Investments