Think at London Business School
We take an in-depth look at the largest financial sector most people have never heard of – and unpick the highlights for this year's event
By Dan Atkinson
This year's Private Capital Symposium at London Business School welcomed over 200 attendees to discuss market trends and technological developments in private markets that will shape the future funding and investing of organisations.
Capital is shifting from the public markets to the private markets. Private markets, mainly including private debt and private equity funds, are already bigger than the U.S. corporate bond market. Over the past ten years they have grown about five times as fast as the global fixed income and equity markets. Indeed, by 2022 quarterly private market capital raised exceeded syndicated bank lending by a factor of more than three, to reach $250 billion.
But – and it’s a big but – global equity and investment grade debt markets still continue to dwarf private markets. Worldwide private capital assets under management are around 6% of public equity and IG debt.
For investors in private debt funds, the internal rate of return has been seen to outperform both investment grade and high yield bonds.
The IRR metric – often seen as an unreliable and easily manipulated measure of fund performance – as well as the more straightforward multiple of money deployed is an important indicator of performance for investors looking for an alternative to public markets.
Borrowers often have their own reasons to turn to direct lenders or “non-banks.”
Banks have become more reluctant to lend as they have come under increasing regulatory pressure, and as their interest margins have been squeezed. They are also slower to make decisions and tend to be less flexible and innovative than private market lenders.
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'The big direct lenders have the scale and manpower to assess risk and perform due diligence'
Pascal Böni, Professor of Practice at Tilburg University, joined Ares Credit Group’s Jacobson and Alon Avner, Europe head of Bain Capital Credit, to discuss developments in the private debt markets. Böni explained that direct lenders are often able to provide capital solutions to less profitable and highly leveraged borrowers that would find it difficult to tap into traditional bank finance, thus expanding the “credit space” beyond its previous reach.
Firms with lower or sometimes negative Ebitda or high debt to Ebitda ratios are more likely to borrow from non-banks – but they will pay significantly higher interest rates. Moreover, even profitable borrowers will likely face different “non-price” terms, such as covenants, compared with the terms available from banks.
This translates as a very interesting asset for investors, since the risk-adjusted returns are attractive.
The big direct lenders have the scale and manpower to assess risk and perform due diligence on a potential private company borrower quickly and thoroughly, but also have a responsibility to their investors not to lend rashly or without protections.
Unlike banks, the source of their funds is not savers’ deposits and the bond markets. Instead, they are funded by their limited partners.
Institutional investors are increasing their allocations to private markets, as returns have outpaced those on the public markets. These allocations have doubled over the past ten years and are expected to double again over the next ten years.
However, these capital inflows will be concentrated in fewer funds, both in the direct lending and private equity spaces, as LPs continue to consolidate their GP relationships. That means the biggest, and top performing, fund managers will attract most of the money.
In 2022, 57% of all capital raised in the market was concentrated in the hands of GPs managing funds of $5 billion or more. This is seen as a flight to quality, as investors prefer to go with the managers that have proved themselves over previous funds.
But the scale of funds pouring into the market, not just from big institutional investors and sovereign wealth funds, but also increasingly from family offices and high net worth individuals, will likely mean that there will also be room for investment in different kinds of managers. Provided there is a record of top performance, even smaller or high-conviction, niche-sector fund managers, perhaps including those with a geographical focus, will still attract funds.
There has been a slowdown in fund-raising since the second half of last year, affecting both the amounts raised and the speed with which GPs return to market to raise a new fund. But several speakers pointed out that, historically, funds raised in tough markets later prove to be some of the best vintages.
Private equity investing has long been considered the preserve of institutional investors, such as pension funds, insurance companies or sovereign wealth funds, with large sums to deploy and able to put money aside for ten years or more.
But figures from consultancy Bain & Co. show that individual investors, mainly ultra-high net worth individuals and family offices, hold roughly half of all global wealth. While family offices are a growing investor segment (see below), individuals with less than $30 million to deploy, (including the “mass affluent,” with less than $1 million to invest), are a tiny portion of the market. With a few exceptions, such as U.K.-style listed investment trusts, private equity is not set up to attract the individual investor and has generally regarded retail investors as too costly to pursue.
That is beginning to change. Hg Capital Trust chairman and London Business School Executive Fellow Jim Strang moderated a discussion on democratising private equity investments with three high-profile panellists, Jeroen Afink of Truffle Private Markets, Sanjay Gupta of Moonfare and Edward Talmor-Gera of NewVest. They agreed that, increasingly, either directly or through third party advisers, fund managers are looking to attract a wider range of high net worth individuals and small-scale retail investors.
Technology is essential to the task, as managers build on the growing range of online platforms that make it easier for the individual to take control of their own money. Gupta said private markets should form an integral part of every investor’s portfolio. That portfolio should be customisable and could include private equity, growth equity, real estate or any other private market segment. Such an approach could involve direct communication between the provider and the investor or could go through intermediaries such as an adviser of broker. Eventually, individuals could be investing and customising their own portfolios using a simple app on their phones.
Talmor-Gera said individuals should initially invest in a private-markets version of an exchange traded fund, that would aggregate different alternatives onto a single platform. That could then be combined with more sophisticated add-ons in a so-called bar-bell approach as the individual investor became more experienced over time.
The old adage runs that if you know one family office, you only know one family office. In other words, no two family offices are the same, whether in risk profile, investment aims, maturity phase or expertise. Some may be investing on behalf of one family alone, while others may be serving several family groups. And no matter how experienced you may be, you’ll still have to take each family office on its own terms
'The real profits are to be achieved by driving growth: professionalising management, improving workplace culture, investing in new products and more efficient processes'
But, as panellists Herbert “Bud” Scruggs of Cynosure Capital, Benedetta Balducci of Federated Hermes GPE and Merifin Capital’s Heidempergher told Florin Vasvari, Professor of Accounting and Academic Director of the London Business School’s Institute of Entrepreneurship and Private Capital, family offices are becoming an increasingly more important source of investment for all forms of risk capital funding, from classic buyout funds, to private debt funds, real estate and venture.
Recent Goldman Sachs figures show that family offices have on average a 44% allocation to alternative assets, of which 26% are for private equity. That’s far higher than institutional investors, and almost in line with their allocation to public market equities (28%).
There are thousands of family offices globally. Estimates vary, depending on how they are counted, but family offices are said to manage anywhere between $6 trillion and $10 trillion. For comparison, the total global assets under management of private capital markets, mainly including PE funds, debt funds, infrastructure funds and real estate funds, is around $11.6 trillion.
Balducci talked of a virtuous circle, where, as family offices become more comfortable with private equity, private equity is learning to become more comfortable with them. This can mean that if the two work together well over one investment, they are likely to want to work together again in future, not only across new deployment opportunities, but also via higher allocations as LPs of this asset class. Their allocation to PE is however different from that of large and more traditional institutional investors, in terms of higher risk appetite and more significant demand for diversification, as well as a more entrepreneurial approach to investing and appreciation for a quicker deployment pace.
Private equity firms say the days are long gone when the industry could make huge returns by financial engineering alone - or by leveraging up, breaking up, slashing costs and selling off non-core businesses. While all those techniques are still part of the toolbox, the real profits are to be achieved by driving growth: professionalising management, improving workplace culture, investing in new products and more efficient processes, expanding into new markets and geographies and, above all, through digitalization.
Carmen Alonso, head of U.K. and Iberia for Tikehau Capital, for example, pointed to the opportunities for growth presented by three current trends: reducing carbon emissions, improving cybersecurity and digitalization and what she called “re-onshoring.” Alonso was in discussion with LBS Associate Professor of Management Practice and IEPC Academic Director Luisa Alemany. She said Tikehau is supporting companies that are looking to secure and to decarbonize their supply chains by bringing back to Europe the production and technologies they had previously found cheaper to produce in China or elsewhere.
Such trends are seen as in the interests not only of investors, but of all other stakeholders as well.
Increasingly this means a focus on Environmental, Social and Governance (ESG) issues, not least because GPs’ own investors insist on it. PE managers and venture investors alike say they will work with management at their portfolio companies to meet ESG targets they believe will add value. Even direct lenders, whose main focus is inevitably on financial returns, often find themselves under pressure from their own limited partners to include ESG terms and provisions in their lending conditions. Some will offer borrowers lower interest rates if they commit to measurable improvements.
Venture capital firms raised a total of $27.5 billion in the first quarter of 2023, according to the latest figures from alternative assets database Preqin, down 67% from the same quarter in 2022. It was certainly a dramatic fall. But Shmuel Chafets, founding partner of Target Global, told a panel on opportunities and challenges to VCs in a tough climate that to judge the state of the industry on the basis of just one year in a ten-year cycle was just “wrong, wrong, wrong.”
The market would normalise over time, as the market gradually re-priced and stabilised and VCs and founders eventually learned to take the hard decisions, cutting their losses and letting companies fail.
Chafets and fellow panellists Megumi Ikeda, managing director at Hearst Ventures, and Octopus Ventures’ Maria Rotilu, were in discussion with the IEPC’s Luisa Alemany. All noted the very different dynamics that were emerging today in contrast to the “crazy” months of 2021 and 2022, when money was pouring in not only from established professional VCs, but also from so-called “tourists”. These opportunist investors thought they could outsmart the market, often coming in on excessively founder-friendly terms with no real safeguards and without demanding seats on the board. They were now pulling back.
The panel said there was a flight to quality, a “bifurcated market,” where VCs might still make a conviction investment in a perceived winner but would not pour money into every new business for fear of missing out to a competitor. Investors were now able to take a lot more time to decide. Meanwhile, with such uncertainty over valuation, some VCs were working with founders on internal rounds, raising money from existing investors, rather than going out to market for the next institutional round.
Rotilu, as a very early-stage investor, said she saw slowdown as an opportunity to build businesses, working with founders to solve problems and to get incentives and rewards in place before they become too big. While many would fail, there would be a few winners.
The conference heard from Deep Shah, of technology focused private equity firm Francisco Partners, who pointed out that previous big advances over the past two decades had been accompanied by huge rallies in technology stocks amid excitement about how the new development will disrupt other sectors of the economy. With AI, however, the focus was on the impact on technology itself. And it had come at a time of a big correction in tech stocks.
Nevertheless, over the longer term, technology values would continue to grow faster than overall GDP.
Falling valuations also made investment in quality companies more attractive. There were great opportunities for investment in fallen unicorns. Improving the efficiency of under-managed and often mismanaged companies with the right products provided opportunities for good returns.
Shah saw a number of key investment opportunities: getting involved in succession processes where a founder was looking for a good home for his company; and investing in corporate carve-outs and add-on acquisitions. Take privates were also looking more attractive, now that valuations were becoming more realistic.
Business plans would likely include investment in the sales force, reducing costs, seeking suitable add-on acquisitions, and, increasingly, the application of AI to improving efficiency.
The venture capital industry started out in the U.S. Despite a long period of low activity and hesitancy following the dot.com crash and the great financial crisis, it has now taken root in Europe. Elsewhere in the world, development has been slower.
The conference heard that in Africa in particular – with its four main markets of South Africa, Nigeria, Kenya and Egypt – venture and growth capital have been relatively late to take off, but that interest has grown in the last five or six years. There has been a lot of investment in improving productivity. Growth capital has tended to come from U.S. investors while early-stage funding is more local, often from development finance institutions as well as domestic GPs and managers, so that the industry has seen a mix of financial sources.
It is easy for outsiders to make the mistake of imagining Africa as one big market. In fact, said Gbenga Ajayi, Africa partner at QED Investors, there are 53 countries in Africa (or 54, depending on who you ask). They are at very different stages of economic and political development and with vastly different cultures. The conference was told that start-ups tend to focus first on their domestic market. Only once they grow do they start looking at possible regional expansion – though not pan-African.
Meanwhile the MENA region, while largely sharing Arabic as its official language, still covers huge disparities of wealth, economic development and population density.
Khwarizmi Ventures managing partner Abdulaziz Al-Turki pointed out that while North Africa and Jordan largely rely on foreign investors, the venture is quite new in the six countries of the Gulf Cooperation Council and began with injections of government cash. As recently as 2019 some 60% to 70% came from government backed funds. But recently this has shifted with the sector becoming much more attractive to family offices, HNWIs and some foreign investors. The government funds now account for about 20%.
'When times are tough, the alternative investments industry gets going, tapping into new or expanding sources of capital'
Al-Turki said the region’s relative resilience in the face of the economic downturn was attracting additional investment from both international and local players.
Japan, meanwhile, is known for its large corporations producing advanced technologies, but less so for its venture sector and small startups.
The third speaker on the panel was Aizawa Asset Management CEO Shinichiro Shiraki, representing the conference sponsor, the 336-member Japan Venture Capital Association as well as his own company. His membership included 143 venture capital firms, 114 corporate venture investors and the rest were “supporting members.” Altogether in 2022 the sector saw 2,224 deals with a record total value of $7.3 billion. Some 145 funds raised ¥616 billion (about $4.5 billion) of new money, but Shiraki’s presentation showed Japanese venture funds are struggling to scale up due to a lack of progress in attracting capital from institutional and foreign investors.
Shiraki, who was in London with a number of JVCA members, said his goal was to attract interest in the Japanese venture sector. He said the JVCA was there to provide solutions to overcome the language barrier and facilitate contact with previously domestically focused firms. Potential investors could turn to his association for support.
The final speaker of the day was Niels Nielsen, the founding partner of deep tech fund 2xN and former chairman of Cambridge Quantum Computing.
Nielsen said he’d decided in 2016 that quantum was no longer science fiction when he learned that China had launched the first quantum communications satellite.
He explained that quantum computing will perform tasks in minutes that would take millions of years on a classical computer. While the technology is still at a very early stage, it is expected to be important but also disruptive across a range of sectors from pharmaceuticals to financial services and from material design to cyber security.
Intriguingly, considering the hype around generative AI at the moment, Nielsen predicted that quantum computing and artificial intelligence will eventually merge and that “there will be no true AI without quantum.”
But quantum will not directly replace generative AI or be available as a standalone consumer electronics device. It will be the platform that ChatGPT and the like work on, although the consumer will not know the difference.
Nor, Nielsen added, will it replace blockchain technology, as the encryption that underlies blockchain can work along with quantum computing.
Already companies with deep pockets are investing billions - $2.2 billion was invested privately in quantum technology in 2022 alone. Europe has the talent but lags the U.S. in private funding.
Governments, which recognize the potential importance of AI and quantum for national security, are also providing public funding on a vast scale. China, which also owns half of all quantum patents worldwide, leads the pack with $15.3 billion of public funding to date. It is followed by the European Union with $8.4 billion, the U.S. at $3.7 billion and the U.K. at $2.5 billion. NATO too is planning a $1 billion technology fund, a lot of which will go towards quantum.
Once again, the IEPC’s Private Capital Symposium has shown the ingenuity and resilience of the private markets. When times are tough, the alternative investments industry gets going, tapping into new or expanding sources of capital – be they family offices or private credit funds – and taking a step back from the crazy deal making of the last two years. GPs are returning to a more considered approach to investing. Deal terms are getting tougher, and there is a flight to quality among venture and private equity investors alike. There are growing opportunities in emerging markets and, in the case of Japan -- home to our generous sponsor, the Japan Venture Capital Association – in a developed country previously not explored by international venture capital investors.
For more information, resources and to register your interest for next year’s event please visit our event webpage.
Think at London Business School
We take an in-depth look at the largest financial sector most people have never heard of – and unpick the highlights for this year's event
By Dan Atkinson