Private markets rebounded in 2020 after a turbulent first half, but performance varied by investment type. Meanwhile, diversity and new ways of working are central to a changing business environment.
A year of disruption in the private markets: McKinsey Global Private Markets Review 2021
The year 2020 was turbulent for private markets, as it was for much of the world. We typically assess meaningful change in the industry over years or decades, but the COVID-19 pandemic and other events spurred reassessment on a quarterly or even monthly basis. Following a second-quarter “COVID correction” comparable to that seen in public markets, private markets have since experienced their own version of a K-shaped recovery: a vigorous rebound in private equity contrasting with malaise in real estate; a tailwind for private credit but a headwind for natural resources and infrastructure. The year also saw a deeper focus for private markets firms on their people, the set of factors they consider when investing, and the ways they work.
Private equity (PE) continues to perform well, outpacing other private markets asset classes and most measures of comparable public market performance. The strength and speed of the rebound suggest resilience and continued momentum as investors increasingly look to private markets for higher potential returns in a sustained low-yield environment (Exhibit 1). The most in-depth research continues to affirm that, by nearly any measure, private equity outperforms public market equivalents (with net global returns of over 14 percent). We highlight several trends in particular:
- PE investors appear to have a stronger risk appetite than they did a decade ago. During the global financial crisis (GFC) in 2008, many limited partners (LPs) pulled back from private asset classes and ended up missing out on much of the recovery. This time, most LPs seem to have learned from history, as investor appetite for PE appears relatively undiminished following the turbulence of the last year.
- All things considered, it was a relatively strong year for PE fundraising. Overall funds raised declined year on year due to an apparent short-term discontinuity in the early months of the pandemic, but the prepandemic pace of fundraising returned by the fourth quarter (Exhibit 2). Growth in assets under management (AUM) and investment performance in most asset classes eased off in the spring, as the industry adjusted to new working norms, then came back strong in the latter half of the year. Venture capital (VC) bucked the broader trend with strong growth, driven by outsize interest in tech and healthcare.
- In PE, fundraising growth of successor funds strongly correlates with performance of the preceding fund at the time of fundraising launch. This is an intuitive pattern, now backed up by data. But another bit of conventional wisdom among LPs—that growth in fund size risks degrading performance—turns out not to hold up under analysis. Growth in fund size seems to have little correlation with performance.
- Private equity purchase multiples (alongside price-to-earnings multiples in the public markets) have kept climbing and are now higher than pre-GFC levels. In parallel, dry powder reached another new high, while debt grew cheaper and leverage increased—factors providing upward support for PE deal activity. Few transactions were completed in the depths of the (brief) slide in the public markets, reminding many in the industry that “waiting for a buying opportunity” may entail a lot more waiting than buying.
- Fundraising for private equity secondaries flourished in 2020, tripling on the back of strong outperformance in recent years (Exhibit 3). The space remains fairly concentrated among a handful of large firms, with the largest fund sizes now rivaling buyout megafunds. Continued evolution in secondaries may be key to making private markets more accessible to a broader range of investors.
- The phrase “permanent capital”—like “private equity” itself—means different things to different people. To some, it refers to general partners’ (GPs) sale of a stake in the firm, either directly to an investor, or via a fund-of-funds stake, or via IPO. Others interpret the term to allude to LP fund commitments of longer-than-normal or even indefinite duration. Many now also use the term to connote GPs’ acquisition of insurance companies with balance sheets that may be investible at least partly in the GPs’ offerings. In all of these forms, permanent capital has accelerated as private markets firms continue to diversify their sources of capital away from traditional third-party blind-pool fundraising.
- Another form of permanent capital, special-purpose acquisition companies (SPACs), boomed in 2020. Enthusiasm for the tech, healthcare, and clean-energy sectors propelled a huge surge of SPAC deals. Private markets firms dove in, both as deal sponsors and as sellers. SPAC activity has continued into 2021, as many investors remain optimistic that this third wave of SPACs will prove more durable than those in prior market cycles.
Real estate was hit hard by the pandemic, though the degree of recovery within the asset class remains unclear as the public-health crisis continues. Fundraising and deal making fell sharply, as owners avoided selling at newly depressed (and uncertain) prices. Rapid changes in how the world lives, works, plays, and shops affected all real estate asset classes. Office and retail saw the most pronounced changes—some of which seem likely to endure—which are causing investors and owners to rethink valuation and value-creation strategies alike.
- The success of the unplanned transition to remote workplaces surprised employers and initiated a review of both their footprints and their in-office experiences. Office values fell on the expectation of lower demand, forcing investors to contemplate the office of the future as they rethink their investment approaches.
- A rapid shift to omnichannel shopping impaired retail real estate valuations, particularly for shopping malls. The industrial sector proved less vulnerable, benefiting from a surge in demand for direct-to-consumer fulfillment.
Private debt was a relative bright spot in 2020, with fundraising declining just 7 percent from 2019 (and North America fundraising increasing 16 percent). The resilience of the asset class owes to a perfect storm of long-term growth drivers (for example, low-yielding traditional fixed income) that were complemented in 2020 by renewed investor interest in distressed and special situations strategies. The asset class is likely to continue growing into 2021, entering the year with a record fundraising pipeline.
Natural resources and infrastructure had a challenging year, with lackluster investment performance and further declines in fundraising. Energy transition remains the main story, as depressed demand for conventional energy increasingly contrasts with growing interest in renewables.
Change is more than just numbers. In some respects, the PE industry in early 2021 strongly resembles the picture a year earlier: robust fundraising, rising deal volume, elevated multiples. But for the institutions that populate the industry, transformation has come faster than ever, accelerating old trends and spawning new ones. We consider three notable vectors of change for GPs and LPs over the past year:
- Who they are. Diversity, equity, and inclusion (DE&I) made strides in private markets in 2020—in focus if not yet in fact—with consensus rapidly building on the need for greater attention and action. On the whole, gender and racial diversity at PE firms are stronger in entry-level positions than at the top (Exhibit 4). Both GPs and LPs are beginning to be more purposeful in identifying and tracking DE&I metrics, both within their own ranks and in their portfolio companies. Change is afoot.
- What they consider. At the same time, more GPs and in particular LPs are now tracking environmental, social, and governance (ESG) metrics in earnest. Some—a small but growing minority—have begun to use these “nonfinancial” indicators in their investment decision making. Whether this trend ultimately proves a boon for investment value (in addition to investors’ values) remains to be seen, but one thing is becoming clear: our research increasingly suggests that the individual companies that improve on ESG factors also tend to be the ones that improve most on total return to shareholders. That, plus growing pressure from customers and shareholders alike, suggests that more focus here is likely.
- How they work. Remote interactions have proven more effective for raising funds and making deals than many in the industry expected. Faced with this involuntary proof point, reasonable minds differ on the extent to which GPs and LPs will return to business as used to be usual. It seems likely that norm-defying decisions in pre-COVID-19 times—for example, the online annual meeting or the deal team that signs a term sheet before meeting management—may henceforth just be run-of-the-mill process options.
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After ten years of dynamic growth, private markets settle in for the next decade.
Welcome to the 2020 edition of McKinsey’s annual review of private investing. Our ongoing research on the industry’s dynamics and performance has revealed several critical insights, including the following trends.
Private markets complete an impressive decade of growth. Private market assets under management (AUM) grew by 10 percent in 2019, and $4 trillion in the past decade, an increase of 170 percent (Exhibit 1), while the number of active private equity (PE) firms has more than doubled and the number of US sponsor-backed companies has increased by 60 percent. Over that same period, global public market AUM has grown by roughly 100 percent, while the number of US publicly traded companies has stayed roughly flat (but is down nearly 40 percent since 2000).
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The fundraising outlook remains favorable. The early prognosis for 2020 is for continued strength: by the end of 2019, large firms had announced targets collectively approaching $350 billion, more than at year-end 2018. Further, limited partners (LPs) continue to raise their target allocations to private markets. Even at current levels, LPs appear to be under-allocated versus target levels by more than $500 billion in PE alone—as much as the global amount raised for PE in 2019.
Industry performance has been strong, but manager selection remains paramount. PE outperformed its public market equivalents (PME) by most measures over the past decade. Variability in performance remains substantial, however (Exhibit 2). So, the challenge—and the potential—of manager selection remains paramount for institutional investors. Although persistency of outperformance by PE firms has declined over time, making it harder to predict winners consistently, new academic research suggests that greater persistency may be found at the level of individual deal partners. In buyouts, the deal decision maker is about four times as predictive as the PE firm in explaining differences in performance. This finding is intuitive to many in the industry but remains tough for many LPs to act on.
The more things change.... The shape of the industry has evolved as it has grown: buyout’s share of PE AUM dropped by a third in the past decade, while venture capital (VC) and growth have taken off, led by Asian funds. Today, Asia accounts for more than twice as much growth capital as North America does, and about the same amount of VC.
... the more they stay the same. Megafunds of $5 billion or more increasingly dominate buyout fundraising, making up more than half of the total in 2019. The share of funds below $1 billion has fallen to a 15-year low. Yet paradoxically there is little evidence of any consolidation at the top of the industry. And even as the number of active PE firms continues to grow (it’s now nearly 7,000), more managers are calling it quits than ever. Most of those raised just one fund, suggesting that attrition is mainly a result of one-and-done managers.
Technology in every sector. Deal volume declined in every region except North America, where the amount of capital invested rose 7 percent to $837 billion, a new high. Tech deals, up almost 40 percent, powered this growth. In parallel, the number of tech-focused private market firms has grown rapidly, while many others have tilted in that direction. Increasingly, we see general partners (GPs) that once had a technology “vertical” team now starting to view technology as a horizontal theme cutting across many of their deals.
Signs of a peak? US buyout multiples climbed yet again in 2019, continuing a decade-long trend, to reach nearly 12x. Leverage surpassed levels last seen in 2007. Dry powder rose further due to record fundraising and stagnant deal volume. It now stands at a record $2.3 trillion (Exhibit 3). PE accounts for most of this total, though PE dry powder is still less than two “turns” of annual deal volume, within the range of historical norms.
The industry finds new opportunities in ESG. Public interest and LP pressure to take environmental, social, and governance (ESG) factors into account in investing have soared, prompting greater transparency on ESG policies and performance as well as a rise in dedicated “impact funds.” Nine of the ten largest GPs now publish annual sustainability reports. Perhaps more significant, our survey data show a clear uptick in the value that managers attribute to ESG—in other words, they increasingly find that these factors are positive (or neutral at worst) in achieving strong performance. Still, the private markets are only in the early stages of materially incorporating ESG factors into investment and portfolio management processes.
Diversity remains a challenge. Private market firms have made only limited progress in improving diversity and inclusion. Women represent just 20 percent of employees across the private markets and less than 10 percent in investment team leadership positions. The industry’s performance on other forms of diversity is also poor—recent McKinsey survey data places combined black and Hispanic/Latino PE representation at just 13 percent for entry-level positions and less than 5 percent for senior roles. Private markets firms may be missing an opportunity: increasing evidence shows that greater representation may meaningfully enhance performance.
Many firms are thinking about how to digitize the investment process—and a handful are moving ahead. The largest GPs have taken the lead, especially in sectors such as real estate where investors can draw upon larger, more accurate data sets. In these areas, machine-learning algorithms using a combination of traditional and nontraditional data have demonstrated the ability to estimate target variables (such as rents) with accuracies that can exceed 90 percent.
Many firms have predicted a downturn, but fairly few have adapted their operating model to prepare. New McKinsey research shows that while most fund managers consider cyclical risk as part of their due diligence and portfolio management processes, only a third have adjusted their portfolio strategy to prepare for a potential recession. GPs can take several steps to build resiliency and improve performance through a downturn. One example: GPs with dedicated value creation teams outperformed those without them by an average of five percentage points during the latest recession.
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McKinsey’s annual review reveals an expanding and developing industry.
Private markets stayed strong in 2018. True, fundraising was down 11 percent. But $778 billion of new capital flowed in. Investors have a new motivation to allocate to private markets: exposure. More investors believe that private markets have become effectively required for diversified participation in global growth. Global private equity (PE) net asset value grew by 18 percent in 2018; this century, it has grown by 7.5 times, twice as fast as public-market capitalization (Exhibit 1). Private markets, including PE, debt, infrastructure, real estate, and natural resources, have graduated from the fringes of the economy to the mainstream.
More tools for investors and managers
With growth comes maturity. In 2018, private markets added more flexibility, depth, and sophistication. As our report examines in detail, secondaries have scaled rapidly and made the asset class easier to access and to exit. These funds are injecting liquidity and creativity into the marketplace, helping limited partners (LPs) shift strategies and manager lineups more quickly, and more than ever, helping general partners (GPs) restructure and extend legacy funds. They also offer increasing flexibility for investors to diversify and manage portfolio-construction risk, including through the use of options on investment stage, geography, industry sector, and fund manager.
Another structure gaining prominence, capital-call lines of credit have (along with other factors) compressed the J-curve (Exhibit 2), while drawing a watchful eye from some LPs. Our research finds that median funds in vintages 2012 to 2015 broke even in their second year, rather than in the third, fourth, or fifth year typical of most prior vintages.
Co-investment is a third structure adding depth to private markets. It has shaken off concerns about adverse selection to become an effectively standard dimension of pricing. In some cases, LPs have sought to partner with their GPs and secondaries fund sponsors to restructure and extend funds, a growing strategy as crisis-era funds reach the end of the road yet still have meaningful value-creation potential. A few large institutions have
even developed strategies focused on sourcing direct transactions from their GPs’ portfolios. Done well, they can find quasi-proprietary deals in which to deploy large sums of capital while enabling GPs to eat their cake and have it too by recognizing gains while maintaining some degree of upside over time.
Inspired, many other LPs are voicing similar intentions. But a supply challenge looms: demand for PE co-investment vastly outstrips the opportunities provided by GPs. Even when LPs successfully build a small portfolio of direct investments, they may be running more risk than they think. One or two impairments can adversely affect the asset-class portfolio, with knock-on effects on employee compensation and even the institution’s long-term health. Very few direct investments have been exposed to a broad-based downturn. When one comes, the way that LPs and their governing boards react to impaired positions will bear watching.
New management techniques
Collectively, these developments have helped the industry broaden its appeal to LPs without abandoning its underlying structures. And the industry’s conduct has changed with its context. Savvy GPs have expanded their firms’ abilities to take advantage of today’s most prominent sources of value creation. McKinsey research shows that the 25 largest GPs all have operating teams, and most plan to expand them. Leading firms have also pioneered several digital techniques to wrest greater efficiencies in operations, deal sourcing, due diligence, and other core activities.
Several recent examples are detailed in our report. A European venture-capital (VC) firm has built a machine-learning model to analyze a database of over 400 characteristics of more than 30,000 deals, identifying about 20 drivers of success for various deal profiles. These often turn out to be unusual combinations of characteristics that no one would otherwise have suspected had much bearing on performance.
A PE firm conducting a due diligence wanted to validate its revenue forecast for a banking product. It used natural-language processing to analyze the public-complaints database published by the US Consumer Financial Protection Bureau. The tool found a spike in customer complaints about a similar product at a rival bank, and the firm discounted its revenue projection accordingly. Another adviser has gone a step further and digitized several of its due-diligence processes. It uses web-scraping tools to monitor changes in market sentiment for its retail clients. Geospatial analyses help it evaluate the strength of its footprint. HR analytics help it evaluate management’s capabilities.
These are all noteworthy advances. Yet pressure continues to build in the system. Deal multiples have continued to rise—to 11.1 times, from 10.4 times in 2017—spurred in part by record levels of dry powder, at $2.1 trillion. Deal value hit a record, but the number of deals remained relatively flat for the fourth consecutive year. (Note, however, that as a multiple of annual equity investments over the prior three years, dry-powder stocks have crept noticeably higher, growing 22 percent since 2016. If growth in dry powder continues to outstrip deal volume in a strong market, this may provide a tailwind for multiples. But if the market slows (say, if multiples contract or deal activity slows), then this sizable war chest may contribute at least for a period to downward pressure on fundraising.)
Venture capital’s very good year
On balance, then, the industry is in fine health. Even with the slowdown, 2018 was the third-highest fundraising year on record—and venture capital had one of its best years in memory, continuing a stretch in which it has outperformed other PE segments (Exhibit 3). That’s not the only way VC has been strong lately. Capital deployment mirrors and even exceeds the surge in fundraising, up an average of 17 percent per annum since 2015, capped by a 53 percent increase in 2018, when the industry invested $251 billion. Supersize venture rounds in which start-ups attract $1 billion or more from VC firms emerged in 2015. In 2018, 25 supersize rounds represented over 25 percent of all VC deal volume.
Key differences between 2007 and 2018
Another highlight from 2018 was deal value: despite the flat trend in deal count, the value of PE deals reached a new high at $1.4 trillion, finally surpassing the precrisis peak in 2007. That feat, along with the recent seesaws in public-market valuations, suggests that a look back at 2007, the last high-water mark, may be in order. Whenever the next downturn comes, many in the industry are saying that the industry may be in a better position now (Exhibit 4). Further, sellers have more options, notably secondaries; investors are more committed to pacing plans; and co-investment has replaced the ill-starred club deal. All of this suggests that LPs and GPs alike will better weather the storm, whenever it comes.
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Our annual private markets review showed the market scaling in 2017. The way limited partners and general partners respond to the opportunities that arise will be critical to their success.
The year just past was, once again, strong for private markets.
Even as public markets rose worldwide—the S&P 500 shot up about 20 percent, as did other major indices—investors continued to show interest and confidence in private markets. Private asset managers raised a record of nearly $750 billion globally, extending a cycle that began eight years ago.
How private equity fared in 2017, and what’s ahead
The industry continued to scale, but amid growth in private markets, some challenges remain. Here’s the state of the industry and a look ahead to its future.
To understand the landscape, we conducted our second annual review of private markets, drawing on new analyses from our long-running research on private markets and conducting interviews with executives at some of the world’s largest and most influential general partners (GPs) and limited partners (LPs). Our latest report summarizes our findings, looking at the industry’s capital flows in 2017, including fundraising, assets under management (AUM), and capital deployment. It also reviews the implications of these dynamics for the relationship between GPs and LPs as well as discusses ideas for finding continued success.
Within 2017’s tide of capital, one trend stands out: the surge of megafunds (funds of more than $5 billion), especially in the United States and particularly in buyouts (Exhibit 1).
Remarkably, the industry’s record-setting 2017 growth is attributable to a single subasset class in one region. Notably too, if mega-fundraising had remained at 2016’s already lofty level, total private-market fundraising would have been down last year by 4 percent. Of course, this trend to ever-larger funds is not new. Megafunds have become more common, in part as investors have realized that scale has not imposed a performance penalty. Indeed, the largest funds have on average delivered the highest returns over the past decade, according to Cambridge Associates. What was interesting in 2017, however, was the way in which an already-powerful trend accelerated, with raises for all buyout megafunds up over 90 percent year on year. Meanwhile, fundraising in middle-market buyouts (for funds of $500 million to $1 billion) grew by 7 percent, a healthy rate after years of solid growth.
Investors’ motives for investing in private markets remain the same, more or less: the potential for alpha, and for consistency at scale. Pension funds, still the largest group of LPs, are pinched for returns. Endowments are already heavily allocated to private markets and do not appear keen to switch out. Meanwhile, sovereign wealth funds are looking to increase their exposure to private markets, increasingly using co-investments and direct investing to boost their ability to deploy capital. Fully 90 percent of LPs said recently that private equity (PE), the largest private-asset class, will outperform public markets in coming years—despite academic research that suggests such outperformance has declined on average.
And so, capital keeps flowing in. Our research indicates that, in the past couple years, the industry’s largest firms have begun to collect a growing share of capital, perhaps starting to consolidate a fragmented industry. Yet private-asset managers did not have it all their way in 2017. The industry faced some mild headwinds investing its capital. Although the deal volume of $1.3 trillion was comparable to 2016’s activity, deal count dropped for the second year in a row, this time by 8 percent (Exhibit 2).
In two related effects, the average deal size grew—from $126 million in 2016 to $157 million in 2017, a 25 percent increase—and managers accrued yet more dry powder, now estimated at a record $1.8 trillion. Private markets’ AUM, which include committed capital, dry powder, and asset appreciation, surpassed $5 trillion in 2017, up 8 percent year on year.
Why did managers hesitate to pull the trigger or struggle to find triggers to pull? One explanation is the price of acquisitions. Median PE EBITDA multiples in 2017 exceeded 10 times, a decade high and up from 9.2 times in 2016. With price tags increasingly printed on gold foil, GPs had to be smarter with their investment decisions and more strategic with their choices.
The byword of 2017 was scale. The way that LPs and GPs respond to the challenges and opportunities of scale will be critical to their success. No matter their size, LPs and GPs will need to hard-code discipline into every part of their business system. Before long, GPs might find themselves having to choose between two models: managers capable of deploying capital at scale, and specialists operating at a smaller scale. For the first group, capital will continue to pour in, but what counts as an attractive deal might shift given that asset classes like PE are not infinitely scalable—at least not with historical levels of performance. For the second group, a strategic decision is at hand: get bigger, or stay the course. Both options can be successful if firms recognize their differentiation and execute their strategies with the necessary rigor.
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A new report from McKinsey finds that in 2016, private markets again defied expectations. But competition is getting tougher for both managers and investors.
In 2016, the most exciting news for private markets may have been what didn’t change. In these markets—mainly private equity, but also closed-end real estate, infrastructure, natural resources, and private debt funds—investors’ desire to allocate remains strong. Our long-running research on private markets finds that, whether performance is measured by fundraising (firms received $625 billion of new capital in 2016) or assets under management (AUM), now $4.7 trillion worldwide, 2016 was another impressive year in a long cycle of expansion that began in 2008. The industry continues to provide a source of excess capital for investors; in 2016, distributions outstripped capital calls for the fourth year running. New entrants continue to flock to the industry, and the number of active firms is at an all-time high.
While more fundraising, an increase in AUM, and greater capital distributions to investors are trends to celebrate, growth also presents challenges. The larger number of general partners (GPs) reflects the industry’s success but also heralds increased competition, which has contributed to rising deal multiples. As GPs have become gun-shy about today’s higher prices, deal activity has fallen, and dry powder has reached an all-time high—though our research suggests that dry powder is not nearly the problem that some have suggested. In fact, in this and other ways, the industry is overcoming its growing pains and finding new ways to deliver for its investors.
Our research included interviews with executives at some of the world’s largest and most influential asset managers, which revealed several common expectations for 2017. All acknowledge that an extraordinary number of wild cards are now in play, especially in geopolitics. While these unknowns will create opportunity for some, most GPs acknowledge that this sort of uncertainty is very difficult to price. As one CEO told us, “Some of these changes in the US will raise the base case for GPs, but the tails are very fat.”
Most agree that public markets, despite their recent run-up, are becoming structurally less attractive to many limited partners (LPs), who will likely respond by further raising their allocations to private markets. Creativity in fees and products will flourish, producing a range of options: we will still see full-service GPs offering closed-end funds, of course, but also more LPs in co-investments, more separate accounts, and at least a few more LPs investing directly. Finally, most executives believe emerging markets will normalize following the recent period of turbulence and will start to look more like the industry in developed markets.
As the challenges grow, we see four ways for GPs to prolong private investing’s remarkable ride: more proactive and creative sourcing, greater conviction in due diligence’s findings, new operational approaches to the portfolio, and greater flexibility in exit timing.
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