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Private markets come of age

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.

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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.

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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.

Ratcheting higher

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.

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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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Download Private markets come of age, the full report on which this article is based (PDF–5MB).

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