How to avoid the "Valley of Death"

There has always been an allure to an IPO. Fortunes can be created and lost in hours, as the market sizes up a new participant and the preceding wave of hype.

Why then? Have companies recently been foregoing this, and electing to stay private for longer? To Sven-Christian Kindt, the Head of Private Equity Portfolio Solutions at Private Markets Group, Credit Suisse, it ultimately comes down to the coming of age of the private equity market.

Expanding from a 'cottage industry', private equity now allows companies to acquire more capital throughout their growth stages, as Sven puts it:

"There are lots of benefits if a business stays private, such as less volatility, less publicity, so the business can focus on continuing its growth."

In this Expert Insights interview, Kindt discusses how private equity is allowing private firms to vault over the "Valley of Death", and he explains his thesis for choosing high-performing managers in the private equity space.

Edited transcript

What does the private equity market look like today, compared to in the past?

Sven-Christian Kindt: The private equity market today looks very different from the past. If you go back about 20 years ago, private equity really was a cottage industry. And since then, the industry has grown by about 15% per year until today, so it's really one of the fastest growing sectors that you can find out there. 

Today, the market is very fragmented compared to what it used to be. 20 years ago, people thought of private equity as buyouts and venture capital. Today, there's a new name for private equity, which is private markets. Private markets also include credit strategies and real asset strategies. 

Private equity has gone into niche areas, called thematics, and we see more and more specialists operating in these areas. In comparison 20 years ago, pretty much everyone was a generalist.

What are the key trends driving rapid growth in the private equity market?

The rapid growth in private equities is really due to investors searching for a higher return. As investors couldn't find return in other asset classes, they've gone up the sort of risk curve and ended up in private equity. 

If you are looking for strategies today that can contribute to your overall portfolio return, then private equity is a good place to be. Over the last 10 years or so, a lot of investors have internalised that and are now also investing in private equity.

Why are more companies staying private for longer?

Why they're not staying private for longer is, number one, because they are able to raise capital on the private side, so they don't really need to go public anymore. That's the biggest reason why. There are lots of benefits on top of that if they stay private, such as less volatility, less publicity, so the business can focus on continuing its growth. 

In the past, it was more difficult because there was less capital available. There used to be a "valley of death", where a lot of startups got stuck because they lost financing as they grew. 

That has completely changed in recent years. There's this asset class that emerged called growth capital, sometimes also referred to as pre-IPO, and the capital in this class is able to support these startups so that they can stay private for longer.

What are some of the key thematics that you are seeing?

It's all about sub-sector focus, and about picking certain themes where these managers can differentiate themselves. It can be in technology healthcare services. It can be particular geographies or a certain investment style. Really trying to find the edge in a certain area. And, in order to get there, you need to focus, or else you'll just be taking part in the next auction process, and that's not a great place to be in private equity.

What makes private equity appealing to investors?

Yeah. I think it's primarily the search for returns, and coupled with that of course is the long-term nature of the asset class. It does take time to get to these returns. 

There is often discussion about the 'illiquidity premium' that you can achieve in private equity. To get there, you need a team that is hands-on and can actually support the company that you've invested in. If you invest in the right managers, then you will also get good returns.

What are the benefits and risks of investing in private equity compared to investing in public companies?

Private equity is less volatile. You only receive a quarterly report, rather than being subject to daily fluctuations in the market. Emotionally, that's a far better spot to be in. 

Ultimately, if you have the best performing managers over a longer period of time, you will outperform the public markets. 

If you instead take the average return in private markets, you will not be better off.

What characteristics make a private equity fund manager stand the test of time?

The funds that we like to invest in are safe pairs of hands. That means they have been around for a long time, and have lived through multiple cycles. Generally, these managers were a part of the last environment where you had inflation, and therefore understand inflationary environments. 

It's a mix of older people, but also the younger people that were trained during that time. That's point number one, and typically if you end up with a manager fitting that bill then you can sleep quite well at night. 

Secondly, you have to isolate the first or first decile or first quartile performance very carefully. Since you don't have a Bloomberg terminal that provides you with the answers in private equity, you have to travel to all of these companies and get the answer from them. And so the process consists of getting a meeting, building a relationship, and getting the data so that you can benchmark these funds.

Furthermore, there is a concept in private equity called persistency of returns. As an investor, you're looking for persistence in returns across a long period of time. If these managers then solve for above median or ideally first quartile performance over that long period of time, then you're in the right neighbourhood.

What returns do you look for in fund managers?

It really depends on the asset class. If you're looking at a venture capital fund, they're extremely illiquid. You've got to wait for your return for a very long time. They typically will tell you that they sold for three to five times money. Attached to that is a very high loss ratio, so these funds are fairly volatile. 

If you go to other asset classes like buyouts, they typically tell you they sold for somewhere between two and three times money often with an extremely low loss ratio of somewhere between 5% and 10%.

Every asset class within private equity has a slightly different risk-return profile and liquidity profile. With most of these strategies, you're looking for at least two times money.

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