Flight to quality, impact investing to drive allocations in 2023 – HarbourVest

With fundraising down 45% in H1 2022 amidst a tougher environment, the firm is “hearing and seeing that the denominator effect is back on the agenda in 2023,” said Managing Director Alexander Wolf.

In spite of this, there is a key difference between now and the crisis of 2008/2009, Wolf added. “Back then, there was a hard switch-off of new private equity comments – but given that the asset class has now had 15 years of strong performance, there is a willingness from LPs to find ways to keep committing,” he said.

This is having an effect on LP preferences, with a flight to quality in all segments, ranging from megacap funds to small buyouts and venture capital, Wolf said. “Category leaders will still raise capital quickly and will be able to raise as much as they want. But outside this ‘golden circle’ it will be harder and slower, particularly for emerging managers and those with average performance,” he said.

Still, some parts of the market will be insulated. “Impact and sustainability is where we will see an exception to this – this is a megatrend driven by a wave of LP demand so this part of the market may well be more insulated,” Wolf said.

Secondaries surge
The challenging fundraising environment, and in particular the fact that the denominator effect will require some LPs to rebalance or reduce their old exposures, might lead to a “surge” in secondaries activity in 2023, said Managing Director Valérie Handal. “For these LPs it’s more about this overallocation than liquidity issues,” she said. “Others will sell to generate liquidity given the slowdown in private equity exits.”

Secondaries buyers will be selective, she added, reflecting the theme of the flight to quality in fundraising. “We’re seeing large portfolios coming to market with buyers targeting the highest quality funds,” she said. “Pragmatism has therefore entered the seller universe – there was strong pricing in the last couple of years, but now there are significant discounts.”

This environment is leading to more deferrals in the secondaries market, with portfolio acquisitions being paid for on a deferred or staggered basis of up to two years, Handal added. “Buyers are being cautious and offering large discounts, since they are not projecting a lot of near term exits in these portfolios, given the macro uncertainties and because market dynamics are in their favour – and deferred payments can help buyers to pay a higher price,” she said.

Deferrals can address overallocation quickly, she noted. “The sale comes off the seller’s books even if they have not received the cash, meaning that they are free from this NAV and any future obligations.”

Meanwhile, with GPs facing liquidity challenges amid a tough exit environment, GP-led secondaries have become an “established, viable fourth avenue”, having grown in popularity over the past five to six years, Handal said. LPs are increasingly taking the opportunity to seize liquidity in these situations. “Historically, around 60% of LPs used to sell their stakes in these deals,” she said. “It is now closer to the mid 70% and we're hearing from some advisers that they're often seeing 90% of LPs opting to sell in a GP-led deal.”

GP-leds are also being increasingly adopted in other private market asset classes, namely infrastructure, according to principal Diego Jimenez. “We’re seeing an increasing appetite for GP-leds in this space, given that these assets have long-term cashflows, they are more yield-oriented than reliant on major operational improvements or turnaround plans, and have the added benefit of being less disruptive for the company than an M&A process,” he said.

Co-investment gains
The private equity co-investment space has remained active amid a tough market for those seeking liquidity and new fund commitments, according to Managing Director Corentin du Roy. “GPs are using these deals to elongate the life of their own funds by sharing a larger portion of their deals with co-investors as it’s now more difficult to get firm lender commitments, meaning that leverage is less available,” he said.

Given the prevalence of the denominator effect, LPs have somewhat retracted from co-investment activity as cutting their deals in this space is an easy way to cut their private equity exposure without creating any relationship issues with their GPs, he said. “We are finding that we can source co-investments from GPs where we are not already an LP, or where we are just a smaller LP,” he added.

“GPs are also more worried this year about taking on syndication risk – they don’t want to end up heavily overexposed to a single asset in their own fund,” added Wolf.

“We work with GPs on co-investments at all stages, but we’re seeing more happening ahead of time now,” du Roy said. “We’re looking at value-oriented co-investments, focusing on mid-market deals with a more complex deal thesis.” HarbourVest is seeing opportunities in the technology, healthcare, and business services sectors, as well as sectors not significantly exposed to industrials, inflation, and energy, he added.

Energy transition in focus
While infrastructure is a younger asset class, and an area of private markets in which LPs are still “playing catch-up on their allocations”, it has nevertheless been affected by the current environment, said Jimenez. LPs’ liquidity constraints and their need for cash have had an impact, he added. “For example, when UK pension funds needed cash earlier this year, they found infrastructure easier to sell as it typically trades closer to NAV,” he said.

Although Jimenez expects to see a slower year for fundraising in the infrastructure space, there will still be some growth, he said. “Historically around half of the capital in the infrastructure space tends to go to the top 10 managers, which adds challenges to the fundraising cycle,” he said. “The exception to this can be sustainability and the energy transition, where there are several new managers or strategies within existing platforms being launched and LPs keen in getting exposure to this part of the market.”

Digital infrastructure and energy transition will be “key drivers” for infrastructure in 2023, Jimenez said. “These kinds of companies need more capex over a longer period, for example for fibre roll-out, and we will see new vehicles for this who are able to provide liquidity efficiently,” he said.

Long-term view
HarbourVest will look past the short-term picture for its investments in 2023, particularly in the case of primaries, said Wolf. “For example, looking at a growth equity manager, you can’t conclude their next fund will be weak just because of what we saw with valuations correcting in 2022,” he said.

Du Roy noted that there is likely to be a shake-out of later-stage technology valuations in the coming 12 months, meaning that it is harder to underwrite businesses that are not profitable. However, technology as a whole is “too big to ignore”, Wolf said. “GPs have now built so much domain expertise and specialism in technology – it will continue to be an important part of the market,” he said.

In its secondaries activity, HarbourVest will look for diversified portfolios with exposure to multiple sectors, Handal said. “All the more important in these volatile times, we look for businesses with resilient business models and sustainable capital structures that are backed by GPs with strong track records in these sectors,” she said.

Energy transition will continue to be a key theme in 2023, with the topic “becoming an asset class in itself, on a very broad basis,” said Jimenez. “There are energy transition companies with established technologies such as wind and solar, but others with more venture type technologies such as smart grids, and hydrogen, which means very different risk profiles and return targets,” he said. “We’re working with our PE colleagues on how this is developing.”

In spite of the opportunities, 2023 is likely to be a tough year for many businesses, Wolf noted. “The turmoil in the market has so far been driven by the macroeconomic environment, rather than a deterioration in operating performance,” he said. “But 2023 will likely be a more difficult stress test on revenues and EBITDA.”

Fundraising is also likely to be challenging, but HarbourVest still expects to see a bust market. “Looking ahead, the market dynamics in 2023 should be similar to that of the last nine to 12 months, bar a big macro reversal,” said Wolf. “It should be another big year in terms of the number of GPs looking to raise funds. A lot of GPs deferred fundraising in the latter part of 2022, but they can’t do that indefinitely.”

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