A Glass Half Full

Dear Investors,

While 2022 ended with a surge in investment activity, 2023 has begun with a whimper. Driven by continued macro uncertainty around increasing interest rates, untamed inflation and questionable growth, private equity managers have largely slowed down their investment pace. Investment activity was less than half that of the first quarter of 2022. Meanwhile, exit activity was down by the same proportion, albeit off an already low base. This steady decline in exit activity will continue to encourage certain investors to solve their liquidity issues through the secondary market. Finally, while fundraising was actually 18% higher than the same quarter last year, it continues to be dominated by the mega cap funds: one fund accounted for over 25% of the total amount raised. Indeed, with at least 10 mega cap managers targeting fundraises of USD 15bn or greater this year, it will be increasingly difficult for both established and emerging mid-market managers to fight for investors’ allocations. For those happy few who have dry powder in the mid-market, 2023 has all the ingredients to be one of the most attractive vintages of the last decade.

Investments Down, Exits Down

The global aggregate value of private equity deals closed during Q1 2023 was EUR 177bn, 52% down on the same quarter last year[1]. This decline was seen across all regions with North America (-49%), Europe (-50%) and APAC (-60%) down by similar levels.

Possibly driven by a recent fall in fundraising in the mid-market, investment activity in mid-market companies (defined as deals with an enterprise value of less than EUR 500m) was down by 56% compared to 48% for large companies.

Meanwhile, exit activity showed similar declines. The global aggregate value of exits was EUR 108bn, a decrease of 49% on the same quarter last year. This decline was also uniform across regions with North America (-44%), Europe (-51%) and APAC (-63%) all down. This has now been a relatively consistent trend for the last four quarters, with each quarter being close to 50% down from the same quarter a year ago.

Figure 1: Exit Activity

Source: Pitchbook, April 2023

Fundraising in Q1, at USD 69bn, was 18% higher than the same quarter in 2022. However, more than half of this came from five mega cap funds, suggesting that small and mid-market funds continue to have a difficult time. According to Preqin, there are over 1,000 buyout managers in the market raising an aggregate of close to USD 760bn. Thus, it remains a daunting task for fund managers to convince investors to allocate to their funds, given current fundraising pace.

Furthermore, the market remains bifurcated between the well-established blue-chip names who can raise multiple billions in a matter of months and smaller managers who are taking up to two years to raise, or finalising on smaller than anticipated funds. For example, in April 2023, Genstar raised USD 13.4bn for its Fund XI in a first and final close.

While it is often seen as the comfortable choice for investors to invest with large, household names, data shows that during previous market troughs, it has been the first-time fund managers who have outperformed established managers. There are likely various reasons for this: (1) less capital is raised at the smaller end of the market during difficult periods, leading to less competition for deals, (2) first time managers do not have the burden of needing to fight fires across large existing portfolios, and (3) lesser-known managers are highly motivated to deliver decent returns to investors, while established managers would rather take low risk, low return bets in a more difficult environment.

Figure 2: First-Time vs Non-First-Time Funds

Source: Preqin. Data as at 31 December 2022

In our latest emerging manager programme we have made three commitments in the last two quarters which highlight the attractiveness of backing first or second time funds. We outline two of them below.

In Q4 2022, we committed to Nordic Alpha Partners II. Nordic Alpha is a growth investor in the Nordics, specialising in scaling high potential sustainable hardware technology companies that are addressing the green transformation. Shortly after our commitment, we co-invested in Spirii, an electric vehicle charging infrastructure provider. With over 100% annual revenue growth, the company has quickly become one of the leading EV charging companies in the Nordics and has now launched into Germany. Nordic Alpha and Unigestion were able to invest in this company at a valuation significantly below comparable valuations of its peers.

In Q1 2023, we committed to the Achieve Edtech Buyout Fund, which seeks to invest in software or tech-enabled services companies that facilitate learning. The team at Achieve Partners has worked together since 2016 investing in, operating, and advising EdTech companies, and has deep sector knowledge and expertise, as well as a compelling track record.

Prior to committing to the fund, Unigestion co-invested in MasteryPrep in Q4 2022, a tech-enabled education company that partners with schools and districts to help underperforming students score better on state exams (ACT, SAT, PSAT, TSIA2). MasteryPrep has grown to serve 400+ school accounts mainly in low-income areas within the Southeastern USA. Importantly, Achieve Partners and Unigestion were able to acquire this company at a highly attractive valuation, even though the company is experiencing strong revenue growth.

In this environment, we continue to see attractive secondary dealflow. In March 2023, we closed a direct secondary investment with Charterhouse in Funecap, the largest European funeral services and crematoria business, operating in France, Italy, the Netherlands, Germany, Belgium, and Switzerland. This deal has allowed Charterhouse to roll its investment from a predecessor fund to its current fund. Funecap has downside resilience due to high barriers to entry, long-term demographic trends, pricing power and a leading position as a value-for-money player. The company is expected to continue its successful roll-up consolidation strategy in the fragmented European funeral services market and strengthen its position in adjacent offerings (e.g. insurance).

We are excited about the opportunities that are arising in this environment. In addition, despite the overall slowdown in exit activity, we are working on a number of attractive exits across our direct and secondaries portfolios. We look forward to reporting on these in the coming quarters.

The Investor’s Dilemma

March 2023 might very well be remembered for its tumultuous banking events. Around mid-month, the US Federal Reserve announced an emergency bank term funding program after the sudden collapse of California’s Silicon Valley Bank (SVB) and New York’s Signature Bank. This was followed by a steep drop in Credit Suisse’s share price which, given it was facing imminent failure, was sold to its Swiss rival UBS for CHF 3bn in a government-brokered takeover.

The mood on both sides of the Atlantic was to keep raising policy rates, justified by the ECB and Fed’s resolute battle against inflation, while signaling they could slow upcoming hikes as the banking turmoil is expected to act as a drag on credit growth. This comes in an environment where bank lending standards are already tightening – another headwind for growth.

Like many investors, our first priority was to undertake an in-depth evaluation of our portfolios, assessing our own direct holdings and banking arrangements. We also ascertained the exposure of our fund managers in Europe and the US. Following this evaluation, we confirmed that (i) the exposure to SVB or Credit Suisse is limited, and (ii) there has been no adverse impact on any of our private equity portfolios.

However, while the global banking system is not under the same acute stress as in March, we do not believe that the topic of systematic risk in the regulated and non-regulated banking system is behind us. The effects of rapidly rising interest rates may not yet be fully baked in and, given that central banks remain focused on fighting inflation, further rate rises are likely.

We believe that it is therefore prudent to map and monitor counterparty risk across all of our portfolios on an ongoing basis. This will allow us to react swiftly in the event of any future banking, or other financial crisis.

In the aftermath of this confidence crisis, private equity and venture capital investment activity will likely remain subdued. As a direct implication of SVB collapsing, lending for technology and healthcare companies, mainly venture to growth stage in the US, will become harder and more expensive.

There will be secondary effects and it is not yet clear how this will play out. For example, how resilient will the less-regulated private lending market be? In addition, it is quite reasonable for lenders to increase their credit risk margins in the context of the higher volatility and uncertainty. Hence, we should expect that overall lending costs will experience a significant uplift.

However, for experienced investors, the current environment has the ingredients to make 2023 one of the most interesting and attractive vintage years in the last decade. What will be the most appealing opportunities? Here are some ideas:

Companies expected to be the market leaders of tomorrow. We define these as companies that are leaders in their niche, have strong financial profiles, together with predictable growth from a thematic tailwind and robust balance sheets to invest in organic or acquisitive growth. Returns to investors will thus come from growth and margin improvement rather than leverage. Such companies are found in the mid-market and, in this environment, can be acquired at highly attractive prices.

Entrepreneurs looking to partner. It has likely been decades since entrepreneurs have been confronted with so many moving parts in this “new normal” environment. Just think of the rapid evolution of technology, geopolitics, unstable supply chains, cybersecurity, the climate challenge, inflation, interest rates, FX volatility and ESG. They may prefer to tackle those transformation opportunities with a partner rather than carrying them out on their own. Private equity will excel as the partner of choice, bringing the financial resources as well as contributing strategic and management experience.

Consolidation and build-ups. As the operating environment gets tougher, the advantages of scale become more obvious. Many industries have become ripe for consolidation. The private equity backed mid-market companies that lead these consolidations will benefit in multiple ways: higher margins through synergies, broader offerings, cross-selling to acquired customers, regional/international expansion and enhanced ability to attract talent.

Secondaries. As well as denominator or portfolio management considerations, there is a structural re-balancing between some traditional institutional private equity investors, such as defined contribution pension plans and insurers, who have achieved their return objectives with private equity. As a result, they are looking to re-allocate to bonds given the more attractive fixed income opportunities that are available now. This will result in attractive secondaries dealflow, ranging from traditional LP stakes to GP-led continuation funds, as well as other structured solutions. How secondaries investors should distinguish between the different opportunities will be a topic in the next quarterly letter.

As has been shown by the SVB collapse, the current environment also brings important risks and challenges that should not be overlooked. A fly on the wall in our investment committee meetings would see that we leave no stone unturned when we consider all possible downside scenarios. With the luxury of a healthy dealflow, we have no qualms in rejecting deals if they do not meet the very high bar required for us to invest. We look forward to reporting on the exciting investments that make the grade.

Yours sincerely,

The Private Equity Investment Team,
Unigestion

Unigestion Private Equity Activity

Here are the highlights of some of the investments and exits that we completed in Q1. Reference to specific securities should not be considered a recommendation to buy or sell.

	In March, we committed to Hg Mercury 4. Hg Capital is one of the Pan European leaders in the mid-market, with a focus on software and services companies along eight clusters: Tax & Accounting, ERP & Payroll, Legal & Regulatory Compliance, Automation & Engineering, Technology Services, Healthcare IT, Capital Markets & Wealth Management IT, and Insurance. The Firm pursues three parallel strategies: Saturn, which invests in upper mid-market companies, Genesis, which invests in mid-market companies and Mercury, which invests in the lower mid-market. Unigestion has previously invested in Hg’s Mercury and Genesis programmes.
	Also in March, we committed to Axiom I. Axiom’s investment strategy is to focus on ambitious high growth companies that are too mature for venture capital funds but still fly under the radar of larger UK mid-market funds. To be considered attractive for Axiom, a company has to operate in the UK B2B SaaS market, show 20%-50% growth in (mostly recurring) revenues in the range of GBP 5m – 20m and have a highly sticky mission critical product offering. Its value creation approach is to leverage its big tech network with strong relationships in key areas, implementing its growth hacking team with an operational focus through a high degree of data analytics and supporting the management with its expertise in M&A.
	In the same month, we made a secondary investment in the Bencis IV Continuation Fund, a multi-asset portfolio of four European companies active in the specialty packaging, machinery, and food production industries. These companies were previously in several older funds managed by Bencis, with the companies being at inflection points and acquired at attractive entry valuations. The four companies are: a leading producer of high-performance B2B specialty packaging for pharma, chemicals, and food ingredients industries; a lifestyle and functional food producer for private labels and retail outlets with a leading position in the European protein bar segment; a confectionery producer for private labels and branded players with a market-leading position in socially responsible products; and a leading global technology group specialising in the development, engineering and manufacturing of high-end processes and handling equipment in high-grade materials and IP-sensitive products.
	In February, we committed to Charterhouse XI. Charterhouse is a Pan-European manager located in London with 36 investment professionals. Charterhouse targets mid-market companies (typically family-owned businesses) headquartered in western Europe, primarily across services, healthcare, specialised industrials and consumer sectors. Charterhouse XI currently has three investments including a French private higher education platform providing tuition and qualifications to 17,000 students through a network of 21 schools across France, a leading children’s English as an Additional Second Language (“EASL”) provider with 526 schools, and a European Funeral Services and Crematoria business operating in France, Italy, the Netherlands, Germany, Belgium, and Switzerland.
	In January, we closed a secondary investment in Capiton Quantum, a multi-asset continuation vehicle. The vehicle includes two well-performing niche companies in the microelectronics and nanofabrication industries. The first company is a full-service provider of advanced packaging for micro- and opto-electronic systems focusing on highly customised, low volume applications with very specific, hire precision requirements. The second company is a global developer and manufacturer of systems and software for the production and analysis of nanofabrication structures. The assets are expected to benefit from long-term growth trends in the global semiconductor market, driven by ongoing digitalisation, increasing demand for connected electronic devices and global innovation mega-trends.
	In the same month, we closed a secondary investment in Samara IIB, a multi-asset continuation vehicle. The USD 150m transaction includes three companies from Samara Fund II – a manufacturer of minimally invasive cardiovascular devices (stents, structural heart devices) with market leadership in India and a sales presence across 69 countries; a staffing company in India, offering diversified HR staffing solutions with a headcount of more than 118,000 associates; and a Hyderabad-based biryani chain restaurant with over 70 outlets across 10 cities in India. All three assets are within the top three players in their respective segments and are high quality companies with different underlying growth drivers.

[1] Pitchbook, April 2022.

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