Mind and machine: The future of private equity
Head of Private Equity
Mark Zünd may have just taken over as Head of Private Equity at Unigestion but his career in private markets dates back 22 years when he joined Lombard Odier as an Associate.
During the past two decades, Mark has built his career alongside the evolution of the private equity industry from a niche play to a major asset class for institutions and helped drive the emergence of Akina and then Unigestion as a key player in the global mid-market.
In this interview, Mark explains how the industry’s coming of age has benefited investors and provides an insight into his current views on a range of issues including, the importance of working with technology, the denominator effect, larger GPs dipping down into the mid-market, and the implications of SVB’s collapse.
Q | Mark, you have worked in private equity for 22 years. What in your view is the biggest change you have seen in the industry?
The private equity industry has grown up over the past two decades, shifting from an artisan, niche trade for investors to a thriving, major asset class which forms a significant part of the asset allocation decisions of institutional investors and, increasingly, private investors.
Along with that has come the supporting ecosystem of increased regulation and improved standards that are required for such a significant part of the financial services industry.
But, despite that, some things stay the same. Notably for me, the fascination of supporting entrepreneurial management teams and innovative companies in their growth journeys, and achieving strong returns for our investors.
Q | You are taking over your role from Christophe de Dardel, who has become CEO of Unigestion. How does having a CEO immersed in private equity help you?
While private equity has become a mainstream asset class, it still requires specialist knowledge, skills and a language that is very different to other asset classes such as equities and bonds. Private equity has become a very substantial part of Unigestion’s overall business over the past 20 years and still has promising growth potential so it is great to have, in Christophe, a CEO who fully understands what is needed to make this happen.
Q | How has Unigestion’s investment process changed?
In the early days our investment committees involved a few people sitting around a table with a coffee and croissant on Friday morning discussing the opportunities we had scouted during the week.
As we grew up, we worked on developing tools and processes to assess companies as well as a much more formal approach to due diligence. This process takes a lot of time and includes a whole group of other people across the business, such as operations, ESG experts and legal.
Unigestion has a strong focus on collaborative intelligence, working with technology to enable us to place more focus on detecting the source of Alpha early and taking a theme driven approach. We now have more than 50 people globally sourcing opportunities and we work hard with new colleagues to develop in them the same discipline for high-quality processes and criteria when selecting investments, passing on the experience and know how we have established. The AI/machine learning tools we have designed give us a real advantage, helping us maintain consistency and be efficient in prioritising the investment universe.
Our PEpper tool is a great example, enabling us to add real value by applying AI to fund and company data, as well as external data, to forecast the performance of investments. It has a great success rate and we are actively employing it in our investment process to support the investment teams.
There is also greater collaboration with other investment lines these days – there is a big benefit to being in a house with equity and private equity businesses – it helps us anticipate what may come our way.
Q | How do you plan to evolve Unigestion’s private equity division?
Christophe has been a great leader and successfully brought Akina together with Unigestion’s private equity division six years ago. We emerged from that far stronger and energised with a motivated team, a distinct client value proposition and a fresh and future-oriented product and solutions offering.
Christophe and I have worked very closely together during this time and have the same vision of the future, of how we can build on the solid foundations we have established. Our ambition is to grow our business while ensuring we foster an entrepreneurial spirit to develop our talents and empower our people to thrive and take ownership. By doing so we can continue delivering successful partnerships with the investors we work for and the companies we invest in.
Q | Private equity has become a much greater part of investors’ portfolios in recent years. How much harder is it to get access to decent deals now than a decade ago?
The growth and maturing of private equity is very good news for investors.
On one hand, sellers are better informed about valuations now so it’s harder to get returns just from buying well. But at the same time, there is a much broader choice of investment opportunities across sectors, situations and transaction sizes as private equity has become the buyer of choice for many sellers and partner of choice to management teams. The average quality of company has dramatically improved as has the speed at which value creation happens today vs a decade ago. The speed of value creation is largely thanks to the availability of great management and board talent eager to work with private equity on entrepreneurial projects.
In addition, the exit options for companies have dramatically increased, particularly given the greater sophistication of the secondaries market. There is also a lower loss ratio in portfolios given the improvement in management expertise.
So overall, I believe today’s mid-market offers an attractive, and more predictable and repeatable, return pattern than 10 years ago.
Q | More recently, of course, the environment has become trickier. Were 2021/2022 the halcyon days for private equity and how do you see the outlook?
2020 and 2021 were quite complicated years for investments, but at the same time, the Covid pandemic created value opportunities in some particularly high-quality businesses. From past experience, we felt that we should continue investing, when many were on the side-lines and it currently looks like those vintage years will be interesting.
No sooner had we emerged from Covid than 2022 than the Ukraine/Russia war introduced a rough awakening from a decade of cheap and easy money. It also brought about totally new paradigms including soaring inflation and strongly increasing rates – a multipolar world with many moving pieces.
The rumbling in the financial markets that started in March with the collapse of SVB and other, smaller US banks, and quickly led to the forced absorption of Credit Suisse by UBS is probably only the beginning of an adjustment process to tighter financial conditions and a new reality for global financial markets. We are already witnessing a significant increase in financing costs driven not only by the rise in reference interest rates, but also by the risk premia lenders are requesting in this more challenging environment.
Q | We have seen big declines in equity valuations over the past year but private equity valuations seem to be defying gravity. How can there be such a disconnect?
Public equity valuation adjustments in 2022 were most pronounced in technology and growth stage companies, which are often valued based on optimistic top-line growth expectations. Private equity valuations in technology and venture / growth capital also started adjusting in 2022 but we probably haven’t seen the bottom yet. Past financing rounds are still often used for valuations so we will only see the adjustments in the next financing round.
We have to remember that despite the stock market falls, 2022 was still a very strong year for many companies and industries. For example, we have portfolios, where average EBITDA growth was around 20% in 2022. So, if for example, the public market comparables have adjusted by 20% in the course of 2022 and at the same time underlying earnings have grown by 20%, a flattish valuation versus the end of 2021 can be justified.
Another challenge in comparing public and private market valuations is the sector composition. Since the covid pandemic, I have seen a persistent “flight to quality” in private equity, meaning that for the previous three years, most transactions have been focused on relatively resilient industries and essential products or services such as healthcare, subscription-based software and services, education, waste management or energy transition. As a result, the private sector portfolio mix is probably more resilient and more “future-proof” than public market indices.
I don’t believe valuations have adjusted for higher financing costs yet – neither in the public nor the private markets. I expect this to happen over the next 12-18 months, when it becomes clearer where mid-term interest rates will end up and what risk premia will be requested to finance private companies. It is likely the major valuation impact will be in the larger, highly-leveraged transactions and in venture and growth capital.
Q | What do you see as the biggest challenges for private equity investors in 2023?
Managing the paradox of having to deal with the allocation limitations caused by the denominator effect (where the value of one portion of a portfolio decreases faster than others leaving investors overweighted to certain asset classes) at the same time as not missing out on what could be one of the most interesting vintage years.
Q | What do higher and rising interest rates mean for private equity and Unigestion’s investment style?
Rising rates will affect all parts of private markets where high levels of financial leverage are used (e.g., highly levered buyouts, but also private infrastructure and real estate investments) and growth and venture capital, due to higher financing costs and higher discount factors applied to future earnings.
Our focus is on the “leaders of tomorrow” in the mid-market. Those companies generally have very strong financial profiles, combining high margins and cash flows with strong growth from a thematic tailwind. We leave ample cash flows for the companies to invest in organic or acquisitive growth, so our portfolios have moderate leverage levels of around 3x EBITDA. We sense that this strategy, based on profitable growth being the prime returns driver, will be less exposed to the deterioration in financing conditions.
Q | Where are the most appealing opportunities for investment in the coming years?
Partnering with entrepreneurs to transform. Maybe it has 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, instable supply chains, cybersecurity, the climate challenge, inflation, interest rates, Fx volatility, 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 & management experience.
Consolidation and build-ups. As the operating environment gets tougher, I see many industries ripe for consolidation or roll-ups to broaden the offering.
Secondaries – as investors got overallocated to private equity or their portfolio requires more financial or management resources than are available.
Q | Can ESG and impact add real value for investors?
Yes, I see many companies and situations where active private equity ownership can drive the ESG and impact transformation and turn traditional businesses into ESG and impact leaders with a corresponding positive impact on profitability, growth, strategic attractiveness and ultimately, valuations.
Q | What have been the differences in dealflow between 2021, 2022 and YTD in 2023? Have we seen an uptick?
During the early part of the Covid pandemic, GP-led continuation vehicles were mainstreaming. Due to travel restrictions, it was hard to perform due diligence on new investments, so investors felt more comfortable with transactions where there was no obvious information asymmetry and strong alignment with the GP and management.
Since 2021, we have been seeing a strong pick-up in direct transactions as many company owners who had experienced the challenges of Covid were reassessing their priorities. This trend met the pent-up exit pipelines of private equity funds to create an unparalleled flow of investment opportunities.
The secondary market has become saturated with GP-led transactions in all shapes and forms and sometimes these lack investment rationale. Investors seeking to mitigate the denominator effect in their portfolios, as well as pockets of market stress and active portfolio management, are driving a very dynamic and broad flow of opportunities across portfolio sales, LP stakes and special GP situations. Given our view on valuations, we remain highly disciplined on pricing, and at the same time are positive about the market opportunity in front of us.
Q | GPs raising larger funds are investing in large deals. If deal-flow has dried up in this space do you expect them to be buyers of mid-market companies?
Larger funds have started dipping down into the core mid-market. This trend provides excellent exit options for our portfolio companies and was one driver of our record exit year in 2022. We have seen such temporary strategy drift in the past as well. Typically, this doesn’t last for too long as economically, it just doesn’t make sense for them. We are also seeing a more problematic effect of ever-larger fund sizes – the systematic roll-over of older portfolio companies from previous funds into their new funds or into continuation funds. While this provides liquidity to older funds, in the case of rolling-over to the new fund, paying management fees of 2% and carry of 20% is hard to justify for essentially being served a substantially similar portfolio as in the previous fund. Valuation practices for such transactions may also require close scrutiny by LPs.
Q | Where is Unigestion underwriting deals for secondaries and directs? Is the line blurring between the two strategies?
In single asset secondaries, we are looking at low risk situations (known asset, known management, known GP and hence limited information asymmetry), extra strong alignment with the GP and a clear inflection opportunity in the underlying business created by such a transaction. We typically underwrite gross returns in the vicinity of 2.0x for relatively short holdings and consequently higher IRRs. Those transactions are suitable for our secondary programs and we are willing to pay the GP for their work.
For directs, we are targeting >2.5x base case returns over a 4-5 year period and we don’t pay terms and conditions as we lead / co-lead those transactions or co-invest with our fund managers. These transactions are for our direct investment programs. We apply the same fundamental underwriting process in both instances.
Single asset continuation deals are here to stay and the availability of such transactions may increase in the current environment, as GPs continue to be pressured to get liquidity back to LPs.
Indeed, it might look like the line is blurring and single asset continuation vehicles are an easy and supposedly safe way to get access to nicely performing assets with more time for decision taking and less scrutiny required vs direct investments.
So it might be tempting for resource constrained investors to see this as a path to build bespoke portfolios of direct holdings.
Ultimately, it will come down to whether those transactions live up to the performance expectations. The jury is out, whether plain vanilla single asset transactions are ultimately living up to the performance promise and worth paying fees for.
Q | It seems that some parts of the exit markets have nearly been frozen since Q2/22. Do you see the same in your portfolios?
There are multiple options for exits given the trend for larger funds to dip down into the mid-market, the arrival of new entrants into private equity such as family offices, and revived activities from strategic buyers. Valuations also remain solid in many sectors.
We had a record year for exits in 2022 and have continued to see plenty of activity so far this year. I believe buyers are looking at multiple value creation levers and want to diversify away from leverage-based returns. The leaders of tomorrow in our portfolios offer resilience, value creation and liquidity across cycles thanks to their growth, cash generative business models and the attractive sectors they are active in.
Q | Why is the current market environment good for secondaries transactions, where is your focus (sectors, regions, market segments) and how do you ensure a solid pipeline?
Apart from tactical rebalancing due to 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 at re-allocating to bonds given the more attractive fixed income opportunities that are available now.
This is being balanced out by new entrants, such as sovereign wealth funds and family offices / private wealth managers, who are under-allocated to private equity and are seeking greater exposure to this sizable, attractive and innovative part of the real economy to gain long term capital appreciation.
We have always applied a fundamental underwriting approach to our secondary transactions and focused on high quality underlying companies that fit well with our theme-based investment focus across all our investment programs.
Our global investment platform enables us to source and evaluate attractive opportunities through our GP network. Our theme-focus across investment programs provide us with significant synergies across our primary, secondary and direct teams and also a consistency in our market approach with intermediaries and partners.
Given the current valuation uncertainty and further down-valuation risks, particularly in venture and growth capital, as well as large leveraged buyouts, those segments are attracting significant discounts in the secondary market, which are hard to be swallowed by trustees or investment committees. So, a bit counter-intuitively, investors prefer to sell their midmarket portfolios, where buyers see less down-valuation risk and are willing to price higher in secondary market transactions. With our midmarket focus, we are therefore seeing a strong flow of opportunities in our core areas of competence.
We remain selective and conservative on the valuation side. Additionally, we generate an important part of our deal-flow in direct interaction with GPs and sellers as we are known in the market as problem solvers. It is also a great time to build-up portfolios and exposure and we recommend all our investors maintain a relevant allocation to secondaries.
Q | What risks should LPs consider in this market?
There are three areas LPs should focus on in my view:
Track record analysis and due diligence. Given the fundamental changes the “new normal” provokes, LPs should focus on cycle-proven value creation strategies and should normalise returns derived from high financial leverage as well as unsustainable multiple expansions in the track record so to arrive at a realistic return assessment of the fund managers strategy. What has worked in the past few years may not work in the current environment. We also emphasise the operational due diligence, including systematic analysis of third-party risk exposure to custodians / banks, administrators and financing providers.
Assessing GP survival, alignment, team dynamics and GP stability. A generation of experienced fund managers are coming up for succession as founding partners start retiring. While those fund managers are often specialists focusing on succession situations in their own portfolios, we have observed a high failure rate in their own ability to hand down the keys to the younger generation of partners. Also, for fund managers whose portfolios maybe challenged by the changes in the environment, LPs should probe GP stability in case, for example, the previous fund wouldn’t produce carried interest or the GP only manages to raise a sub-scale fund.
ESG integration. ESG aspects will become a “must have” for mid-market companies and we already see that strategic investors apply significant discounts if a company doesn’t have a state-of-the-art ESG framework and process. ESG is being viewed as an indication of strong governance and risk mitigation as well as a framework for value creation.
Q | What are the implications of SVB for the private equity market?
SVB had become THE specialist lender for the technology and healthcare sectors, mostly venture to growth stage companies and funds in the USA. It was one of the few debt solutions providers for start-ups. As a direct implication, I can see that lending for those type of companies will become harder and more expensive as alternative lenders may have different underwriting criteria, adding to the relative drought of capital in VC/growth financing. This is equally the case for fund financing lines.
As we witnessed some contagion to other banks in the US and Europe, such as Credit Suisse, we must monitor closely how this confidence crisis unfolds and whether the less-regulated private lending market will prove resilient. In addition, it is quite reasonable for lenders to increase their credit risk margins in the context of the higher volatility and uncertainty and hence overall lending costs are experiencing a significant uplift.
Q | If Unigestion leads a direct deal, what are the deal characteristics?
We are looking for companies that are the market leaders of tomorrow within one of our investment themes and that are benefiting from positive fundamentals and resilience. They should also be strategically attractive to a broad range of buyers. The following factors are key:
- Robust financial profile – profitable, cash generative, strong growth potential
- Positive alignment with founders or managers
- Clear ESG positioning and positive impact on an SDG
- Multiple value creation opportunities and industry experts available to support value creation
- Low financial leverage, which allows the re-investment of free cashflow into growth
- Reasonable valuation and tangible returns of 2.5x invested capital as a base case.
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