Q&A with StepStone’s Tom Keck on 2023 private equity trends

"LPs may need to make some hard choices about committing capital in 2023, as allocations are already stretched – so fundraising will continue to be elongated."

The market dynamics of private equity changed dramatically over the past year.

Will a possible recession, high inflation and rising interest rates continue to change how LPs allocate to private equity? And does the volatile macroeconomic picture provide headwinds or opportunities for the asset class?

We spoke with Tom Keck, partner and head of research and portfolio management at StepStone, to hear his views on where the industry may be headed.

LPs were certainly impacted by the volatile economy of 2022. What do you expect the economy to look like in 2023 and how are you preparing with regards to private equity?

The market expects the Fed to start to cut rates by mid-2023. There is a decent probability that the Fed will need to maintain a hawkish posture longer than that, as inflation drivers may be more structural than the market expects. This could challenge the “soft-landing” scenario we are all hoping for. But if there is a recession in the US, it will likely be shallow.

The situations in Europe and Asia are more difficult to forecast, but it seems safe to expect that growth will be slower in Europe than in the US as a result of the Russo-Ukrainian War. Asia will be challenged by the difficulties China is having in unwinding the zero-tolerance covid policy. China will likely figure this out, however, so there is a chance that growth in Asia will surprise to the upside, despite recessionary issues elsewhere.

With regard to private equity, deal-making will begin to pick up relative to 2022 but will be focused on higher-quality companies and companies in deep distress in the first half of 2023. We are seeing more P2P activity and would expect that to continue, especially if public-market volatility remains elevated. LP secondaries will be more common, largely a function of overallocated LPs impacted by the denominator effect. We think GP-led secondaries volumes will continue to be strong, principally because managers have even fewer liquidity avenues today while the pressure to generate liquidity and outperform peers remains a key focus for LPs. Distressed strategies, which have largely been dormant for a decade-plus, will become increasingly more common as default rates start to tick up.

Historically, periods of dislocation generate robust vintage returns. Are we likely to see that in 2023?

Yes, 2023 will likely be a strong vintage for private equity. Valuations will be more attractive, especially in secondaries, growth-oriented sectors and VC – the long-term drivers of growth in those sectors are still very favorable. Another reason is that credit markets will be tight. This favors secondaries where legacy financing structures are cheaper with more flexibility. VC and growth equity will likely also benefit since these strategies rely less on credit to drive value. And lastly, it’s our view that only the best deals will get done, so from a quality perspective, it should be an attractive vintage. LPs may need to make some hard choices about committing capital in 2023, as allocations are already stretched – so fundraising will continue to be elongated.

The denominator effect has had a big impact on LPs this past year – some funds had to stop making commitments earlier than planned, etc. How will the denominator effect shape 2023?

To the extent there is a deeper market pull-back, fundraising could become even more challenging. However, fundraising in 2023 will likely be similar to 2022, unless interest rates begin to fall again due to both Fed activity and the bond market. That would allow GPs to start exiting companies more aggressively, freeing up capital for new commitments. This is an unlikely scenario.

LPs continue to want to build long-standing relationships with GPs; however, one-to-two-year investment periods seen in recent years (versus three-to-five years, historically) have challenged the ability to maintain this approach. The denominator effect exacerbates this issue and will strain LP budgets, especially those that are over-allocated. However, there continue to be new pools of LP capital coming online, which will help boost fundraising.

First-time funds with proven track records will continue to be able to raise capital; however first-time managers with no/limited track records will find the fundraising environment challenging.

On the secondary side, the denominator effect is widespread and exacerbated by ”the FX effect”; it’s become significantly more expensive for certain LPs to fund capital calls. CIOs are in the process of assessing their situations, planning alternative solutions and socializing those options to their committees. Investors are not panicking; they’re planning and watching. But by this time next year, it’s likely that we will see peak supply volumes at a time when valuations have fallen/stabilized, rates have settled and uncertainty has moderated. It could pan out to be an optimum entry point for secondary investors.

Is a challenging market environment creating strains in GP-LP relations? We have also heard that many LPs have limited staff, which is impacting decision making.

GP-LP relations are not strained, but lean teams and allocation limitations are impacting decision-making. The rising tide has lifted all boats in the past decade, so it has been difficult for LPs to detect differences in performance. This has also allowed GPs to have more leverage to raise new strategies and/or push the envelope on terms. As the economy slows down, any defects in GP portfolios will begin to emerge, which will impact LP relations and decision-making. As the fundraising cycle and pace normalize, LP staffs should have more capacity to analyze and diligence their existing relationships and assess potential new managers.

Given the nature of the asset class, private equity valuations have not historically seen the same level of volatility as the public equity markets as PE owners are rarely forced sellers and can hold investments longer, manage through any periods of softness, and sell in a more optimal environment. We have not seen GP-LP strain due to valuation concerns.

In past times of market volatility/recessionary periods, co-investment “tourists” exit the market, and GPs lean in on their strategic co-investment partners. Co-investment opportunities will continue, but the syndicated market will likely shrink as GPs prefer to partner with strategic co-investors earlier in the transaction process.

Will private equity make new inroads on the ESG and diversity front in 2023?

Yes. Investors both public and private are increasingly using ESG as a lens to look at each investment. As more data become available, they will inevitably lead to more information with which to make investment decisions. ESG data are currently scarce and confusing, but as that situation resolves, these factors will increasingly drive the cost of capital for companies, and therefore investors will ignore ESG at their peril.

DEI will continue to be a priority because private equity is fundamentally about finding talent, and LPs and GPs alike cannot afford to ignore any pockets of human capital that could provide great talent. LPs are continuing to focus on DEI and are increasingly tracking and measuring GPs’ progress, which brings more accountability.