According to Attrato Advisors, investor demand for growth remains implacable across public growth stocks and private equity and venture capital funds (often in TMT and healthcare). In previous dispatches, we have discussed the significant amounts of capital raised by PE/VC funds, citing dry powder at an estimated $1.0 trillion in addition to the planned increases in commitments by investors. In the 3Q18 dispatch, we discussed that deal volumes had set a record before the year was even over and the size of the largest deals was growing tremendously. As the IPO markets have remained strong, Silicon Valley Bank expects that the flood of capital from these exits/IPOs will lead to a virtuous cycle of investors receiving capital back from funds, entrepreneurs starting new ventures, and LPs reinvesting in the next fund vintages. Preqin stated in its 2Q19 PE and VC Update that 41% of funds closed in the first half were in the market for six months or less, which shows that managers have had relatively seamless fundraising processes. According to PitchBook, PE-led acquisitions accounted for almost 40% of North American M&A volume in 1H19, which is a continuation of a trend from its average of about 30%. Valuations on private equity transactions remain elevated, with managers communicating that attractive deals are consistently trading at mid-teens or higher EBITDA multiples (versus 10-12x multiples seen just a few years ago). The high level of sponsor activity, including sponsor-to-sponsor transactions, and level of available capital to allocate brings about questions regarding how the competition is impacting forward returns. Valuations, the size of funding rounds, the length of time that companies are remaining private, and exit strategies have all changed in response to the influx of capital this cycle. We expect that exuberant PE/VC capital activity will present opportunities down the road for distressed managers, secondary private equity funds and lenders that can step in to provide liquidity to funds that run into trouble late in their investment periods. However, these opportunities will take some time to emerge as a large amount of dry powder currently available in the market will allow prevailing trends to continue in the near to medium term.
Captive Incubators: There is a growing trend of captive incubators within venture firms. Incubators are typically managed with only General Partner (GP) capital and do not provide access for Limited Partners (LPs). The growth of internal incubation platforms has occurred as early-stage funding rounds have occurred later in the start-up life cycle, in the larger size and much more competitively. The advantage of an internal incubator is that very small and very early stage GP investments can give priority access to LP funds when the companies are ready for additional funding rounds. With often 1-3 years of exposure to the management teams and businesses via the incubator, the information asymmetries are materially reduced between the management teams and the GPs. This creates a more favorable dynamic in investment selection by the GP on behalf of LPs. One major question that arises is how companies move from the GP investment pools/funds to LP funds. In some instances, we have seen managers look to assign a reasonable market-based valuation, even if they and co-investors allocate all the capital (so the real market value is not tested). In other instances, managers have sought to transfer the companies over to the LP Funds at the cost to mitigate the conflict of GP ownership mark-up into the next funding round with LP capital. Incubators are likely to become more prevalent as managers seek ways to avoid the high level of competition for on-the-run transactions.