I ran into investor Jason Calacanis from the All-In Pod a few weeks ago at a video game arcade here in the Bay. If you need a great place to go and play ‘80s and ‘90s video games with your kids - that place is a ton of fun. It reminded me that the All-In Pod is definitely my favorite podcast - I’ve been listening to it every week for a few years. One of the reasons is because it’s always helped me put a macroeconomic frame around what’s happening in Silicon Valley, but also because it’s one of the few podcasts that stays focused on GDP and interest rates as it does on tech news.
On their most recent episode, they talked about the recent GDP news and the implications for the broader economy. This discussion sparked my thoughts on the current conditions and outlook for limited partners (LPs) in venture capital and private equity. Given the interconnectedness of GDP, interest rates, and private market conditions, it's crucial to consider these macroeconomic factors when making predictions for the LP world. By framing our understanding within this broader economic context, we can better navigate the challenges and opportunities that lie ahead.
Economic Context
GDP Growth: The U.S. economy’s grown at 1.3% in the Q1 2024, a significant slowdown from the 3.4% growth observed in the fourth quarter of 2023. This deceleration was primarily driven by a decrease in inventory investment, although consumer spending and housing investment saw increases.
Interest Rates and Inflation: The Federal Reserve has maintained a high federal funds rate, with 11 rate hikes in 17 months, currently between 5.25% and 5.50%. This has led to higher borrowing costs and persistent inflation, influencing economic activities across various sectors.
Fundraising and Deal Activity: Fundraising for private markets has seen a significant decline. In 2023, private equity fundraising dropped by 15% to $649 billion, with a notable decline in VC and growth equity strategies. Smaller and newer managers struggled compared to larger, established funds.
Performance and Strategies: Hedge funds have also faced a challenging environment with increased volatility and uncertain macroeconomic conditions. Many hedge funds have shifted their strategies to focus on more liquid assets and employ advanced risk management techniques. Additionally, there has been a growing interest in quant-based strategies and the integration of AI for predictive analytics and decision-making. [For information on our upcoming course on AI automation for investment firms, look below this story in the newsletter.]
Fundraising: Hedge funds have experienced a mixed fundraising environment. While some high-performing funds have continued to attract capital, the overall sentiment among LPs has been cautious due to recent market volatility and performance concerns. This has led to a more selective allocation process, with LPs favoring funds with proven track records and robust risk management practices.
Market Dynamics: The commercial real estate sector has been under significant pressure due to rising interest rates, which have increased the cost of financing and reduced the availability of credit. This has led to a slowdown in transaction volumes and downward pressure on property valuations. Sectors such as office and retail have been particularly hard hit, while industrial and multifamily properties have shown more resilience.
Investment Strategies: CRE investors are increasingly focusing on value-add and opportunistic strategies, seeking to acquire distressed assets at attractive valuations and implement improvements to enhance value. There is also a growing interest in niche sectors such as data centers, life sciences, and logistics, which have shown strong demand and growth potential.
Investment Shifts: There has been a significant focus on value creation and operational efficiency. Private equity firms are also increasingly utilizing AI to optimize investment decisions and enhance portfolio performance. Continuation funds and secondary transactions are gaining popularity as traditional exit routes like IPOs remain less viable.
Sectoral Performance: Private debt has been a standout performer, showcasing its countercyclical appeal. In contrast, closed-end real estate funds experienced negative returns, and infrastructure funds underperformed relative to historical averages. The performance disparity across sectors highlights the need for strategic allocation.
Geopolitical and Regulatory Influences: Geopolitical tensions, particularly between the U.S. and China, have impacted capital flows, with significant slowdowns in fundraising for China-focused PE/VC funds. Regulatory uncertainties and protectionist trade policies continue to pose challenges.
5 Predictions About LP Behavior
1. Selective Fundraising: LPs will remain highly selective in their commitments, favoring larger, more established funds. Emerging, smaller and newer managers may continue to face challenges in raising capital.
2. Increased Focus on Value Creation: PE firms will double down on strategies that enhance operational efficiencies and profitability within their portfolio companies. AI and other technological innovations will play a crucial role in these efforts. [For more information on our upcoming AI automation course for investment firms, see below.]
3. Geopolitical and Economic Uncertainties: Ongoing geopolitical tensions and economic policies are going to continue to shape the investment landscape. Managers with strong networks and expertise in navigating these complexities will be better positioned.
4. Sectoral Divergence: The performance of different sectors will vary, with private debt likely sticking around as a strong performer. Real estate and infrastructure may continue to face headwinds unless there is significant economic stabilization.
5. Potential Recovery in Deal Activity
This is probably the most important part. Despite the substantial dry powder available in private equity funds, the reality is more complex. According to a recent letter from Lux Capital, much of this "dry powder" is actually "wet," meaning it is not as readily deployable as it seems. The letter highlighted that while there is a significant amount of committed capital, the ability to deploy this capital effectively is hampered by various market conditions, including high interest rates and valuation uncertainties.
Key Points from Lux Capital's Letter: (feel free to read our entire analysis here)
1. Illiquidity and Deployment Challenges: The current high-interest rate environment has made it hard for PE firms to deploy capital effectively. The cost of financing’s gone up, and valuation mismatches between buyers and sellers have made deal-making really challenging. This has resulted in a slower pace of investment and increased focus on managing existing portfolios.
2. Creative Liquidity Solutions: Given the difficulties in exiting investments through traditional routes such as IPOs and strategic sales, firms are exploring creative liquidity solutions. These include continuation funds, secondary transactions, and structured deals that allow LPs to lock in gains while providing liquidity to GPs..
3. Selective Deal-Making: While there’s potential for an uptick in deal activity if interest rates moderate, the overall market sentiment remains cautious. LPs and GPs are likely to be highly selective, focusing on high-quality assets that can deliver strong returns even in a challenging economic environment.
In summary, while there’s a lot amount of capital available, the deployment of this capital is not straightforward. The current economic and market conditions require private equity firms to be innovative in their approach to both investing and exiting investments. This nuanced understanding highlights the importance of strategic planning and adaptability in the current landscape.