Nizar Tarhuni: The State of Private Markets and Venture Capital Investing

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Nizar Tarhuni heads up research for PitchBook, which is a Morningstar affiliate. PitchBook is a premier provider of data on public and private markets. We’re going to focus a little bit more on private markets today because this topic is aligned with what we’ve been talking about recently at Morningstar relating to the evolving investor. The concept there is it’s not traditional financial outcomes, it’s also nonfinancial outcomes. It’s also not just public markets, it’s private markets. It’s another important dimension that advisors have to manage on behalf of their clients.

Background

Bio

Venture Capital, Public, and Private Companies

“Battle of the Funds: Do VC Specialists Outperform Generalists?” by Leah Hodgson, PitchBook, Sept. 21, 2023.

“Quantitative Perspectives: US Market Insights, Q3 2023,” PitchBook, Aug. 10, 2023.

“Analyzing the IPO Market Outlook: Examining Current Market Conditions to Highlight Potential Next Steps for VC-Backed IPOs,” PitchBook, Sept. 7, 2023.

Performance Trends

PitchBook Indexes

Q3 2023 PitchBook-NVCA Venture Monitor

Return Smoothing

“Return Smoothing in Private Markets: Estimating the True Volatility of Private Market Returns,” PitchBook, June 4, 2021.

Strategy and Manager Selection

“Predicting Performance: How Persistent Are Private Fund Returns?” PitchBook, Aug. 26, 2023.

“Allocator Solutions: Evaluating Persistence in Fund Performance,” PitchBook, Aug. 24, 2023.

PitchBook PE Barometer

Transcript

Jeff Ptak: Hi, everyone. Thanks so much for coming out. We’re really thrilled to be doing this live recording of The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: We wanted to start off by thanking Ben for the warm welcome, also to the Ritholtz team for organizing this wonderful conference, and also the other conference organizers for their tireless efforts to bring this to fruition.

At this point, I’m really pleased to introduce our colleague, Nizar Tarhuni. Nizar, if you’re not familiar with him—we won’t give you the full CV—he heads up research for PitchBook, which is a Morningstar affiliate. They are a premier provider of data on public and private markets. We’re going to focus a little bit more on the private markets for purposes of today’s discussion. I would say it’s very much aligned with some of the things that we’ve been talking about recently at Morningstar relating to the evolving investor. And the concept there is, it’s not traditional financial outcomes, it’s also nonfinancial outcomes. It’s also not just public markets, it’s private markets. It’s another important dimension that advisors are having to grapple with and manage through on behalf of their clients, and that’s why we’re so thrilled to have Nizar’s time today.

So, we’re going to get into manager selection and dispersion of returns and many of the salient topics that are so important to you and your clients that you serve when you’re trying to make a prudent selection. What we thought that maybe a logical place to start was what’s happening in private markets right now. Nizar and his team put out reams and reams of interesting research. Some of it is landscape research that talks about what’s going on big picture in the private markets. And so, I thought I would start there, Nizar, if you don’t object.

Maybe you could do a little bit of context setting. How many private equity-backed firms are there in the U.S.? And how does that compare to, say, the total number of listed firms on New York Stock Exchange and Nasdaq?

Nizar Tarhuni: Well, thank you for the kind welcome. I appreciate the opportunity to be here. I think it’s been really fun for me to see the get-ups of everybody here. I think the last conference I was at was in June. It was 85 degrees, and I was in a suit and tie with a lot of private equity firms. So, I think it’s fun to see the environment here.

In terms of the question on inventory, I think if you go back to 2000, I think there was roughly around 2,000 privately backed companies, specifically private equity-backed companies. And I think you had somewhere around 4,000 to 5,000 publicly traded companies. And then, if you went forward to 2006, there was this intersection where now you had around 5,000 private equity-backed companies and 5,000 publicly traded companies. And then, you fast forward to today, and now you’ve got 11,000 private equity-backed companies in the United States and you still have around somewhere in the 4,000 to 5,000 range of publicly held companies. And that doesn’t even include the venture-backed businesses. From a venture-backed perspective, you’ve got over 50,000 companies today that are backed by VC that have raised a recent round of capital and haven’t gone bankrupt, so they’re still operating.

And so, I think the landscape, just in terms of the volume of what you’re seeing in private companies has actually gotten significantly larger. And then, when you think about the private equity-backed businesses, some of those are smaller. The median deal size in a private equity-backed business is actually only $50 million, but you do have a tremendous amount of companies as well that are doing a billion or two in revenue and now all of a sudden, they start to compete, and they look comparable to what you’ll see in a lot of publicly traded businesses. And so, I think the landscape of how people look at private companies is shifting quite a bit, not only from how much time you have to spend with the volume of companies there, but also in the makeup of the businesses that are privately held.

Benz: Naz, I wanted to ask if you can help us get a sense of scale of private and venture capital. Maybe to put it in perspective, you could talk about how big those firms are in aggregate relative to the market cap of all publicly traded companies. And then, a related question is, if advisors are thinking about putting their clients in these types of companies, is that a good way to rightsize position size as a percentage of an equity portfolio?

Tarhuni: So, you can look at it a couple of different ways. I think if you look at the total market cap—and for us, we would use, for example, in private businesses or private equity, we’d look at net asset value—so total value that’s remaining in a fund that’s in the ground in addition to capital that’s been raised by these funds but hasn’t yet been distributed. So, just think about total NAV of the private equities industry in the U.S., collectively, that’s only 5% today of the total U.S. equity market cap. And if you look at the venture market, the venture market is actually only around 2% of the total U.S. equity market cap. And those figures have both doubled over the last, call it, three to five years.

And so, yes, the market is getting bigger, but as a percentage of the equity market, it’s a very small sliver. And I think in terms of how you size a portfolio if you are an advisor, I think it’s really different relative to institutions. And I actually think there is a lot of conversation around advisors wanting to be in private equity or in venture and alternatives in general. And I think there’s a lot of danger there, because when you think about placing money in private equity, what you see right now for retail or even high-net-worth individuals, the types of vehicles that are afforded to them or available to them—whether that’s BCRED or Carlyle, these are great asset managers—but they are very different products than what you’re going to see the institutions in. I also think when you think about an institution that’s got a ton of diversification happening inside of alternatives—so they’re finding different varying correlations, whether it’s in a secondary strategy or in a private credit strategy versus private equity, versus real assets, a lot of retail investors—what you’ll see is, well, can we place them in a pure private equity fund or a venture fund relative to public markets? And you’re not going to get that same diversification there, and you’re not going to get the same return profile that you think you might get.

So, I actually think sizing, there’s no one size fits all, and it all goes down to the access of the type of strategy you get, whereas I think a lot of the strategies that are available to ultra-high-net-worths or even retail investors in general aren’t actually going to accomplish what people think they might accomplish or what they read about in the paper. It might actually be more of a detriment to that portfolio than a help.

Ptak: And we’re going to delve some more into topics like manager selection, asset allocation, portfolio construction, which you’ve touched upon. I thought maybe briefly we would talk about trends, probably most manifest of which is performance. I think that PitchBook has developed a set of proprietary indexes to track the buyout, private equity growth, venture capital segments of the private markets. What’s performance look like in recent years?

Tarhuni: So, in recent years—it’s kind of hard to fully put it in perspective because you have a few different things working against you when you’re valuing in private businesses or valuing private funds. Number one is volatility. So, I think, based on the last question you had in terms of sizing a portfolio for advisors, you get a lot of questions around, well, do you get outsize returns, and do you get less volatility in private equity? Well, the returns that are reported are reported on a quarterly basis. There’s not an active trading process to try to clear a transaction. And so, pricing a deal or figuring out where something might trade at in the market that’s privately held is difficult to do. So, it’s effectively an academic assessment of where you think that business would trade through a process.

I think what we’ve noticed historically is that firms tend to be very quick to mark up assets and very slow to mark down assets. So, at that point, when you try to level and think about, for example, like a Sharpe ratio, the Sharpe ratio you’re getting from private equity is actually nowhere near what you’re getting from a public market or an equivalent buying a stock or investing in a fund when you think about really de-smoothing the returns and thinking about volatility. You’re taking on more risk for maybe higher return in private equity.

So, from a return perspective, I like to look at just vintages. So, if you think about a fund 2012, 10 years ago, what we find is about six years in, the returns that are stated by a manager tend to actually converge with the real returns that they end up realizing. So, a good barometer of that is if you go back 10 years, now we know those returns are pretty much real and a lot of that capital has been distributed back in private equity in the U.S., you see, we use a PME to take a look at a dollar in private equity versus a dollar in the public markets using the S&P 500 outperformed by about 9%. And then, if you look at the venture markets, it’s a bit higher where you see a dollar in the S&P versus venture outperformed by about 25%. But then, if you look at private credit, a dollar in private credit then versus today, unleveraged, actually underperformed the S&P. And a lot of that’s totally OK because the people investing in that strategy aren’t necessarily looking for a return, they’re looking for income. So, on a relative basis, you’ve seen some outperformance, but I think what you don’t get with that is thinking about could you stomach that volatility through periods of illiquidity?

If we look at it recently, we do measure indexes, we try to get a sense of how NAV and distributions are moving every quarter. You’ve seen private equity decline over the past three to four quarters, and you’ve seen them marked assets probably lower, more in line with public marks faster. What you’ve seen with venture is effectively a few quarters of no marking down, and then all of a sudden, you saw massive markdowns over the last couple of quarters. And effectively, what you got there was you’ve got a big plethora of companies that have become unicorns. We’ve got 800 of those today, that’s double what it was two years ago, that can’t raise capital in the private markets right now. If they need to go public, their comps don’t look very great. And so, you end up seeing a ton of down rounds that are coming to market. You’re seeing VCs unable to distribute capital back to LPs. So, all of a sudden, now they’re forced to mark down those assets. So, even on a quarterly basis, you’re seeing that asset get marked down by 10%, 11%, 12% on a quarterly basis.

Benz: Can you discuss deal activity and how that has trended recently?

Tarhuni: I’ll break that up into private equity versus venture. On the private equity side, you’ve seen deal value, which will probably decline by about 20% year over year, and it’s done that for the past two years. But you’ll see volume actually remain relatively healthy. And we’ll unpack why here in a second. And then, if you look on the venture side, you’ve seen volume is actually probably going to be relatively flattish, probably a little bit down, but value is going to come in down some 50% on a year-over-year basis. So, if we start with private equity, effectively what you’ve seen—again, you hear a lot about the big transactions, the multi-billion-dollar deals, median deal size in private equity is $50 million.

So, if you think about what’s happening is, effectively, you’re seeing managers say, well, I can’t get credit to fund an LBO. And if I do, my yield to maturity is going to be somewhere at 11% or 12%. Spreads have widened, they’ve come in a little bit, but for the most part, they’ve widened from where they were a couple of years ago, and you’ve got a base rate that’s obviously 300 to 400 basis points higher. So, now, a lot of those assets can actually take on that debt. So, what you end up seeing when you have massive fundraising in a market, is you see bigger shops come down market, and they can overequitize the transaction, and they can swallow the whole thing up. But in order to do that, particularly if a company needs to trade, now they’ve got a bit more leverage when it comes to valuation. And so, they’re paying lower prices for them, they’re paying lower multiples for some of these smaller transactions, and they’re able to staple them onto an existing platform and get growth. So, I do think you’ve seen private equity put money to work in that way with less debt, and perhaps you fast forward two, three years and you refinance, but right now they’re able to do that.

In the venture market, what you’re seeing is, effectively, a big chunk of companies that have gone—we’re used to raising money on a year or a year-and-a-half cycle, that all of a sudden, they’ve been frozen out of the market. And you’ve seen a group of venture investors that have basically said, in order to do a deal, we need to come in at a lower valuation, or we need to add a little bit more structure, or we need to have more liquidation preferences on a transaction. And in order just to go through the paperwork that takes to work through your liq prefs and things like that, that deal takes a lot longer to close. And also, it takes quite a bit of time to benchmark the optimism you’ll see from a lot of founders versus what the VCs are looking at today when you think about pressure from their LPs.

So, you’ve seen valuations start to decline precipitously, even in new rounds in venture. We’ve gone from effectively 0% to 3% of rounds being down rounds to, I think today, we’ve got close to 15% of rounds in the market right now are actually being marked lower from their last valuation. So, you have a tremendous impact on employees and founders and those are the people that are getting marked lower and are having to deal with more dilution. So, deal flow has been OK, but it’s come at the expense of valuations on the private equity side and on the venture side. It has come at the expense of the employees and the founders, but it’s a different market today.

Ptak: I wanted to jump ahead and talk about strategy and manager selection. Your team put out some very interesting research on persistence of performance, persistence of returns, from say one fund to the next fund. What did you find? Did you find that there was any sort of relationship between past and future performance?

Tarhuni: I think it all comes down to the individual manager. I think there’s nothing there collectively across the asset class that I think will actually tell you that there’s full-blown persistence across the entire asset class. I think what you’ll find is, we’ve seen managers that you would say are maybe lower quartile, the bottom-quartile managers that somehow just continuously raise capital—they’ve got three or four vehicles and some of that’s due to the makeup of when they’ve signed up brand-new LPs who commit to two or three vehicles. And you see managers who have tremendous persistence and are incredible risk-takers.

I think in terms of from an advisor perspective, I think that’s, for me, it makes the conversation around, can you put more retail investors in private equity or in alternatives or in venture? It makes it a tougher conversation for me. I think there’s a lot of optimism about trying to include that pool of capital in private equity. But I think that the manager selection piece is where I think part of that falls down. So, access to the best risk-takers in the world, typically those funds have large institutions who have large swaths of capital they’ve put in and are committed for many, many, many years, if not decades, and they typically don’t need to necessarily raise more capital from others. And what I worry about is then you see from a manager selection perspective is net newer managers with less track records who haven’t had persistence for a long period of time. And they’re the ones who end up trying to tap the retail market. So, you end up actually putting investors who need more liquidity and need better Sharpe ratios in less-proven managers without performance persistence. So, I think it varies, but it certainly comes down to access to the type of manager that you’re putting money in.

Benz: Relatedly, you found that the range of returns among private funds is much wider than it is for public markets. For instance, over the two decades ended in December 2022, you found a more than 10% annual gap between the top and bottom quartile of PE funds. And it was even wider for venture capital. So, it seems like that puts a premium on fund and manager selection. Kunal referenced this yesterday in his conversation. So, how can an advisor improve his or her odds of success on the manager selection front?

Tarhuni: It’s a great question and one that I think is really hard to answer in one simple way. I think, from an advisor perspective, a lot of it comes down to how much money can you actually put to work and what’s the capacity you have as a platform. I think what we’ve seen is where we’ve seen larger advisors who pull a tremendous amount of capital together across their platform or find ways to also allow a lot of individuals in their platforms to invest directly with sidecar vehicles tend to have a little bit more control over the fee structure, which improves the outcome that they’re going to get. But I think when you see advisor platforms that look to just simply find some sort of small allocation in a larger fund or with bigger managers that has a little bit more liquidity involved, typically what we’ve seen is the more liquidity a fund offers, the less return it’s typically going to offer.

I think from that perspective, the relationship with a manager that you’re invested in truly has to be long term in nature. So, when you look at institutions who have been able to seed big GPs over the past decade or two, typically they’ve committed capital to three or four vehicles at once. So, if you’re committing capital to three or four vehicles at once, that means you’re building a 12- or 13-year relationship right off the bat. And I think you’re also OK with that illiquidity for 12 or 13 years because you’re going to reinvest into multiple vehicles before you ever know how they really perform. I think that’s probably hard for many advisors to do, depending on the size of saying, hey, I’m going to put money to work. And it’s OK, we don’t need to know what the return profile might look like. And I’m OK with the illiquidity for 12 years. And I think depending on who you’re serving, you might have some investors or individuals who are OK with that, and you might have some that simply aren’t. So, I think it’s a challenging question, but it really comes down to can you put together the capacity of capital that’s really attractive to a GP that also allows you to get preferential treatment in some of your return stack? And then, the fee treatment, do you have the sophistication to underwrite some of the direct opportunities you might have alongside that manager, and can you do that for an extended period of time?

Ptak: Maybe to take the glass-half-full argument, especially from an advisor’s perspective, you’ve got upfront commitments, lockups, typically longer time horizons. One could argue that those things protect you best from the devil you know, which is yourself, or in this case, your client. So, do you think that the structure in and of itself, well, it suffers from some shortcomings that actually can confer some behavioral benefits because it basically enforces patients and not acting impulsively to one’s own detriment?

Tarhuni: I think, in the public markets you hear a lot about: you can’t time the market and you’ve got to have a consistent allocation; you have to stick to it. I think one of the things that I think is helpful with private equity is, when you’re picking a top manager or a top-quartile manager, ironically, what you’re really paying for is someone who can time the market, like that’s a lot what you’re paying for in that illiquidity premium. So, if you look at private equity alone, for example, if you’re a majority holder of a private business, there are many levers you can pull if things aren’t going well or in a challenging economic environment to help that business grow or to stabilize and stop the bleeding. You can take the keys if you need to. If you’re in private credit and you’re a first-lien investor, same thing, like you can have the keys turned over to you, and there’s a negative probability scenario that occurs.

So, I think there in a market where you might see things in the … Which is why I think the private equity returns haven’t been marked down as fast as the venture ones today. I think what you basically see is that you’re in an asset where the manager can actually step in and control the situation a bit more than if you’re in a stock or if you’re in a venture-backed portfolio company. So, from then, you’re paying for that manager to be able to recognize an adverse event, step in and help rectify that situation and help preserve the capital for the investors in the fund.

I think on the venture side, it’s a little bit different because you are in a power law business where the majority of the investments that you do in that fund are not going to work. And if you end up in an environment like we’re in today where a yield spike, the way they have over the last couple years, you are going to heavily discount those future cash flows. And there’s not a lot you can do about that. And then, you also start to dry up capital into an asset class that needs multiple rounds of continuous funding. So, for example, if you’re at the Series B or C level, and you’ve got to invest heavily in sales and go to market and that capital dries up, but you have no option but to take that and your equity pool drops and now you can’t hire as well, those things are really hard to stomach. So, from that perspective, I think you end up in just SOL in venture. But if you’re in private equity, I do think that’s a place where if you can handle the illiquidity, you’re paying that manager to time the market well.

Benz: We wanted to ask about the PitchBook Private Equity Barometer. Maybe you can talk about what that is. But I have a second question, which is that you track private equity valuations relative to fundamentals, and you found that private equity valuations largely overshot fundamentals in 2020 and 2021, but they underperformed fundamentals last year and earlier this year. So, can you talk about those divergences, but also just what you’re trying to do with that barometer?

Tarhuni: We have a quantitative research team that effectively will take a plethora of different macro data points and we’ll tie that to our transaction flow, our valuations, and our fund returns and our fund cash flow data from the underlying funds that we track. And effectively, what we try to map is can we help create a bridge between where a manager might mark their portfolio versus where it’s really going to land. And what we found in 2021 and 2022 is that of course you had private equity firms that were actually performing significantly better than where we thought the market should mark them. And then, what we’re seeing today is obviously the opposite.

I think it’s not rocket science. Why? I think, all of a sudden, your cost of capital goes from 6% to 13%. Your assets don’t perform as well. You’ve got to triage things a lot harder. You can’t put money to work at the same clip. And that fund structure that allows you to create those leveraged returns goes away. But effectively, what we’re trying to measure there is that bridge between real returns and where a fund might be marking them. And what you’re seeing today is effectively, I think the marks are coming down where they probably should have been. Like I said, I think private equity is a lot easier than venture to manage that, but it’s also not immune to the broader macroeconomic environment.

Ptak: You mentioned some of those fundamental inputs to the barometer before. I think that you found that private equity performance is positively correlated with the performance of smaller companies, and it’s negatively correlated with things like financial stress indicators, high-yield spreads, and the like. Do you think in a roundabout way that’s a confirmation of sorts that when you boil it down, private equity investing is a bet on investing in smaller companies that have gotten cheap in doing so with borrowed money? Or do you think that’s too oversimplistic?

Tarhuni: I think when rates are at where they were two, three years ago, I think that holds true a bit more. I think if you look at firms like Dan Rasmussen at Verdad Capital, a lot of what they’ve done is, say, can we take small-cap companies that can afford to take on more leverage and is that a good proxy for private equity? What you found is in a low-rate environment, it worked pretty well. What you’re finding today in this environment is it doesn’t work as well. Because those companies also—if you think about the leveraged loan market where you’re pricing debt that’s floating and all of a sudden, that rate spikes up on you quite a bit and you have no financing capability unless you can actually grow your cash flows to cover that down, that’s really hard for a smaller business to stomach. If you are a larger business, well, then all of a sudden, you have a lot more options in terms of you probably have more cash flows, you could probably raise more equity—maybe they’re not at great terms, but you can do it. You can also get creative with your payment structures for the credits that’s on your cap table. You’ve got private credit offerings that can do delayed draw-type pieces that allow you to sit with Unitranche solutions, you clean up that balance sheet, whereas you don’t get that for some of those smaller businesses and I actually think it’s really challenging. So, I think what we’re seeing today in this market is that that’s not really what you’re seeing is a leveraged bet on small companies. I think the leverage component alone is what throws that equation off.

Benz: You’ve referenced the volatility smoothing dimension of all this. I guess Cliff Asness calls it volatility laundering, whatever you want to call it. And you and the team have measured that and found that reported private equity volatility was only about half of estimated actual volatility, and in the VC space, the estimated volatility was about 2.5 times what was reported. So, what are the implications for asset allocation and portfolio construction for advisors potentially who are looking at this area?

Tarhuni: I think that’s where it comes back to capacity, and manager selection, and who you’re trying to serve. I think from an advisor perspective, let’s take a look at venture on its own. Venture, that’s the most volatile asset class you can be in. Most of the things you do fail. I think the common perception or anyone investing is, like, I don’t know—I don’t think any of us like losing money and I don’t buy in a portfolio of stocks and just assuming that, you know what, 70% of these might actually suck, but if I can make money on 30%, I feel pretty good. So, I think with venture, that’s what you get there. I think what we’ve tried to do is unpack and just try to draw a little bit more education to, you are dealing with a very volatile asset class. You’re going to see a lot of red on all of your statements for many, many years. And you better hope that that manager has a selection capability to actually get you above the curve.

If you look at the best managers in the world, like the Sequoias of the world, they don’t take public money. They don’t need retail money. They don’t need advisor money. And part of that is capacity. If you look at a benchmark, it’s the same thing. They’ve got a strategy that works with a certain fund size. I don’t think it’s any different than a hedge fund saying, I don’t want to get past a certain size because I can’t make my strategy work. And I think that’s what you see.

Where I always find concerns is where you find a venture strategy that typically works in that $250 million to $500 million fund size strategy. Say, all of a sudden, we want to go to a $1.5 billion or $2 billion, well, then the first place they’re going to tap is they’re going to leave the institutions and they’re going to try to get advisor money or retail money, and you’re seeing that right now. But then, the strategy, the economics get thrown off and then you need more managers, and that creates a tougher investment committee meeting. And then, you need more parameters around how you go forward with a transaction. So, that extends the time that you actually take the due diligence and put money to work, which then there’s an opportunity cost. So, I think, in general, it’s a very volatile asset class. And unless you’ve got the ultimate sophistication and the access to a particular group of managers, I don’t think it’s actually the best place for advisors to be. And I think you’re better off being in a more liquid equity market.

Just to hand around maybe a little bit of that piece of why I don’t think it makes sense. One of the things I like to look at is if you look at the correlations within alternatives. And so, if you look at an institution that’s putting together a strategy in alternatives across 12 different pockets, they might be in private credit or in secondaries, real assets, and so on, you’ve got a correlation with private credit that’s actually 60% correlated to private equity because all that is, for the most part, 70% of those deals are going to support leveraged buyouts. And if you look at it from a PME perspective, they actually underperform the S&P, but that’s OK because an institution is typically in a private credit fund, might be going into what we would call a master feeder structure. And so, they’re investing in something with a new vintage, but they actually have access to the entire loan portfolio over the life of that firm that’s still active. And so, they get income in the first quarter after investing. And then, after five years, now they’ve got three years after that where they can get their principal out, but they’re actually getting income the entire time. If you’re a pension plan or a scholarship funder, and so on, that’s valuable to you to preserve your capital and get income because you need that cash flow. I think for the advisor or the retail market, you might not have that level of complexity and that’s just scratching the tip of the surface to need that. And so, if you’re just looking at private equity or venture alone, I don’t think it does many individuals all that well or all that good.

Ptak: Since you mentioned correlations, I think that when you’ve done the work that you’ve done correcting for some of the return smoothing, it’s probably yielded some insights as you just referenced into the true relationship between different types of alternative private market strategies. What do you think are some do’s and don’ts—apart from maybe buyer beware, which it sounds like is an overarching message that you would convey to many advisors out there, especially as it relates to venture? But as it relates to portfolio construction, maybe do’s and don’ts an advisor would want to keep in mind when it comes to combining different types of alternative strategies in a diversified portfolio and knowing what you know about return smoothing and correcting for it?

Tarhuni: One of the things I think about is, can you in an adverse scenario, just getting to fetal position and sit in the corner and are you OK with that? And if you’re someone who used to manage actively, I think it’s a very tough market to be in and you need to be able to handle those questions with the constituents that are investing or that advisor is representing. I think one of the things you have to think about—you need consistent time commitment. And so, if you’re not going to get access to the top-quartile managers, which the reality is you won’t, you won’t get that. Those managers have institutions in place. It’s easier for them to work with them. They’ve known them for years. The reality is, you’re not going to get access to who is currently a top-quartile manager for the most part. So, if you’re identifying a budding star or a net new manager that’s coming to market and you’re going to make that bet, well, then you have to be prepared to make that bet for a few years over an extended period of time because you’ll invest today and you’ll have no clue over the next three to four years how that fund is really doing. You’ll have some signals, but again, things are marked slowly. And then, you got to invest in two years when they come back to market, you’ve got to put money in that fund. And then, when they come back two years after that, you’ve got to put money in that fund. And you have to be able to do that across a platform of multiple managers. So, I think one of the things is, you have to ask yourself, can you actually commit to that type of longevity in a private strategy?

I think the second piece is, you’ve got to figure out if you can actually get capacity. We’ve seen some firms where—we have clients who are RIAs, who say, we want to do SMAs for certain firms and we’ll get a handful of people together and they want to maybe get some direct exposure. I haven’t seen that really work that well. I think what we’ve seen work well as a firm says, we’re going to scavenger a thousand families that we represent and we’re going to see if we can actually come in as a single LP with institutional terms and we’re going to be able to step in the same way that New York Life Insurance might step in. And from there, we want a sidecar vehicle. We want to invest directly. We’re going to put a team together that can actually underwrite these deals directly as well, which helps us save some money on the fees and get better information rights. And we also have the team in place who understands what that looks like. If you can get that kind of capacity and you can commit for a longer term and you’ve got the stomach to do that, I do think you can have some success. It’s more of the, you can’t dip your toe in this market. I think that’s the thing that I feel I read a lot about of, like, well, I think now they’re just going to let retail investors step in, and it’s not that easy, it’s not that simple. And that might be more adverse than helpful.

Benz: One question that’s been on my mind as you’ve been talking, Naz, is I would imagine advisors often have clients who have some business in their orbit that they are inclined to invest in, where the client’s saying, oh, my buddy from law school is doing blah, blah, blah. Do you have some talking points that advisors could use about the universe of small companies and the risks of making that sort of direct investment in a business?

Tarhuni: I think to a certain extent, you’re probably always going to have someone who says, my college roommate just started this. I don’t really care. I’m going to put money into work in it. And because it’s an emotionally driven decision, it’s not necessarily a financially driven scenario, even though we might mask it as such, that’s what that is. I think to me personally, I’m not an advisor. It feels like that’s a hard one to walk somebody off of it if it’s a close personal thing.

I think, in general, though, it’s the ability, can you truly underwrite it? And it doesn’t have to be perfect. You’re going to underwrite a transaction that’s a small company that’s maybe not that old or doesn’t have fast-growing cash flows. But you’re not going to be able to underwrite it with a traditional DCF the way you would do a public company. But can you have some sort of mental model or a foundation in place to help you walk through what the outcome of scenarios could be and what the probability of those scenarios could be? We see investments, even at the venture stage, I think you hear a lot about “we’re just investing in people” and “we’re making a bet on this person.” But I guarantee you, if you look under the hood at a lot of these VCs, that’s not what’s happening. There’s a tremendous amount of work that goes into how they value a TAM, how they value maybe any metrics they have. If they’ve got any market fit or product usage, they’re looking at that with a fine-tooth comb. There’s so much work that goes into what is the true addressable market; what is the real serviceable market; what will actually cost for us to penetrate that serviceable market; what would have to happen for this to go wrong; how do we think about the range of scenarios in two years versus five years? There’s so much work that goes in. It sounds better to say, “Well, we’re just investing in a person. I really love this person, this founder. They were so hungry.” Most founders can be pretty hungry, but there’s a lot of work that goes under the hood to create some sort of mental model to help those firms evaluate those businesses. So, if an institution is going to do that, every individual and advisor should also be trying to root themselves in something like that as well. It’s not just a bet on a charismatic founder who can actually just go drive a business.

Ptak: I wanted to ask you about private credit. It’s come up earlier in the conversation. It seems based on the research that you’ve done that institutional demand for private credit has cooled off a bit this year. And so, it seems natural that they would start passing the hat around amongst high-net-worth individuals, many of them represented by advisors who are out there. Given that, if you had to provide counsel to a financial advisor who is diligent saying a private credit deal that they were being pitched, what are the top two or three questions that you think they ought to be asking themselves on behalf of their client to make sure that that’s the sort of pitch that they should accept on behalf of their client?

Tarhuni: Private credit, I actually absolutely love. I think it’s a great strategy for advisors and institutionals alike. And I also think there’s various market tailwinds that play in dynamics that serve it really well today. I think one of the things most institutions in private credit, there’s some alpha they’re looking for, but it’s usually—again, it’s a sleeve within the alts portfolio. And if you look at a PME from 2012 in private credit, it’s probably performed at 70% of what you would get in the S&P 500. But again, there’s a couple of structural pieces here.

The good private credit funds, many of which can serve an income need, like I said earlier, you’re in something called a master feeder vehicle. You invested in new vintage, but you have access to all the loans in the portfolio. Those managers can actively trade some of those loans. They typically also have mandates to trade broadly syndicated loans within that private credit portfolio. So, there’s ways to make sure that there is more continuity in the income stream that’s coming to investors. So, to the extent that you’re looking at it as a preservation of capital with income coming on a consistent basis, that’s a good place to be. And I actually think it serves that need really, really well.

I think one of the things where you fall is everybody, even today, wants to benchmark it and say, “OK, well today, the yield/maturity on a private credit deal should be 12% to 13%. That’s what it’s going to cost. So great. I want to be there.” Well, again, you can’t take a business as cost of capital from 6% to 13% and then assume that that’s a good place to be because the business might default on that. And two, if you are also in—especially on our end, institutions or larger advisors—if you’re in the credit of these companies, you’re probably somewhere exposed to the equity of these businesses. So, if the equity starts to fall apart at the same time that the credit is picking up, you’re just washing things out. Even if you look at some of the big managers like Carlyle, and so on, or a Golub or KKR, a lot of them fund many of their own transactions. You’ll see their credit funds are also on the cap table of the companies that they’ve done the equity deals in. And in some ways, the equity declines when the credit goes up.

So, you don’t want to benchmark on rate of return. One of the things we look at is, you want to benchmark on loss rates. So, if you look at a portfolio and you say, OK, out of all of your 10-year history in a credit fund, how many deals have you actually lost money on that you haven’t been able to actually recoup in some capacity? And you’ll see everything from 300 to 400 to 500 basis points all the way down to 9 basis points. And those are the funds you want to be in, where people learn how to preserve capital and make sure that you don’t lose your principal and the income continues to step in.

The other piece that you want to ask about is covenants. So, if you looked at 2008, when private credit stepped in, the government basically said that the banks couldn’t lend to a lot of these leveraged buyouts past 6 times leverage. Well, private credit could, and they could step in with a simpler solution. But then, the covenants got really, really, really, really loose. So, all of a sudden, then you were basically competing on the lowest set of terms. So, if you look at the big shops, whether it’s Ares or Golub, and so on, they’ve got the capacity to be able to do that and step in if they like a company without the covenants. Whereas if you’re in a smaller fund, even a fund that’s got $8 billion or $9 billion in AUM, the covenants matter, and do you have the ability to actually step in and help? I think people think about covenants as, if they trip them, well, then the rate is going to go up. Mostly vehicles, they’re not trying to hurt the portfolio companies that they’re in, but they’re trying to see it earlier. They want information rights. They want to know when things might pop up, and they want to be able to actually help rectify that situation for everyone. So, covenants can actually be an incredible thing in this market. And you are seeing more of that step up.

The last thing I’d say is the funding base. Most private credit funds, many of them, you see them, they’ve raised $2 billion, but they’re probably deploying somewhere in the world of four to six. So, they’re typically pretty leveraged. And that leverage is traditionally coming from the banks, ironically, that’s not allowed to lend to the portfolio companies more than 6 times, but they’re usually giving most of these funds quite a bit of fund-level leverage. And you want to get a sense of, are you leveraged at 2 to 1, 3 to 1, 4 to 1? The bigger shops can be leveraged anywhere from 5 to 6 to 7 times. And the smaller shops are going to be leveraged. There’s a fund, without naming names, here in town, they’ve got a few hundred million AUM and they’re leveraged at 3 times. So, you’ve got to figure out those leveraged returns can be pretty nice, but you also have to figure out, are you OK taking that on? Because that funding base, for example, this has happened in history is, if you lever a fund and the bank shows up and says, hey, you’ve done nothing wrong, but we need you to draw that leverage down. Well, then the whole economics of that entire vehicle goes out the window when all of a sudden, you’ve got to take equity out of a fund to pay down the debt.

And so, what do you see these managers doing? They spin it out and they put it in a CLO. And who tends to be the buyer of the AAA tranches in the CLOs? It’s the banks. So, you’ve got to find ways to see, do they have the ability to actually shift that leverage off into a 12-year note, into a CLO, and so on, or do they not have the ability or the track record of doing that? And if they’re leveraged and things don’t go well for them, or the bank decides to pull it down, well, now you’re stuck with a very different return profile, a very different Sharpe ratio. So, in general, it’s loss rates and the funding base and the leverage is pretty big.

Benz: We wanted to ask about the IPO market. The market for VC-backed private firms going public has frozen up for all intents and purposes. Do you see any signs of a thawing on the horizon?

Tarhuni: I don’t, personally. I think you’ll see, if your Instacart is going to market, I think what a $9 billion-something valuation, I think it’s a third of what their last private market valuation was. That doesn’t feel great to anybody there. They probably, if they could, would raise another private capital round, but also, might just make sense to go to market now. You look at like a Cava, for example, which did well, but that’s not really a technology business. But I think it’s hard. We have a VC-backed IPO index. So, we track companies that went public that were venture-backed over the last two years. And if you looked at in 2021, even beginning in 2022, from a price/sales perspective, those companies were trading in the public markets, just recently went public, at 25 times sales. And that actually shot up quite a bit. And then if you looked at it today, those companies are trading at a 5 times sales. And it’s basically been there for like four or five quarters. So, I think what you’re hearing is in the equity market, sure, we’ve had this run up soon, but you’re still seeing that pool of companies that were venture-backed with venture-backed profiles in their P&L, nobody really wants to touch them with a 10-foot pole. And people are nervous about their ability to actually get to a place of profitability. I think that makes it hard when you think about the pool of private companies that would go to market with that type of P&L.

From a unicorn perspective, you’ve got 800 companies that are current unicorns. That’s a number that’s grown more than double over the past few years. And the average of those companies has actually raised—the median company in that cohort raised money 17 months ago in a very different valuation environment. So, what happens in a boardroom then is do we raise money at a significant down round, which is starting to happen? Do we think we can shift the P&L to go to market and get some sort of traction? But either way, it’s probably not going to be a great outcome for a lot of the founders, the VCs who have re-upped over multiple rounds, or the employees. So, I think people try to push that off as long as they can until they have absolute no choice, or they’ve exhausted all options to raise additional capital at any somewhat favorable term. You’ve seen some companies that are best-in-class go to venture debt, but venture debt is also pricing you at SOFR plus 6%. So, you’ve got to be able to be a cash flowing business that can also handle 12% to 13% on your cap table. And if you can’t, you’re probably not top best-in-class company, and now you find yourself in a tough predicament. So, I think we’re still in a period of people are going to try to push this out as long as they can and see if they can get the market to shift, rates to shift, and the comps to shift.

Ptak: Before I ask the next question, I believe that you have the ability to submit questions via an app. I could be mistaken about that. We welcome those questions. We’ve got about eight minutes to go. We’ll leave some time for your questions in the last five minutes, which I know Naz is happy to address. Before we do that, I wanted to maybe build on your previous answer to ask you, to what extent do you think a closed market for VC-backed IPOs might threaten their viability? Do they have enough funding, do you think, to survive without doing a public offering or are they at risk?

Tarhuni: I think so. I think if you’re at the late stage, or if you’re what we call a venture growth company, you’ve raised at that point seven or eight rounds of capital, you’re probably sitting there with a few billion dollars in your valuation, if not tens of billions of dollars. And I do think what you’ll see from your VCs is the ability to put more money to work but at significantly more favorable terms for the venture investors. So, we track an indicator of how founder- or investor-friendly the market is. And we look at things like liquidation preferences, valuation step-ups, time between rounds, and different fee structures. And what you’ve seen today in this market is this is the most investor-friendly or GP-friendly market that we’ve seen ever. And effectively, what that means is, you have these VCs who are driving the terms.

So, I think the capital is there for the best-in-class businesses. But one of the things I think sometimes gets overlooked is for a VC-backed company what happened in COVID, it’s happened over the last year, is effectively you look at your portfolio and you put them into different buckets, maybe three different buckets, and you put more money to work at better terms that are advantageous to the GPs in the top companies, you try to offer your time to the middle companies to help them weather that storm, and then, you basically forget about the bottom third. And it’s not a great outcome if you’re that portfolio company, but that’s what they end up doing. So, I think the capital is there, but it starts to go to a much smaller set of companies in the venture universe than it was over the last few years.

Benz: We wanted to ask about real asset, that whole sector. The infrastructure strategies have seen a lot of interest and a lot of assets raising around $60 billion from investors. In public markets, at least there’s a familiar pattern of this return-chasing, performance-chasing, flows-chasing returns, and that is to investors’ detriment. Do you find the same in private markets or do lockups help to moderate the effects of some of those behaviors?

Tarhuni: I think the lockups help for sure. I feel like what we heard quite a bit on the real assets side was I think people are just so worried about inflation and the rate environment and just trying to protect against that. And so, being in some sort of real asset, you saw growth come in in tandem with private credit and the real asset side. So, I think a lot of what you’ve seen there is can you provide yourself some hedges? I think people also feel like when you did see for a period of time, especially in the commercial space, valuations really decline, could they take advantage of that? I think today the market is probably less clear and you’re starting to see jury still out. But I think a lot of that was about, can you hedge against the macro factors?

Ptak: We have had a few audience questions come in. Maybe I’ll pose the first of them to you, Naz. Where does AI come into play in the alternative investing space? On the technology side, this questioner is pointing out, there’s not so much funding. Maybe you could address the first piece. Where does AI come into play in the alternative investing space?

Tarhuni: It’s a good question. Obviously, when you’re thinking about venture, they’ve tried to do a lot of things over the years to drive efficiency and technology with machine learning, and so on. And I think you’ve seen models in play before where it’s, hey, send us all your company statistics and we’ll give you an answer within 48 hours based on our models if you will have success or not. I think what you found when some of the firms went down that path is that it didn’t work all that well, because number one, you had to do a bunch of work to think about how might the TAM change, how might the market change, how about the serviceable market change? And I think a lot of that does come down to investment committee meetings and people doing a ton of work really trying to see the forest through the trees.

So, I don’t think you’re going to actually see it. I think you’re going to see a lot of VCs talk a lot about it. I don’t think you’re actually going to see a lot of them actually sit there and use that to decide what deals they get into and what they don’t. I think where you want to see it is on the back-office operations, whether it’s the paperwork, the administrative that goes into these transactions. There are so many lawyers, so many bankers. There’s a lot of accountants, and so on. There’s a lot of people on the back end involved in all of these transactions, particularly when you’re thinking about running a sale process or a funding round, and so on. I think those are the pieces where you’re doing a lot of duplicative but very necessary work that you see technology can step in. And you’re seeing that now, whether it’s companies that are helping make their way through documents and summarize things or legal AI agents and assistants and things like that. I think it’s more that back-office side is where you see the impact.

Benz: Another question from the audience, which was one of our questions actually as we prepped for this. Has the rise in yields and the increase in inflows to fixed income affected private equity firms and funds?

Tarhuni: Yes. I think I would focus on the yields’ component. So, if you look at even just last year, I think today we’re somewhere at SOFR plus 600 or something like that, and you’ve got the average yield/maturity on a deal supporting an LBO is about 11% to 12%. You go back two years ago, all in, net, some of these firms were paying 4% to 5%. So, it completely changes the economics of how they can go about doing a lot of their transactions in private equity. I also think when you are thinking about the leveraged loan market and trying to go to market, that market also dried up quite a bit because you didn’t have the banks who wanted to step in and syndicate those deals.

So, if you look at this year, technically, the leveraged loan market is only down 20% from where it was last year. I think we’ll do $150 billion so far today in leverage loans, the broadly syndicated market. But that also includes all the refinancings that people had to do to clean up the paperwork and clean up the terms and the covenants. If you pull out those refinancings, that market is down 80%. So, if you don’t have broadly syndicated loan market, private credit steps in, but there’s a tremendous amount of transactions that just can’t get done. A lot of cap tables, you’ve got both. You’ll have a syndicated loan in there and you also have some private credit investors in there and some private placements. So, the yield component has really just hamstrung traditional private equities playbook. And that’s where we talked a little bit about earlier, you’ve seen bigger shops move lower, can put more equity in a transaction. You’ve seen a lot more add-ons. So, you’ve seen a lot more companies by smaller businesses truly boil up that strategy to roll these things up together with smaller check sizes. But the platform strategy from the past couple of years hasn’t been there given where rates are at.

Ptak: Minute to ago. Last question. What’s something that’s on the PitchBook research agenda that you’re particularly excited about as you look to the future?

Tarhuni: I think a lot of the quant work we do is really fascinating today. I think we do a lot of work at just providing more transparency into the underlying assets. So, if we think about how we think about cash flow modeling, we track more fund cash flows at an intimate level than anybody else out there. So, we do a lot of work with our analysts of unpacking. If somebody wanted to reach X amount of allocation with X amount of return, what would they actually need to do to reach that? I think we do that with quite a bit of accuracy. So, we build that stuff into our software.

I think our quantitative models in terms of really unpacking real returns versus stated returns, we do a lot of work there that we continue to iterate on. We’ve done a ton of work building models to help predict when venture-backed businesses will go to market, in what way they’ll go to market, and what those outcomes would be. And I think we’ve been able to do that with some accuracy. So, it’s basically being able to apply a quantitative model to private markets that I don’t think has been done at large scale like it has in the public markets. I think that’s where we’re spending a lot of time with our customers.

Ptak: Well, Nizar, this has been a very enlightening conversation. Thanks so much for being our guest on The Long View podcast. We’ve really enjoyed it.

Tarhuni: Thanks for having me.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)