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Why Hedge Funds Are Turning to the Private Markets

2021-09-28

Hedge funds are turning to the private markets, bringing increasing competition to the space. Goldman Sachs’ Kristin Kramer and Freddie Parker explain the shift in public and private market dynamics and the implications for investors. 

This is an unofficial transcript meant for reference. Accuracy is not guaranteed.
This is exchanges at Goldman Sachs and I'm out Nathan, a senior strategist in Goldman Sachs Research. Today we're going to talk about the growing role that hedge funds playing in the pilot markets. What that means for investors and to how that's affecting the interplay between the public and private markets Do that were joined by Christian Kramer and Freddy Parker from our global markets, division, Kristen, fatty work under the programme thanks so much for having us. Thank you. Your team recently published report that looks at the nature of hedge funds. Participation in the private markets, particularly in private equity and venture capital, put this into context for us and talk about how and why you
to focus on this topic. Absolutely we ve observed an acceleration of activity and private markets among our hedge fund clients. So we wanted to understand the key drivers and the implications on our industry. We believe there is a confluence of factors at play here, and the first is that there has been a pretty significant shift in the capital formation process for companies. don't often hear this conventional wisdom, that companies are staying private for longer, and that may be the case. Over a multi decade period by our research actually suggests that the time to Ip Yo has been largely stable for the past fifteen years or so, and not about nine to ten years on average. One has changed is the enormous amount of value creation during the private phase of a company's life, the media,
company today now goes through an average of three equity funding rounds prior to going public. That was just one back and twenty eleven on average companies are raising almost twice as much capital pre IP, oh as they did a decade ago. So, as I am sure you can imagine, the impact on these valuations has been dramatic and what The best ways to exemplify this is by looking at the number of unicorns or private companies that are valued at over a billion dollars, there's almost four hundred of these companies today versus just nine a decade ago, that's pray stunning bad. A hundred and fifty five of these attain that status. Just in the first half of this year alone, Why are we seeing this shift in activity and behaviors, as you may expect, given?
this expanding opportunity side. We have also seen private equity and venture capital performance outpace, that of other asset classes and the five year. Growth rate for private equity and venture capital, as an asset class, has doubled that of hedge funds. So all These factors combined certainly have led a lot of our headphone clients to spending a bit more time. Looking at privates right, so you ve got a strong opportunities that you ve got strong return that the great recipe but there are other dimensions that are adding to this Friday. Maybe you have absolutely so. There's a few different dimensions this I think one of them has a lot to do with the capital markets. And we ve seen in the last couple of years a real acceleration in the amount of activity and capital markets, particularly in equity capital markets.
twenty was a record year: the amount of equity issuance. U S, equity and equivalent tissues was coming up on five hundred billion dollars lost here. It looks poised to suppose that this year, on top of which you know, I think, there's been the strong ip pop phenomenon, by which we mean the tendency of IP owes to outperforming the days or weeks after IP, which means has become increasingly competitive. To get access to these. Applications. So, what's this to do with the private market phenomenon, the first is that there is a liquidity pull effect. So if you're investing a late stage, the companies are able to go public more quickly than they might ordinarily being able to do Can these with the IP pop there's a lot of incentive to get an allocation to an idea which is a competitive process so investing- Before that point, definitely gets you in a better position to secure an allocation to the IP there's. A few other dimensions. This, I think, the hedge funds are taking into account, one of which is information synergies. So if you look at public companies and private companies,
you can use the insights derive from want to inform the other. I am particularly thinking about private companies generally the level of disclosure that you'd expect as an investor, is much higher than you get in the public markets. So it enables you to have this much more holistic view of what's going on across the public private divide, but also, hopefully, investing in private in full Your opinion as your public market investments and then lastly, we talked about the performer dimension. One other dimension to the performance question is around volatility. So if you're a hedge fund- and you have private inside your headphone vehicle? You actually get the volatility dampening affair. Told the set of smoothing effect of not marking to market private portfolio and the same right as you do. Your public portfolio, which always he gets marked on a day to day basis. Is the markets go up and down says a sort of natural smoothing effect- which I think allocations appreciate- that I think all of those
suddenly additional factors in drawing had formed into the private market. I want to draw up a not a couple of questions before I do that. Can we just take a setback? How big is the footprint if you can size the volume of the participation of had spent in them that markets today to give a little bit of historical context on that question. This is not hedge funds first rodeo, as it pertains to investing in private in the decade prior to the great financial crisis heads has participated in an average of about fifty private deals per year and that role to about two hundred private deals per year between twenty ten and twenty fifteen, and we ve just seen acceleration from there this year is on peace to be the biggest year by volume in history, and to put a number around that hedge funds have invested in seven hundred and seventy private deals this year, while outpacing last year, which had been the prior you're on record. How
however, while this is a really big uptake for the industry, hedge funds or share of private deal activity versus all of the other private markets. Practitioners, you still pretty modest. We think about four percent of the total volume of private those that have been done? Were you really see the bigger impact of hedge funds? Investing in privates is in terms of dollars deployed, so in aggregate hedge funds are put about a hundred and fifty three billion dollars to work and private deals this year, which is about twenty seven percent of the total capital deployed into private deals? Ok, so they're about a quarter of a veto, morale activity, exactly interesting, and so pretty talkin another about their investing strategies where they investing. How are they investing so predominantly from a strategy point of view. These are equity. Long short manages who doing this of the universe of manages that we see active in privates about eighty five percent. It will take a long should equity funds
within that, I would say there is a pretty profound scooter was sector specialist. So a lot of the managers that are doing this are health care or TIM Tee. and manages many of them a larger. So the majority of this universe are managed that have upwards of a billion dollars of assets on the management, but also, despite the set aside by us too, larger managers. There is definitely a healthy representation of you. the manages, so we ve seen it. And see within managers who launched in the last five years to be investing in private. And actually, if we look at the new launch, We worked within the last year about a quarter of the long short funds that we worked with globally, had some private dimension to their strategy, so there's Daphne and uptake amongst the younger What's it manages, and then, in terms of whether active, I think a lot of this sort of mirrors, the types of manages that they also a lot of these deals within the realm of the tea empty healthcare sectors about seventy percent,
will the deal's hedge funds have done starkly? Have been in those two sectors for comparative purposes those sectors account for about half of the cap weight of the ESA. Ninety five hundred so certainly askew towards two empty and healthcare and geographically as well, less definitely askew towards the. U S historically, which has always been the case, but actually we ve seen a growing. Participation in deals and companies based in Asia and specifically China- and you mentioned or that one of the key motivations is this information advantage. You don't getting more information about private companies by investing in them before they go public, so ultimately, at what stage then, are they choosing to invest in these private companies? So these deals the being done within the realm of what would be traditionally considered the venture capital growth equity space within that I would say there is a definite skew towards the later stages and later funding rounds so well
see hedge funds active, is most often in the series C and later rounds, which accounts for about fifty percent of the deal activity done by headphones and you look around dollar basis is even more profound so about eighty percent of all is that have been put to us by hedge funds, are in those SIRI, see Series Day and even later rounds, so obviously funds are not the only time the measures that are active in the space. We have private equity funds, capital as few have had long expertise and investing in the space. So what differentiates the hedge fund investor from the p, and the basis in this space, one of the key defining features that we hear managers town, It is just a unique set of relationship, so your traditional private equity revenge capital firms have their own set of relationships, their own network that their utilizing for deal sourcing and given that hedge funds planet different sandbox, their potentially leveraging other connections that will lead to a unique set of companies that fell in Basque.
And we also share a lot of hedge funds, talk about their hands off approach. So, as Freddy mentioned, since a lot of these funds are investing in later stage. Deals there really letting these companies management teams run their businesses as they see fit and they're not requiring a board seed, for example, in exchange for their capital at the same time, hedge funds are afraid to bring their public markets in it's too the table to help these companies put early to help coach them and help them navigate the process of going public and everything that comes of being a public. Come Not only are a lot of these insights really valuable by hedge funds may also have a competitive advantage when it comes to their own capital duration, they can be a true lifecycle investor with a company, they can participate in. Kosovo rounds prior to the company going public. They can even cornerstone that Ip Yo and then be-
multi year, holder of the companies public stock. This is a really different pitch them. What you might hear from a number of the incumbent players in the venture capital space, given their typically run, being limited, lay finds that at a certain point, though, have to return that capital back to their investors given their mandate. So we ve talked a lot about the hedge funds moving into private markets, but have you seen signs of private market investors? No p in major capitals investing in hedge funds to compete? So we started to see, I think, more of that develop and I think, particularly in light of many of these sort of competitive advantages, that hedge funds have when they play in the private market. We see private equity and She found wanting to move in the other direction to maybe transitive. We take some of that competitive advantage, but its relatively new and I don't think that's a very large number of firms that you can point to who have successfully built out large headphone franchises, thus far, so we think, there's, twenty or so p
will we see firms that have headphone businesses, of which many are actually equity, longshore businesses so theoretically compatible business. too many of these hedge funds that are moving in the other direction, but thus far at least many of them MRS still remain relatively small, both on an app basis. So a lot of them are in the sub five hundred million dollar bracket and read. if the overall assets, if those firms, a lot of them, are less than five percent of the assets that these funds are running so still quite nascent businesses within the context of the overall size of their assets. With that said, I think totally were starting to observe more private equity and VC firms comes table and try and understand what the opportunities that might be on the public markets and explore whether it might be appropriate to launch a hedge fund, business or another type of public markets, business to be able to compete in the world where the lines between public and private or ever increasingly blood. So if we think finally about the head, funds phase versus the pirate markets. Hedge funds are typically thought of as a very liquid assets, whereas private market our thought of as less liquid. So how are hedge fund
masters. Thinking about this allocation to private markets, are they comfortable with it? So I think there's a few school thought there. The first thing I would say is this definitely variation amongst types of alligators, theirs, types of allocated to a very happy to underwrite this activity or compared to be happy to underwrite this type of activity. I would put that end of the spectrum its foundations, sovereign wealth funds. Family office, is what these having common. In many cases they have very long duration capital, so the liquidity liquidity comparison. I think you, maybe less relevant to them, and they can think about the opportunities that more realistically and the not so constrained. Similarly, if you looked at you ethically? U s- investors and Asia Basin investors tell us that their relative be happier to underwrite headphones activities in the private site versus oppian investors, who tend to be more liquidity, sensitive as a whole. With that said, I would group investors into two camps. I would say there are those who are very
pianistic proponents of this? They believe in only advantages that hedge funds potentially can having the space, and I think in many cases, view it as potentially a differentiated set of opportunities than they getting from their traditional VC p portfolio and then on other side the table. I think you haven't some investors. Why would characterized as may be more reluctant except us, so visa groups that have, I would say, the ability to and on occasion will underwrite hedge funds involvement in private markets, but they'll do so maybe more because they particularly compelled by a single manager and fair abilities and their differentiated and push back some Here from those investors tend to fall into a few different buckets, one is to do with that equality point in the fact that they have I would say silos in their portfolios and this sort of crossing over and blurring of the lines makes it difficult for them to
position these investments in their portfolios. In many cases they have different teams within the same organisation who have to underwrite public market investments versus private market investments. So you have to find way to marry the work of those teams to fail to underwrite these positions. And then there the considerations, I think around risks involved in this, so the implications as for the total liquidity of your portfolio, especially when, as you said, hedge funds are typically characterized historically priorities. what investments and then memories of some prior crises, where you ve seen a liquidity and portfolios become problematic, and I think some best is therefore a little bit reticent and I think especially when you consider the amount of money that flowed into the private market, not just from hedge funds but from other as is well, maybe a little bit more rests to underwrite boasted of forces into privates on the part of hedge funds. At this point, as a result, say you think there actually reason to be worried about this trend in this clarity and again thinking about past crises- and this has an always gone well rate so
the one hand, while we have those memories in the not too distant past. We do think that hedge funds, or trying to be very thoughtful, this I'm around about how to better align their terms so that they can support them. I've investing efforts, but also better sulphur asset liability matching and we ten nay, to see hedge funds structuring their private investments in two key ways, so the first is actually having privates in traditional hedge fund vehicles themselves, and most often this is done via aside pocket, which allows hedge funds to segregate privates from public assets in certain cases, enables the underlying investors to choose whether they want to have exposure privates and how much this has become a much more commonplace way to have hedge funds action structure privates within their own vehicles and was much less the case during the two thousand
crisis. We have also seen a meaningful number of hybrid funds launch which we define as hedge funds that can invest twenty percent or more of their assets in privates. The second way that hedge funds are offering private investors is through separate and dedicated vehicles. This could be through a stand alone, drawdown private equity, find or through a Cohen best men which an investor can select to participate and to get exposure to a single deal, so over I think the bottom line is that there is a much more intentional approach on the part of many hedge fund managers to get the right separation of public and private and the right line terms for those vehicle and would also emphasise that there is no one size fits all approach, so a number of our hedge fund clients, are offering multiple structures, given investors have different needs and at the end of the day, these alligators really need to take a hard look at what the hedge funds
Investing strategy is the way they decide to structure it and then determine how that fits into their own portfolios, understood tat. The implementation is just a lot different. It sounds like this time around. Absolutely that's it. We ve observed we think about the future. Do we think this is a trend? That's gonna persist, or is it more cynical nature something that may be here today gone tomorrow, so when we entered, Hydro manages on this topic. We asked them. How do you see this developing in future for your business? all of them said we see this as a structural phenomena. Now a business. We don't see this as being something cyclical our overall, Location to private may vary, it may go up. It may go down as the opportunity sat shifts through time, but we see privates as being something that are going to be here to stay as something in our tool kit that we will use going forward. Kristen funny thing: so much for sharing your insides on this really interesting trend. But you re much thanks. So much back includes this happened
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Transcript generated on 2021-10-15.