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From the explosive growth in private markets to the integration of ESG best practices, the alternatives landscape is rapidly evolving. To help investors adapt, we propose five areas of focus, including thoughts on manager selection, late-stage venture capital, and thematic investing, among other topics.
The former are characterized by low beta, low total volatility, and the potential to diversify a broader portfolio. With diversifying alternatives (e.g., macro and market-neutral strategies), it’s important to remember that returns may be more modest in isolation and that “uncorrelated” doesn’t necessarily mean negatively correlated — these strategies could have a slight positive correlation and still offer a diversification benefit. By contrast, return-seeking strategies are more likely to use equity or credit exposure to pursue compelling alpha. The goal is to find strategies that are successful in timing the beta (adjusting equity or credit exposure) or in hedging.
Figure 1 shows the dispersion of returns across managers in different asset classes. Compared with managers in traditional asset classes on the left, there are enormous differences between the top- and bottom-quartile alternatives managers on the right. Of course, research shows that even top-quartile (and top-decile!) managers will underperform at times on their way to generating great results. For that reason, we think asset owners allocating to alternatives should focus more on up-front due diligence, to ensure they understand and document each manager’s edge and the inefficiencies that play into the investment process and reduce the risk of capitulating at the wrong time.
Looking at the hedge fund results in the chart specifically, the median return of 5.2% is certainly not inspiring relative to the 8.7% median return for global equity managers, but the caveat is that we’re looking at an exceptionally strong 10-year period for global equities. What’s more, the hedge fund data reflects both diversifying and return-seeking strategies, and to our earlier point, the former tend to have more modest returns. Given the potential for global equity returns to be lower over the next decade with increased levels of intra-stock dispersion (a scenario that’s supported by our own capital market research), hedge fund results like these may be relatively attractive, and particularly for asset owners who are successful in identifying top-quartile managers of return-seeking strategies. We’d also note that there are market scenarios in which traditional fixed income may not be as effective in a diversifying role in coming years, which could make diversifying alternatives all the more attractive.
Growth-stage venture capital (VC) may come later in a company’s life cycle, with the advent of longer holding periods and larger late-stage rounds of funding. While early-stage VC companies may be pioneers of new industries with evolving business models, late-stage private companies may have established business models and greater traction in the marketplace, which can support more attractive revenue growth rates. These characteristics could potentially reduce the risk relative to earlier-stage investments.
As an industry built on innovation, private equity is a dynamic, everchanging space. We have observed a greater willingness to deploy capital into niche and thematic strategies (e.g., specific sectors and regions or sustainable/impact strategies). We’ll likely see the diversity of thematic approaches continue to expand as investors hone their private equity programs. They may use specialized sector/regional managers to amplify and deepen overall exposure to innovative themes. For allocators focused on climate change or social justice, private investments may offer closer alignment to such themes and may be particularly relevant to those seeking nonconcessionary returns and measurable impact outcomes.
The idea of incorporating private equity in a thematic allocation is just one example of a trend that we’d like to see continue in the alternatives space: pulling down artificial walls between different asset types and looking for opportunities to pair them in pursuit of a particular objective. This might include using diversifying hedge funds as a complement to traditional fixed income, return-seeking hedge funds as a complement to traditional equity, or crossover strategies that can span the public/private and traditional/alternative spectrums.
In 2020, we saw the private equity market bounce back from the early days of the COVID crisis and gradually gain momentum throughout the year, with late-stage companies fueled by a sentiment of cautious optimism. The momentum only continued to build in 2021, with deal volume and IPO activity surging to new highs. Here I’ll offer a few thoughts on why the market has continued to accelerate as we approach the start of a new year.
In the second quarter of 2021, we saw the number of companies that raised more than US$100 million in a single financing (“mega-rounds”) rocket to 377, and we weren’t sure how much higher things could go (Figure 1). Turns out, almost 8% higher: In the third quarter, 409 companies raised a total of US$91.3 billion in mega-rounds.1 In addition, 127 “unicorns” (private companies with valuations over US$1 billion) were born.
Looking further back, we have seen a 350% increase in deals since the third quarter of 2015. In fact, in the third quarter of 2021 alone, there were over 1.5x more mega-rounds than in all of 2015. In other words, the deal universe has expanded dramatically.
We think that part of the answer is that technology disruption is happening across a growing number of sectors. Back in 2015, the majority of late-stage companies were limited to the SaaS (software as a service) or mobile space. These days, technology is touching health care, financials, education, retail, and many other areas, creating more late-stage businesses than ever before.
Another trend that’s driving change in the private market is that earlier-stage companies are raising more capital at higher valuations. It’s not atypical for us to see companies raising at 100x current revenue (annualized revenue run rate), meaning that a company with US$10 million annual recurring revenue (ARR) can raise capital at a US$1 billion valuation.
And finally, companies are staying private longer, in an effort to remain focused on long-term growth objectives and ultimately be more competitive. As a result, since 2008, the number of publicly listed US companies has decreased from about 5,000 to about 4,200, while the private-equity-backed universe has nearly doubled to over 8,600 companies.2
Importantly, while the number of listed companies has stayed more or less flat, that’s not because companies are no longer going public. In fact, through just the first half of 2021, there were more IPOs and more dollars raised in those IPOs than in nearly any of the past 20 years (Figure 2). And for those who might wonder, this activity isn’t a result of the SPAC fad — the data excludes closed-end funds and SPACs. So, if there have been over 450 IPOs in the past year and a half, why isn’t the number of publicly listed companies going up? We believe this is an artifact of a robust M&A and take-private market, not a reflection of the desire for new public company formation.
We think the bottom line is that the late-stage space is continuing to grow and become an increasingly important segment of the private market. At the same time, we believe the rapid acceleration in activity requires investors to avoid being overly reactive to the market environment, maintain a steady hand, and do the work required to identify the companies with the potential to truly add value.
1Source: CB Insights, State of Venture 3Q21 Report | 2Source: PitchBook, as of December 2020
The growing recognition of the impact of ESG risks and opportunities on private market performance and capital availability is driving rapidly evolving expectations and greater adoption of best practices. These factors are increasingly important for private companies across all stages of their life cycles. Here, we profile five ESG topics that will be top of mind in private markets for the coming year.
Human capital management and DEI will be increasingly important factors for companies, investors, and regulators in 2022. We view DEI practices as a material input to performance and therefore ask our private portfolio companies to align with our efforts to increase transparency by disclosing their board and workforce diversity data. We believe private companies with strong DEI and human capital management will be best positioned to enhance long-term performance. In addition, as private companies approach the public markets, it is particularly critical to understand and adapt to market expectations.
Notably, the SEC created a new disclosure rule in 2020 requiring public companies to disclose their approach to human capital management. It also approved Nasdaq’s proposal to require companies listed on the exchange to disclose their board diversity and meet minimum diversity targets (or to explain why they don’t). In addition, investors are raising disclosure expectations and voting against public companies that do not meet minimum requirements. Importantly, increased focus on these issues is driving results — for instance, 74% of companies in the S&P500 now disclose board-level racial/ethnic diversity metrics in 2021, compared to only 29% in 2020.1
Climate change will continue to be a dominant theme in the year ahead as global climate-related regulations accelerate, disclosures such as the CDP (formerly the Carbon Disclosure Project) and the Task Force on Climate-Related Financial Disclosures become more standardized (and in some regions, mandatory), and investors’ focus on climate intensifies. Still, many private and public companies overlook and/or underreport material climate-related risks and opportunities. However, we expect disclosure to improve markedly in the coming years, especially given it is an SEC priority.
At Wellington, we’re partnering with Woodwell Climate Research Center to integrate climate science and investment management. In 2022, we will continue to look for private companies across all sectors and stages to incorporate thoughtful approaches to climate change. This includes building resilience for the accelerating transition to a low-carbon economy and the worsening physical events exacerbated by climate change.
As private companies grow, they inevitably deal with more complexity and increased scrutiny from investors and the broader public. We believe this makes corporate governance issues — like oversight, independent and diverse boards (by background and by skill set), and succession planning — critical considerations and key areas of potential value add. Governance issues become particularly important as companies approach the public markets. Many proxy advisers, ESG ratings agencies, asset owners, and asset managers are now taking harder stances on governance for newly public companies. For instance, some proxy advisers recommend voting against the entire board at companies that go public with multiple class share structures and unequal voting rights without reasonable sunset provisions. Europe’s new Sustainable Finance Disclosure Regulation (SFDR) also makes asset managers explicitly define “good governance” without differentiating between public and private firms.
Looking to 2022, we prefer to engage on these issues rather than voting against boards. We understand that private companies are at an earlier stage in their lifecycle and encourage them to make progress toward adopting best practices over time. In our view, this includes familiarizing themselves with asset managers’ proxy voting guidelines to get a sense of evolving public market shareholder expectations on issues such as dual-class shares, classified boards, and independent leadership.
Cybersecurity breaches, inadvertently unethical AI uses, and data privacy/transparency issues are all on the rise. Notably, adapting to COVID-19 forced many companies to bypass certain cybersecurity controls,2 which contributed to a 141% jump in breached records globally in 2020 compared to 2019.3 These issues raise risks for private and public firms including the exposure of confidential company data, supply-chain disruptions, the inability to operate, exposure of sensitive customer data, and reputational harm.
The SEC thus identified this as one of its 2021 priorities and has proposed rule amendments to improve cybersecurity risk governance disclosures.4 In addition, trends in data privacy regulation have seen an increased emphasis on consumer welfare and control. In 2018, the EU created a new set of rules designed to give EU citizens more control over their personal data. Several other regions have since begun implementing similar policies, including California’s Consumer Privacy Act in the US. Going forward, we encourage private companies to proactively adhere to these guidelines, use clear language in their privacy policies, provide high-level disclosure on any AI decision-making processes, and facilitate consumer control over personal data.
Companies are more and more focused on supply-chain resiliency, human rights, and modern slavery. During the pandemic, the material risks associated with the complex, opaque, and diffused nature of supply chains were compounded by rising transportation costs, as well as raw material and labor shortages. These risks can significantly impact both private and public companies. For example, a fast-fashion retailer’s shares dropped close to US$2 billion in two days in July 2020 following revelations of poor working conditions in the company’s factories.5
Notably, related regulations are on the rise, including Europe’s new SFDR, which requires investors to demonstrate that the companies they invest in meet basic human rights and labor standards. To date, the SEC hasn’t explicitly outlined guidance on human rights and modern slavery, but companies may face fines and other legal action for noncompliance with regulations in California, the UK, Australia, and other regions. Supply-chain management and transparency is an emerging ESG topic in public markets, and private firms are understandably earlier in their evolution as they build out their supply chains. In our view, this growing issue will become more material for numerous reasons (e.g., business continuity and regulations) and this enhanced scrutiny on supply chains should be integrated into private companies’ future planning.
While materiality differs for each company, we think these topics are particularly relevant for all private companies in 2022 and going forward. In our view, the earlier private company boards and management teams start to think about and address the ESG factors that are material to their businesses, the better. Importantly, Wellington consistently engages with our portfolio companies — offering a wide range of resources — to help them navigate the complex and constantly evolving ESG landscape, especially as they prepare for an IPO.
1Source: Glass Lewis. Data as of 30 September 2021. | 2Source: EY, October 2021, “How cybersecurity risk disclosures and oversight are evolving in 2021” | 3Source: Risk Based Security report, January 2021. Based on roughly 3,900 publicly reported breaches globally in 2020. | 4Source: The National Law Review, September 2021 | 5Source: The New York Times, July 2020
This is an excerpt from our 2022 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.
