Stewart: Welcome to another edition of the InsuranceAUM.com Podcast. My name's Stewart Foley, I'll be your host. We are talking about private markets today with Tom Keck, partner and head of research and portfolio management at the StepStone Group. Tom, thanks for being on.
Tom: Thanks for having me, Stewart.
Stewart: We're going to start this one off the way we start them all. Where did you grow up? What was your first job, not the fancy one, and a fun fact?
Tom: So I grew up in Champaign, Illinois, which is a couple of hours south of Chicago, university town. My first job, I was a bicycle messenger in college. I went to school in Washington, DC so I delivered packages on my bike during the summers. And fun fact, I have landed on aircraft carriers at night, which is, I guess sounds more fun now talking about it than it was when I actually did it.
Stewart: Wow, that is a great fun fact. That's really cool. I want to know more about that. That sounds very exciting. So, insurance companies have become much bigger players in private markets in the face of protracted low interest rate environment that truncated at the end of 2021. We have big run up in interest rates in 2022, but the trend to investing in private assets is certainly continued and as strong as ever. But when we talk about private assets, it can cover a lot of asset classes. So, can you start off by telling us where your focus and what we're going to be talking about? What specifically in the private markets arena?
Tom: Sure. I think historically when people have thought about the private markets, they've thought about equity investments primarily in corporate equities like buyouts and venture capital, in real estate equities, core real estate, and to a certain extent, value add. Over the last 15 or 20 years, that definition has expanded to include equity investments into infrastructure assets, so toll roads, waste management, ports, airports, data centers, so long-term monopolistic type assets as well as, increasingly, private credit. So lending directly to mainly sponsor back companies through a non-bank lender, which has some advantages as has kind of been highlighted in the recent Silicon Valley Bank and Signature Bank issues. But that's been a very fast-growing segment of the market. So we've seen strong growth on the private equity side of the house and the real estate side of the house, but really meteoric growth in infrastructure and private debt. And so I think that part of what has driven the increased participation of insurance portfolios is just a general increase in availability across the capital markets, particularly in those two areas.
Stewart: It's really interesting. I was talking with Phil Titolo who is at MassMutual, and he was talking about the last 20 years of the bank disintermediation trade, which was a driver of some of this private credit growth. I don't see any signs that given what's happened in banking this year to date, that banks are going to be expanding their lending activities to businesses. And it seems to me that just one person's opinion that private credit funded by the insurance industry, for example, is going to be a major driver of economic growth going forward. How does that statement or that view strike you?
Tom: I think there are advantages that your regional or community bank has relative to a non-bank lender. They have relationships with companies and businesses, so they can source credits more easily than today's non-bank lenders. On the other hand, they have some disadvantages. So the mismatch in duration between liabilities and assets in your community and regional banks, as was highlighted in Silicon Valley Bank's case, can be a real problem. And actually one of my former professors just won a Nobel Prize for talking about the fact that as these banks get into distress, the management tends to have very adverse agency issues. You don't have the same mismatch between liabilities and assets through these non-bank lending companies. So in some ways it's a better medium for advancing these types of credits. And I think what we've seen so far is that the direct lenders are primarily sourcing their transactions through sponsored deals.
So there is a private equity firm that is doing a leverage buyout and the direct lenders are participating in the syndicate for those transactions. In addition to the Silicon Valley Bank situation, which I think has driven some lending away from banks. The syndicated loan market has been very challenging, particularly since last summer. And so whereas that would normally be a big source of flow, that has largely been closed. So direct lenders have stepped into that breach as well. So I think the market is continuing to grow because some of the traditional sources of these senior credits are less reliable today than, perhaps, they have been in the last 10 or 15 years.
Stewart: That's really helpful. So in 2022, public markets were substantially more volatile than private markets. That was pretty much across the board. Is that really the case or is that just folks marking stuff, some smoothing going on? Can we get into what really is going on and is there volatility coming in private markets?
Tom: This is a debate that we often have with our clients. How do you think about the risk of private market assets relative to traditional assets? If you look at the time series of valuations and returns, if you just take buyouts for example, relative to the S&P 500, the buyouts are about a 10% volatility, S&P 500 is 16% or 17%. So you see much higher volatility in the public markets. There is a certain amount of smoothing happening in the private markets. You value things quarterly. On the real estate side, maybe it's not even a quarterly valuation. So you're paying less attention to it. That certainly has an impact. And then the best estimate of the current value is whatever it was valued at last quarter, unless there's been significant changes in the financial performance. So in some ways the private market valuation is lower than what the fundamental value might be.
I would argue that the public market valuations are higher in volatility than a fundamental valuation of an individual asset might be. The sort of animal spirits of the markets can drive valuations on stocks irrespective of what's actually happening with that individual company. And so the real volatility as a measure of risk is probably somewhere in between the private market volatility and the public markets. So that's one observation.
We actually did a fair amount of research to try to peel back the layers of the onion to see should we think about using de-smooth volatility as a proxy for the risk of private markets. So we looked at the components of returns in private markets versus the S&P 500, revenue growth, margin expansion, multiple expansion as kind of drivers of unlevered returns. And what we see is that you actually have much higher revenue growth on private market transactions than you have in the public markets.
So the margin expansion is about the same. Multiple expansion is actually much higher in the public markets than in the private markets. So what we see is higher operating results from the earnings of the business. You see less multiple expansion, so less benefit from essentially the lower interest rate environment that we've had over the last 10 or 12 years since the GFC. So it's really greater increases in fundamental value than what you would expect from the S&P 500. So we think that the outperformance of private markets is driven not necessarily by increases in multiples, which has been a driver certainly, but it's really driven by financial results in that higher financial results also can reduce the true risk that you have in these private assets.
Stewart: That's really helpful, thank you. So it leads me to how private markets create value through this cycle. Can you talk a little bit about that and from your perspective of how those markets are creating value?
Tom: Yeah, so and this is similar whether you're talking about real estate or infrastructure or private equity. GPs, they're really arbitraging inefficiencies in the underlying asset markets. Even on the private credit side, to some extent, you are lending to a business with a nice credit spread, but with an understanding that the true risk of that business is probably lower than what that credit spread might dictate. And so why are they able to do that? Part of that is just the availability of capital. It's the difficulty in understanding the assets. But I think the other thing that is particularly true since the GFC, GPs have gotten very good at creating and striking embedded options in these assets that are not priced into the acquisition price. So if you're buying a real estate asset, then there's some development potential in the asset that is unrealized in the sale price.
For corporate private equity, oftentimes it's an undermanaged asset where you can bring in new management or a new strategy. A lot of what has happened in the past 10 years or so has been industry or sector consolidations. So you're starting with a platform company, you're doing add-on acquisitions to create a platform that has greater capability and greater market share within a particular sector, or you're using that M&A program to take a platform and expand it into a white space that's adjacent to whatever that company is. So those white spaces, those abilities to consolidate a sector are options that are inherent in that platform, maybe in that management team, but are not necessarily priced into what the GP is paying for. And so creating a portfolio of those embedded options and striking those options when they become in the money is really what drives the outperformance of private markets. And it's this active shareholding approach, again, whether it's buyouts, venture capital, real estate, infrastructure, that active shareholder making sure that management is focused on the right issues and managing for long-term values, I think what drives a lot of value.
Stewart: This takes me to the question about PE valuations. You hear folks saying PE valuations are too high, increase in rates, people coming into another, needing another round of funding and the prices are down, and so on and so forth. So can you talk a little bit about PE valuations and how you think they shake out right now?
Tom: Yeah, so there have been some comments lately about private equity being wildly overvalued. And I think the insight, which often is not really supported by any sort of quantitative values, the instinct is that we've seen a dramatic decline in public valuations and we haven't seen a similar decline in private market valuations. And so therefore private markets must be overvalued. So, you start from an assumption that everything was fairly valued before the decline. We actually just came out with a research paper to try to look into some of this to figure out maybe it's true, maybe private markets are overvalued. What we found was in 2021, there was a huge spread between the total enterprise value to EBITDA multiple on the S&P 500, for example, relative to the holding values of buyout transactions in our data set. That gap has closed. And so, at September 30th, 2022, those valuations are kind of on top of each other.
So I don't think it's the case that private market valuations are wildly overvalued because they haven't come down. I think public market valuations were probably on the high end in 2021 and they've sort of come back to earth. So that's sort of one analysis that we did to try to dig into this. We actually have a pretty substantial data set going back 40 years of transactions and operating metrics. So we figured that we would also look back at prior cycles and how much downside capture is there when the public markets are headed down, and then how much upside capture is there in private markets when you come back on the other side through the recovery. So we looked at three different periods, the Dot-com bust to the boom in 2007, the GFC crisis in subsequent recovery, and then the COVID crisis. And what we found is that on the downside, private markets capture about 2/3 of the downside in the public markets, but they capture a hundred to 125% of the subsequent recovery.
So if private markets had a tendency to be overvalued, we think at some point during that cycle they would catch up and you wouldn't have as much upside capture as you have downside capture, and that just isn't the case. So what I think is happening is when public markets go down, general partners are holding assets that they don't have to sell. So to have a market transaction, you need not only a willing buyer but a willing seller. And so are the valuations that GPs are holding those assets at unrealistic? Some of that depends on where they are in their fundraising cycle. But we did some analysis on that and I'll come to that in a minute. So GPs don't take all the write-downs that happen in the public markets, because they're not selling when the public markets are down. On the other hand, when public markets are up, GPs can hit the bid, so to speak.
And so they do actually experience the run-up. And so when public markets become overvalued or highly valued, GPs can sell at that point. And so that's what I think is driving the lower downside capture, higher upside capture. And again, if we go back to our volatility conversation, I think this explains a lot of why there is lower volatility. You can call it smoothing, but essentially you have this asymmetric risk capture that I think is a very attractive feature of private markets.
Now let me dig into, because I think I teased a little bit. Are general partners gaming valuations in order to make their returns look better? So, it is something that we look into when we're underwriting a primary fund, where are GPs holding values and are they trying to overstate their track record? But we also did a more systematic look by going back again through our 85,000 transactions that we have data on. And you know what the valuation of a company was when it was sold.
If you look back 2, 3, 4, 5 quarters prior to the sale, what's the change in values over that time period? And what we see is that in the year leading up to a sale, on average, GPs are recognizing an increase in value of 20% to 40%. So if GPs were systematically overvaluing companies, we would expect to see a lower increase in value in those assets in the last year of ownership. So what we see is actually a similar or higher level of appreciation in that final year. So that leads us to conclude that there is not a systematic overvaluation across the asset class, but we know that there are some GPs that do that. And there's a paper by Steve Kaplan and Greg Brown that looked into this as well that came to largely the same conclusion that GPs are not gaming values unless they think they're going to have trouble raising their next fund.
Stewart: That's very helpful and really a thoughtful walkthrough that question. I mean I really appreciate that. When you look out at 2023, where do you think opportunities lie in private markets and is there anything that you're avoiding?
Tom: I think a lot of the way that we think about our investments, private markets are largely about microeconomics. It's probably 2/3 microeconomics versus 1/3 macroeconomics. So we're looking a lot at the idiosyncratic nature of some of these different strategies. I think the things that we like across each of the different asset classes that we participate in, they're interesting opportunities. So I'll start on the credit side because I think that's probably one of the easier asset classes for insurance CIOs to participate in. We talked a little bit about bank disintermediation. I think that continues. The syndicated loan market will eventually come back, but I think that there's going to be some market share that's been gained by the direct lending strategy that's not going to go back to the syndicated markets. And so I do think that there's going to be attractive opportunities to deploy capital into that asset class, and it has one of the highest Sharpe ratios of all the things that we invest in. It's got higher correlation to traditional portfolios, but very high Sharpe ratios. So I think that's a very attractive place and will continue to be.
There's, I think, other opportunities in more of the opportunistic credit space. What's interesting about credit is I think the relative value shifts around more quickly there than in some of the other markets that we participate in. So when I say opportunistic credit, it covers a wide swath of different lending practices, but I think the increase in interest rates that has happened on the short end of the curve exacerbates some of the capital shortages in some of these markets and makes for some very interesting opportunities that we're seeing there.
On real estate, in real estate, you've got some very big issues happening in commercial real estate with all of the work from home and companies shrinking their footprints. I think there's a lot of uncertainty around there. So that's probably when you ask about places that we're avoiding, I think that's an area that we're very wary of. Retail is another area where we have been very cautious for the last few years, but I think we're starting to see some interesting opportunities there in kind of specialty retail. But I think the more interesting plays are going to be in, as real estate assets reprice, there are going to be some interesting buying opportunities there. So we're very excited about the real estate value add market. As these tectonic shifts happen, there's going to be big opportunities to repurpose assets and take advantage of distressed sellers.
On the private equity side, what we've seen is that there's been a lot of institutions that have been committing to the asset class over the last 15 years. They were kind of at the high end of their allocation range when the distress in the public markets hit and the volatility in the public markets hit.
So they're in a situation where they recognize that 2023 is an attractive vintage year, and I'll talk a little bit about that, why that is in a second. They want to participate in the 2023 vintage and the 2024 vintage, but because they're already at the high end of their allocation range, they don't have availability or dry powder to commit to those asset classes. So they're rebalancing their portfolios through the secondary market. So secondary is a very interesting strategy right now, both for the rebalancing reason, but also because there are a lot of GPs in order to get liquidity for their LPs, they are moving their best assets into continuation vehicles and capitalizing those vehicles again through the secondary market. And so that's a very interesting place to buy the best assets with really great alignment of interest with the GPs that own them and know them best.
So 2023, we think it's going to be a very interesting vintage year. Part of the reason is that as fundraising has slowed down, you see it taking longer for GPs to raise money and therefore there's available allocation in funds that historically would've been in and out of the market very quickly. So LPs have an opportunity to upgrade their relationships in a variety of different strategies. Venture and small buyouts are probably the most interesting places to upgrade your suite of GPs that you have relationships with. And so we think those are some very interesting places to commit capital in the next couple of years. And then we think that the repricing of assets due to the increase in interest rates is something that has been ongoing. I think as we get into the second half of this year and into the first half of next year, we're going to see more of that. It's starting with we're seeing a much more active public to private set of activity, but that will roll into private assets coming to market and capitulating to the new valuation environment.
Then finally, on infrastructure, it wasn't as heavily impacted by the downturn in the public markets from evaluation perspective because the underlying businesses are so stable. I think the tailwind in that market is just the incredible need for infrastructure in the developed markets because it's been underinvested in for a long period of time. In the developing markets, it's the rise of the middle class to a great extent. And while a lot of infrastructure is funded through public capital, budgets are really stretched, government budgets are really stretched. So there's an increasing interest in leveraging private capital to get these assets built, restructured, or improved upon. So I think that's a continuing tale that's going to be a tailwind for some time.
Stewart: That's really helpful and really thorough again, so thank you very much for that. I have a question that, I don't know, it's kind of maybe off the wall and you can pass on it if you want, but it's near and dear to my heart. We're a small, relatively small business at InsuranceAUM.com, and so a lot of the private credit deals are with sponsors, meaning a private equity firm is involved, and the availability of capital to small and medium-sized businesses is limited because banks are not lending. Do you see growth in non-sponsored direct lending being a thing? And what's ultimately going to happen is that it's sort of struggling to get capital to grow a business that's got a lot of upside, but it's hard to get it financed, right? And so that's what prompts my question and it's very personal for me, but I mean, I'm curious to know what you think, what your thoughts are on the non-sponsored lending to, it's a very different product, a very, very different deal from the lender's perspective, but something that I feel like is going to be essential to continuing economic growth in the US.
Tom: Yeah, I think in the US and in Europe, certainly, and those are the two places where I think it'll happen fastest. So we're already seeing in the US, one particular GP that we're aware of has partnered with a regional bank to, essentially, as the regional bank is sourcing deal flow to have their pick of credits that are coming across their transom. So I do see the initial stages of these kind of strategic relationships. The banks, as I said before, they have a comparative advantage in sourcing credits because they've got relationships with the businesses in their area or in an industry where they may have some expertise, but they've got some challenges with the liability asset mismatch and the speed with which deposits can search for their highest return. So having some strategic funding relationship, I do see that as a trend both here in the US and in Europe.
Stewart: Very cool. I really appreciate that. I've had a great education and I really appreciate you being on. I've got one final closing question and you can take your pick. What was the best piece of advice you ever got, or who would you most like to have lunch with, alive or dead? I got a lot of grief about “Stop asking about your 21-year-old self. Everybody's tired of doing that question, do something different.”
Tom: Well, the best advice I ever got was to not let my wife get away. So over the years, I've gotten a tremendous amount of support. It's probably been the single best decision I ever made, so-
Stewart: Wow.
Tom: I would have to probably go with that one.
Stewart: I feel exactly the same way. That is really nice to hear. Thanks for the education on private markets. I really appreciate you taking the time. We had some technical difficulties the first time we got together and you were very gracious and flexible with rescheduling this podcast, and we always timestamp these things, and it's Wednesday, April 26th, because markets are moving so quickly. But thanks very much today for being on, Tom. I really appreciate it.
Tom: Well, thank you, Stewart. It's been a pleasure and look forward to further chats in the future.
Stewart: Absolutely. We've been joined by Tom Keck, partner and head of research and portfolio management at StepStone Group. If you like us, please rate us and review us on Apple Podcast. We certainly appreciate it. My name's Stewart Foley and this is the InsuranceAUM.com Podcast.
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