London (HedgeNordic) – Schroders’ semi-liquid range, which allows for quarterly redemptions up to certain limits, now has three strategies: Global Private Equity (GPE), Global Innovation Private Plus (GIPP) and a new Circular Economy (CE) strategy, with an infrastructure fund launch slated for early 2024.
Though the three private equity vehicles have distinct mandates, there is also scope for them to have overlapping investments. One example is Sweden’s online used goods platform, Tradera, which is a good fit for all three. Its reporting KPIs include emission savings to meet the impact criteria of CE and it also fits into some buckets for the other two funds.
GIPP is focused on 8 themes in healthcare and technology: AI; Cybersecurity; Fintech/Payments processing; Consumer; Infra software; Vertical SaaS; Oncology, and Biotech discovery. These are expected to be present for several years:“every 1-2 years we look to refresh them and see if any major changes are needed. I don’t see major changes coming in the next few years. In the past we had 6 themes, and decided to expand to 8 as we got deeper in our domain expertise by sub-sector,” says portfolio manager Michael McLean.
The two broad sectors of healthcare and technology also make up roughly half of GPE. “However, only 10% of GPE is likely to be invested in the sorts of growth stage venture capital that populate GIPP, which limits the overlaps. For example, select cybersecurity firms could be found in both of them in the future,” says Johan Stromberg, Director of Private Asset Sales, who is based in Stockholm. Investors seeking a mix of larger cap and smaller cap investments may allocate to both GPE and GIPP, while some invest in all three. There is also significant standalone impact investing interest in CE.
The attraction of private equity for growth investing includes the growing longevity and size of private companies. “There are fewer listed companies and private companies stay private for longer: now for 7-8 years compared with 4-6 years historically. They can grow more steadily with stable owners and without a focus on quarterly results, which can result in firms switching between public and private hands several times,” says Stromberg.
“There are fewer listed companies and private companies stay private for longer…”
This corresponds well with the normal life cycle for a private equity fund, which is about ten to twelve years allowing for buying, developing and selling companies within an average holding period of approximately five years.
The three semi-liquid funds offer potential for calendar quarterly redemptions up to 5% of the net asset value, dealing with the fund itself and at NAV. Redemptions are not guaranteed, but there are several features that reduce the risk of the fund being unable to meet either capital calls or redemptions or both, even under a 2008 scenario stress test. “They typically hold cash and/or publicly listed equity of 10-20%, which could cover one to two calendar quarters of redemptions. On top there is a credit facility of around 20% of NAV provided by Schroders, which is available to fund underlying capital calls through a period of low distributions. The funds can suspend redemptions for four consecutive quarters. If there are still redemption pressures, the secondary market, which has grown enormously over the past decade, could also be used to create liquidity,” says portfolio manager, Benjamin Alt. The liquidity management framework has not really been tested so far because the vehicles have had net inflows.
In 2021, liquidity management for GPE involved holding 10-20% cash. Now this has been revised to blend 5-10% cash with 5-10% public equity for GIPP and CE (but not GPE). However, since early 2022 the manager has been quite cautious and slow in allocating capital and is sitting on some cash, and has refrained from investing in some more volatile publicly listed equity funds.
Co-Investments and GP-Led Secondaries
Liquidity management also influences the choice of vehicles. Longer term investments often become GP-led secondary deals or coinvestments. “only 10% of GPE is in primary funds because they can create an open ended liability since we cannot predict the timing of capital calls. We would rather keep as much as possible in GP led secondaries and coinvestments,” explains Stromberg.
These vehicles are also attractive for their fee savings: GP-led secondaries typically charge half of regular fees while co-investments usually have no management or carry fees.
The Denominator Effect
The minimum ticket of EUR 50,000 and the liquidity feature can appeal to some retail investors, who can invest in at least Sweden. Equally some institutional investors welcome some more flexibility since the “denominator effect” has resulted in their unlisted allocations over-shooting target levels. “We have seen interest from pension funds in Iceland,” says Stromberg. With publicly listed equities and bonds down 20% or more in 2022, while some private equity and infrastructure has held steady or made small gains, the unlisted weights may have risen by 25% or more.
The denominator effect has arisen because, while some older PE funds (and publicly listed PE funds) do change hands at discounted valuations, many private equity strategies have proved to be more resilient than public equity in 2022.
In some cases, less leverage and lower starting valuations have been helpful. For mid market private equity, leverage multiples, typically a maximum of 3-5 times are lower than at the large end, which can reach 7-8 times. Valuations are lower in smaller PE deals, though they have come down across all sizes. GPE performance held steady in 2022, partly because growth offset valuation multiple compression, but also due to inflows and “averaging down” through follow on investments at lower valuations.
Portfolio manager, Benjamin Alt, illustrates the strong growth dynamics in the portfolio: “Fundamentals across our portfolio have been strong in 2022. In fact, the average revenue growth across our portfolio companies in 2022 was more than 20%. The EBITDA Margin across the portfolio was at c. 25% in 2022, reflecting our focus on robust sectors such as Healthcare and Technology. Most of the positive performance in the portfolio over recent months was driven by company specific events such as a significant overperformance to their organic growth plans as well as accretive M&A add-on acquisitions. The average EBITDA growth across the portfolio in 2022 was +20%.”
“Negative valuation changes are mostly driven by adjustments because of public comparable companies’ trading multiples…”
Meanwhile, the selected cases of lower valuations have had only marginal effect: “Negative valuation changes are mostly driven by adjustments because of public comparable companies’ trading multiples and to a lesser extent by some companies underperformance versus their plans. This had a minor impact thanks to the EBITDA growth of portfolio companies as well as the amount of inflows in the fund and new investments made at prices reflecting current market environment effectively diluting the negative impacts,” Alt explains.
Valuations are received from underlying managers, but Schroders’ valuation team of six people, also make their own adjustments, based on mark to market comparisons with listed peers, and other considerations. The final valuations are signed off by PWC.
ESG, Impact and SFDR
GPE and GIPP report under SFDR 6, partly for legacy reasons. “Article 8 requires KPIs which we negotiate via side letter when investing. As the portfolio is approaching 4 years old, we cannot retrospectively change side letters, and realistically some small investee firms in places like Silicon Valley do not have the time to provide the KPIs,” says Stromberg.
In fact, 81% of direct and co-investments support at least one SDG, but that would not necessarily be enough for SFDR 8 or 9.
CE reports under SFDR article 9. “This also requires clear intentions for the company to make a positive impact at the time of investment, as well as KPI reporting,” explains Stromberg.
Schroders’ impact investments, in CE and elsewhere, have the same investment criteria as any other investment, but must also pass a separate independent impact assessment to qualify. A carve out of previous investments that could have met impact criteria generated returns equivalent to, or better, than the broader private equity platform thereby reflecting the opportunity to deliver “impact with returns.” The myth that positive impact is a trade off against returns is simply not true.
The investment and ESG analysis are integrated as part of a process that has been informed by templates developed alongside microfinance specialist Blue Orchard, which Schroders acquired. “We received a 5 star rating from UNPRI for the Indirect – Private Equity module in the latest reporting cycle. The 5 star rating is a summary score for the module based on outcomes from the assessment of 7 indicators included in this module. Across these 7 indicators, we achieved 96% of the available points, resulting in the 5 star module score,” says Edson Fonseca, Sustainabilty Specialist, who is also a board member of SWESIF, Sweden’s Sustainable Investment Forum.
“The infrastructure fund will also have a strong impact flavour, with a green focus, including energy transition, energy storage, and hydropower,” adds Stromberg.