#1. Decentralization of Finance Propels Early and Novel Asset Ownership
The skillset to invest early in inefficient areas at more attractive valuations will continue to create value. Whether in traditional private assets or more novel structures such as DAOs (Decentralized Asset Organizations), the changing opportunity set identifies opportunities earlier with aligned partnerships.
In the U.S. Lower Middle Market, small buyout partnerships have been rewarded by entering when enterprise values are below $100 million, at a significant discount in earnings multiples, often half of the public market equivalents. The heightened demand for private tuck-in transactions in 2021 is expected to increase as they provide arbitrage to enhance value and expand market share. More than 70% of U.S. Middle Market deal flow in 2021 went to add-on transactions. With large buyout valuations stretched, investors will continue to benefit from being early to participate in the runway of multiple expansion.
DAOs are a new model for investors exploring early and unique assets. In 2021, ConstitutionDAO offered a live experiment in a single-purpose DAO while raising $47 million, starting from a meme and taking crowdfunding to Sotheby’s platform to bid on the U.S. Constitution. The decentralized governance of assets coupled with enabled decision-making across groups of owners is revolutionizing the way investors engage with sponsors. We believe that this has the potential to change asset allocation pie charts for decades to come, disrupting private capital markets by defining new asset types. As history has shown, not many innovations are genuinely beneficial to the end investor. Still, with credibility and the right partners, this model promises to open opportunities for investors to further diversify with a voice.
#2. Sustainable Deal Flow Accelerates
Through the next trajectory of the innovation cycle, opportunities are emerging at the intersection of industries to address the most pressing issues. Leveraging cross-sector expertise to solve these issues will command premium pricing. To illustrate this point, we highlight opportunities in cross-sector hubs where we see an unusually high level of opportune deal flow:
At the Intersection of Industrials-Chemicals-Technology
We note increased deal flow in the monitoring and product development of fire retardants, agrochemicals and preservation-focused coatings for wood products as a response to environmental hazards.
Additionally, to ensure that chemicals are recycled via environmentally friendly practices, there is an increased demand for technology asset disposal systems for batteries and components.
At the Intersection of Education-Consumer-Technology
Among inspired adaptations, education deserves a special mention. Unfortunately, it has remained a top concern for households struggling to support the needs of remote schooling. But, thanks to new awareness sparking innovation, we expect a generational improvement in the engagement methods and access to education, especially K-12, propelling a more inclusive society.
At the intersection of Consumer-Wellness-Healthcare
Data-driven medicine is at the core of wellness and prevention. For example, in healthcare risk management, diagnostic tools for pregnancy risk detection and outpatient care support allow early preventative diagnosis. Therapy options in our pipeline are also accelerating therapeutic methods.
We have also watched with interest the development of ultrasonic blood cell manipulation to support cancer treatments as well as the rise in behavioral health center deals with unique service platforms to address addiction and mental health.
Also, in this intersection, we have seen original approaches to plant-based protein supplements that simultaneously meet increasing nutritional demand with a desire to reduce the carbon footprint by reducing red meat consumption.
#3. Working Capital Needs Increase in the Middle Market
A working capital crunch is underway, particularly among U.S. Middle Market companies with less access to financing alternatives. Inflated energy and input costs, extended delivery schedules and increased wage pressures are a trio of culprits leading to what we expect will be a dynamic set of winners and losers in 2022. This trifecta will conspire to put investors in the driver’s seat, balancing negotiations and dampening valuation levels—which we expect will remain in an attractive range of less than 10x earnings multiples in most Lower Middle Market sub-sectors.
Until the current supply chain issues and labor market dislocations are resolved or at least mitigated, many of the 200,000 companies within the U.S. Middle Market universe will experience rolling periods of stress and therefore look to secure capital partners.
#4. LPs will Seek New Alpha Engines
Alpha and beta measurements are tricky in the private markets, and we believe valuations are now stretched. Since earnings must catch up to drive the next leg of beta-related returns, alpha is ever more valuable. Age-old proxies used to contrast the alpha and beta of private market peers often include (i) leverage levels; (ii) sector/sub-sector definitions; (iii) sustainability of cash flow and (iv) the number of value-added levers. While market beta has driven multiple expansions, there is an increasing focus on identifying teams that bring unique expertise-driven alpha to drive unique return opportunities.
One nascent and growing area for alpha generation is the area of GP stakes, a comparatively new lever to add return from a strategic relationship. Multiple GP stake offerings—including Steward’s—have recently targeted debuting private market managers to unlock talent and empower their success as they target deals at an earlier stage. Why solely invest as an LP when you can also participate early in the GP’s success?
#5. Enhanced ESG Measurement
The rhetoric has been long during the waves of social justice and environmental risk awareness, but results have been less concrete. During this initial phase, progress has focused on hiring JEDIs (Justice Equity Diversity Inclusion officers), assessing vendors, boards and reporting to newly appointed ESG committees.
With the SEC now showing a marked interest in the claims of companies and asset managers, we expect guidance on comparable and quantitative measures. The COP26 investor alliances are at the forefront of this move to ‘measure what matters’ and achieve net-zero carbon emissions. As a result, greater clarity is expected to emerge around quantitative measurements for ESG factors in the investment processes.
As goals are set in the spectrum of ESG-aware to more acute impact, a pre-eminent focus is building on the time horizon used for the risk-return hypothesis. This is because most investors creating risk-adjusted returns with an ESG hypothesis will inevitably be both highly engaged and long-term oriented, where effectiveness can be more directly matched with sustainable outcomes.