Over the past decade, there has been explosive growth in private markets. Private market firms have generated higher and more consistent returns than public market counterparts, which has resulted in larger capital inflows from limited partners. As of 2021, the SEC revealed that in the course of 5 years, the number of private equity funds and venture capital firms increased to 18,000 and 1,700, a jump of 58% and 110% respectively. The fund sizes have also ballooned by 116% for PE funds and just shy of 200% for VC funds in that same time period. We believe this creates significant opportunities and challenges for private market firms.
At Tetrix, our mission is to build the technology infrastructure for private markets to scale and thrive in the next decade. The purpose of this article is to share some of our recent findings and predictions, and to promote dialogue and action in the private market community regarding technology. In the past couple of months, we have connected with over 150 private equity and venture capital executives, including Partners, CFOs, COOs and LPs. Additionally, we have drawn insights from leading industry conferences such as SuperReturn North America, CFO/COO Private Equity New York, and the Emerging Managers Exchange.
Increased competition for alpha - With the increasing number of private market participants, competition for returns and alpha is intensifying. Hence, finding ways to maintain and gain a competitive advantage when it comes to sourcing, diligencing and post-deal execution has become essential. Many of your peers believe technology can be a key enabler in this pursuit. In the words of a CFO from a leading PE firm in Boston, “We have created an internal task force and are exploring how we can use data and technology to drive returns.”
Artificial intelligence - ChatGPT re-excited the world about the promise and power of artificial intelligence. Businesses are eagerly brainstorming use cases and drafting implementation strategies. However, an area of struggle for many private market managers is figuring out how to best use AI in an optimal, compliant and secure way. As a COO from a SF-based VC firm puts it, "Everyone's talking about AI and there are many intriguing prospects for us. We want to figure out where adoption makes sense for our firm while still maintaining control of our data."
Back office struggles - The back-office labor shortage has also emerged as a thorn in the side of private market firms. In fact, “more than 300,000 U.S. accountants and auditors have left their jobs in the past two years, and the dwindling number of college students coming into the field cannot fill the gap”. This matters because PE and VC firms, like their hedge fund counterparts, have come to realize that fund administration does not have to be a core internal capability. As a consequence, there has been a shift amongst PE and VC firms towards outsourcing their fund administration function, a trend described as “co-sourcing”. With little innovation in fund administration software over the past decade, technology has proven to be a limiting factor in achieving effective and scalable “co-sourcing”. The high turnover in fund accounting teams, constant back and forth communication and manual errors resulting from heavy reliance on people have been a big source of frustration for many finance executives we have spoken with.
Regulatory compliance and reporting - Regulatory compliance and reporting requirements to agencies and limited partners are increasing. For example, in August 2023, the SEC announced new rules to strengthen the oversight of private fund advisers, aiming to boost transparency, competition, and efficiency for the protection of investors. In Europe too, we are seeing stricter regulations, as evidenced by the introduction of SFDR which “imposes comprehensive sustainability disclosure requirements covering a broad range of environmental, social & governance (ESG) metrics at both the entity and product-level”. The increase in such requirements is putting pressure on firms to have better internal systems to track data and reduce the manual work involved in the reporting process.
Fundraising the next $10tn in private markets - The fundraising environment has proven very challenging in the past 12 months and many funds have moved towards a state of “constant fundraising”. There is also a growing realization that whilst the growth in private markets in the past decade has mainly come from large institutional investors increasing their allocation, the growth for the next decade will come from increased participation in private markets by multi-family offices, high net worth individuals and registered investment advisors. Compared to large institutional investors, retail investors are significantly underallocated to private markets. Higher and more consistent returns are attracting retail investors to the asset class. Moreover, the way individuals save up and invest is evolving - younger generations are no longer relying on pension funds as a vehicle to invest their savings. As a large LP rightly pointed out at a conference, “no new pension funds are being set up”. The technology infrastructure required to service this long tail of smaller investors will be quite different from the one used to service a concentrated set of institutional LPs.
Unlocking data - Getting seamless access to the vast amount of data that firms possess is still an unrealized dream. Data is fragmented, and being able to quickly search internal documents, pull data from market intelligence sources and connect disparate systems to get the right information continues to plague managers. Many managers we spoke to complained about the lack of a single source of truth in their firm and the missed opportunity around the vast amount of unstructured data that they do not leverage.
Transparency with stakeholders - “Transparency helps with auditability and trust, and yet we lack it with external fund administrators and with our LPs.” says a CFO of an emerging real estate fund. CFOs are not okay with completely giving up control and want to maintain some visibility and transparency over the back office finance and accounting functions, whilst still outsourcing the manual work associated with these functions to a third party fund administration provider. LPs too want to better understand a firm’s processes. Hence, on both fronts, there is a growing appetite for transparency-first solutions.
Reliance on manual work - There is a significant reliance on manual labor work, resulting in unrealized process efficiencies. Be it forecasting, modeling investment scenarios, initiating capital calls, doing waterfall calculations or the like, processes remain reliant on humans and are error prone in many cases. Furthermore, doing such tasks end-to-end manually is taxing and takes away from more productive tasks that internal teams could otherwise perform to bolster the competitive edge of a fund. Lastly, with the expanding long tail of limited partners, there is a realization that you cannot manually scale your way to supporting 2-5x the number of LPs you currently have.
Excel as the default solution - Excel is a double-edged sword. On one hand, Excel offers flexibility and familiarity, but on the other, it is manual, error-prone and does not allow for effective collaboration or version control. “Our requirements and scale have outgrown Excel but we cannot move away.” admits the CFO of a PE firm launching its 5th fund.
Outside of excel, firms walked us through the different tools they had implemented or were considering implementing in the areas of portfolio tracking, customer relationship management and fund accounting. Executives’ frustrations often arose from the lack of integrations between their solutions, the limitations arising from legacy technology infrastructure and the lack of innovative software capitalizing on the AI, data and automation developments.
Technology as a differentiator - Tech stacks will become differentiators for firms looking to attract capital. Gone are the days where arguments like having “exclusive access” to a market, a “stellar team” or a “great partner track record” were enough to seduce investors. LPs are scrutinizing how private market firms are run from the ground up, starting with technology. LPs want more control and transparency with regards to their investments and in the words of many limited partners we connected with, “we are even willing to trade 100-200 basis points of IRR for a better investment experience which entails less back and forth overhead.”
Data consolidation - Leveraging data, often unstructured and sitting in siloes, will become key for success. What is the distribution waterfall for portco ABC at various exit valuations? What is the average margin of companies your firm diligenced and passed on in the past 3 years? How much time is our team spending on supporting portco XYZ? Most private market firms would struggle to pull together the right information and answer these questions quickly without looping in multiple team members. We predict that in the near future, this will no longer be the case. Companies will be able to perform quick and accurate searches across their knowledge base and start utilizing internal, market intelligence and forecasting data to make better investment decisions. We are seeing this with projects like Motherbrain, an internal initiative by the global investment organization, EQT.
Robotic process automation - Automation of processes and workflows will be front and center for efficiency gains. Whilst critical tasks like investment decision making and fundraising will be held close to the vest by private market personnel, supporting and tedious tasks like producing fund statements, writing investment memos and reconciling capital calls with bank transfers will be significantly automated with employees reviewing as opposed to doing the grunt work. We have seen Robotic Process Automation - using software to automate repeatable manual tasks performed by humans - be used in other industries, but have found the private market world to be lagging in its adoption. With new AI capabilities, and more private market tech platforms supporting API integrations, we anticipate value unlock opportunities to emerge on this front.
Collaborative market intelligence - Private markets will become more collaborative, and intelligence and resources will be pooled together more openly. We are starting to see this on the ESG front where benchmarked data is being shared via the ESG Data Convergence Initiative. There has also been a jump in the number of co-investments, further alluding to a more collaborative environment. Looking ahead, we foresee large-scale data sharing projects being facilitated by neutral 3rd party platforms (eg: transaction multiples being shared on an anonymized basis to get accurate comparables from peers).
CFOs and COOs need to start thinking about and investing in the capabilities needed for the tech-enabled private market firm of tomorrow. This investment can enhance internal operational efficiency and improve competitive returns. Additionally, an increasing number of LPs evaluate GPs' technological infrastructure as an indicator of sophistication and are willing to accept slightly lower performance in exchange for a smoother investor experience.
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