Steward Quarterly Highlights - 2nd Quarter 2023

By Steward Asset Management - View as Webpage - Institutionalizing Anchor Investing Issue #14

Post-pandemic, the resurgence of consumer demand, pent-up supply chains, and near-shoring have supported demand resilience during the Fed's attack on inflation. Year to date, the consumption and inventory rebounds have discredited the bond market's fierce reputation as a discounting mechanism. Pricing power and robust consumer activity have deflected some of the rate-inflicted pain. Meanwhile, as the unsteady investment climate finds its footing and the IPO window slowly re-opens, the follow-on effects are starting to show. 

Included This Quarter.

• Increasing Capital Velocity
• Middle Market – A Defensive Haven
• Sector Themes
• Notable Events
• What We’re Reading

Increasing Capital Velocity.

AI (Artificial Intelligence) may be this year's theme, but its application within technology infrastructure extends far beyond solely tech companies. Tech-enabling, a cornerstone of private equity's value-added playbooks, propels competitive advantages across many sector specialties. Healthcare and consumer goods companies with large and complex datasets benefit from better management of user interface profiles, with details right down to cellular-level data captured during drug discovery. AI-enabled companies are responsible for igniting public equity returns earlier in the quarter. This portends an extension of the already robust public secondary offerings into an increasing IPO queue with the potential to improve capital velocity with distributions.  

Larger buyout managers with prolonged hold periods have used the longer runway to increase add-on acquisition, turning to the Middle Market for accretive deals that can close quickly. Over the last two years, deal sizes have decreased, supporting Middle Market valuations and exits. Consumer IPOs, like Cava and Kenvue, belied the worries that an inverted yield curve raises. Among near-term demand for IPO candidates, NYSE President Lynn Martin sees investor demand for industrial transformation, clean energy, and consumer companies. She believes that it will be a while until the large tech companies are welcomed back into the market. With large private equity managers overweight the tech sector, we expect a slow recovery. 

Middle Market – A Defensive Haven.

Middle Market private equity has been a defensive haven with steadier valuations and a more stable exit environment. Business fundamentals are among the key drivers of this resilience. In the recent RSM survey, 57% of Middle Market executives expect revenues and gross margins to increase, as illustrated by inventory rebuilding. This has been supported by the ability of society-critical businesses to pass along inflationary price increases. 

A deal culmination mindset is growing among Middle Market business founders. As lending costs have increased and working capital needs have accelerated, they are inclined to cultivate private equity investors. There is concurrent reluctance to fully exit at current valuations, thus maintaining more aligned partnerships with rising percentages of roll-over equity. These partnerships can propel competitive leaps when backed by fresh capital and a strategic sector-specialist equity partner.

Of late, for allocators, it was as if the hourglass was flipped prematurely when both assets and liabilities moved in opposite directions. Valuations are in transition. As leverage drops and rates increase, net-net strategic equity providers in the Middle Market are more valuable today than ever. 

While the overall debt market has been disrupted, debt availability has been more stable for small and medium companies because of the disproportionate growth in private credit. Going forward, private credit's consistency and familiarity with the Middle Market is expected to provide a reasonable degree of stability.   

Finally, lower entry valuations provide inherent downside protection to the Middle Market. Bain reports that, in the past decade, the average entry valuation is under 9x EV/EBITDA for companies less than $250 million rising to over 12x EV/EBITDA as the target deal size reaches $1 billion. The scale-driven valuation gains and multiple expansion serve as a double reward as companies increase in size and move into the more competitive large buyout universe. This difference in valuation multiples is reinforced by the propensity for Middle Market companies to exit through a financial buyer or strategic acquisition, thereby obviating the need for a healthy IPO market – a distinct benefit in the last 18 months. 

Even though Middle Market investing fundamentals have been more stable, it is still a buyer's market. Valuations remain reasonable, creating what we believe to be an attractive decade-long opportunity ahead. 

Those who have met with our team recently may have noticed how thematically consistent our investment thesis has remained. Our pipeline reflects this conviction. We are pleased to detail economic transformations that provide additional growth opportunities to the sectors where we invest and highlight several others we are monitoring for inclusion in the coming years. 

Active Themes.

Healthcare & Life Sciences Tools. The demand for tools and services that form the ecosystem around advancements in precision medicine, therapeutics discovery and development and global inclusive care continues to grow in size and complexity. Progress in biologics, cell and gene therapies are changing the competitive landscape and selectively accelerating demand for new industry infrastructure to match the level of intensity.

Industrial and Chemical Specialties. Industrial transformation is creating all manner of new demand to assist with the evolution of heavy industry. This is propelling innovative technology to achieve both public and private companies’ goals for desulfurization, preservation and circular economies. Additionally, it is contributing to the development of solutions for carbon capture and the advancement of mobility infrastructure.

Tech-Enabled Business Services. The service economy is seeing accelerating growth in labor management, pathogen remediation, supply chain compliance and monitoring, global talent maps, ed-tech and procurement. The inherent labor supply challenge within many service businesses is opening an opportunity for private equity partners to tech-enable and move beyond geographic limits in linking talent with demand. 

Consumer Lifestyle & Health. Consumers have never had so much power thanks to social media and access to information. Post-pandemic consumers are emboldened to experience personal change, spurring growth in nutrition, health, sports, entertainment and hospitality. Now more than ever, branding is multi-dimensional and socially aware, with private equity investors bringing experience in elevating brand value through the fusion of purpose and connectivity.

Emerging Themes.

Property Management Efficiency. New York City is not unique in passing Law 97 within the Climate Mobilization Act, requiring buildings to meet energy efficiency and greenhouse gas emissions limits by the decade's end. There is accelerating demand for services and devices to assist with the transition.

Industrial Infrastructure, Geothermal Resources & Hydrogen. Beyond electrification, both geothermal and hydrogen projects demand resources through the supply chain. The US, Japan, and Indonesia hold the world's three most extensive potential geothermal resources, each with more output equivalent to more than 20 nuclear reactors. Moreover, innovation is coming onstream to support low-carbon hydrogen, which holds the promise of closing the gap for industries that could prove challenging to abate otherwise, including heavy-duty transportation, steel manufacturing, and production of fertilizer and methanol.

While the above is not a finite list of themes, our goal is to incubate asset management businesses that invest in higher growth trends among small and mid-sized enterprises of the Middle Market. We select teams that are sector specialists in their strategy and win deals not just on price but on keen insights that are uniquely value-driven to help companies grow faster. We partner with managers who support the development of society-critical businesses and anchor those managers that we believe will endure and scale, thus building a collective of funds that reflect an exceptional new generation of private equity managers. 

What We Are Reading

Barings Insights Mina Pacheco Nazemi and Adeline Sparks. Don't Judge a Fund by its Number: what LPs Often Overlook in Fund Selection. Recent performance suggests that emerging managers are over-delivering into the first and second quartiles. 39% of Fund I managers generated top-quartile returns. 

CNBC Television. We're seeing a thawing in the IPO market, says NYSE President Lynn Martin following CAVA's IPO.

FundFire's Michael Taffe. Family Offices Plan to Delve Further into Private Markets. According to a UBS survey, family offices already have a high allocation to alternatives – averaging 45%. Family Offices sophistication is showing up in institutional-style portfolios. 

How Women Lead. Women First Investing and Knowing Your Power. Erin Harkless Moore inspires the next generation of asset management leaders with her frank discussion. 

BCG. Turning a Tech Hub into a Talent Magnet. BCG studied 11 new tech hubs including Amsterdam, Bangalore, Berlin, Dubai, Dublin, London, São Paulo, Seattle, Shanghai, Singapore, and Tel Aviv interviewing more than 1,000 digital tech workers who had relocated. The conclusions are a complex mix of policies that leverage existing strengths and enhance their appeal to leading companies.

Bain. Low Carbon Hydrogen Report. Consortia of companies are forming around the opportunity to climb the experience curve and gain early-mover advantages.

The Economist. Japan's hot-spring resorts are blocking geothermal energy plants. In the leap forward for energy transition, existing small and medium enterprises learn to co-exist with the effort. 

Uxolo, Kennith Rosario, with contributions from Lily Jin. Is private capital the way forward for inclusive healthcare in Asia?  The Asian healthcare sector is increasingly being driven by private investments. But the challenge is in funding private healthcare businesses at scale.

Capital Allocators, Ted Seides. Short-Term Gain, Long-Term Pain, Part 2 Capital Allocators – Inside the Institutional Investment Industry. "Drawing on experience working at Yale and how David Swensen would've been spending his time to prepare for what comes next."

Steward Asset Management is an anchor investor to private equity teams approaching their first institutional launch.  We utilize strategic partnerships to build diversified private equity portfolios. Our lens focuses on strategies that address innovation and disruption in the healthcare, consumer, industrial and technology sectors in the US Middle Market. 

In the attractive small fund universe, funds under $1 billion, Steward’s anchor partnership unlocks additional LP return potential with the addition of GP participation and engagement. Steward serves as a catalyst for founders while providing support and guidance. These features are unique to the Steward program and include a focus on alignment and diversity.

Headquartered in New York City, Steward’s competitive advantages include a deep pipeline of talent, proprietary assessment tools, experience negotiating terms and extensive relationships within the emerging manager investor community. The team has an accomplished track record of deploying capital to smaller and diverse asset managers.

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