StepStone’s Mike Elio sees institutional capital becoming more selective as investors seek better routes to liquidity and reassess where future opportunities lie.
Private market portfolios are adjusting to a world of longer holding periods, uneven exit markets and greater competition for investor capital. For Mike Elio, partner at StepStone, the response is already visible in the growing appeal of secondaries and smaller buyouts – and in a much sharper focus on managers’ ability to return cash.
Elio works on portfolio construction and manager selection for some of StepStone’s largest institutional clients, alongside leading research into US mid-market buyouts and secondary funds. He is therefore in the perfect position to discuss trends across investor demand and asset class opportunities.
Perhaps the biggest challenge has been the shortage of capital being returned to investors, particularly in private equity. “Institutions are struggling with a range of issues, the most prominent is the lack of distributions in their private market portfolios,” says Elio. “They’re looking for places to deploy their capital that will help improve the situation.”
Elio says investors are adjusting where and how they deploy capital, particularly in the direction of secondaries and the smaller end of the buyout market. Secondaries because they offer the ability to acquire seasoned assets with a shortened timeframe. Small- and mid-market buyouts because of the presence of open exit routes, given exits at the largest end of the market are principally reliant on IPOs.
The search for liquidity is also helping to establish a stable role for GP-led continuation vehicles. “GP-led CVs have been a great way for GPs to provide liquidity for their fund investors, while still holding on to some of their best assets,” says Elio. “They have become a permanent feature of the market.”
“The magic metric is DPI – being able to actually sell a company to return capital to the investors. DPI is the new IRR.”
Elio says many LPs initially disliked the way transactions were handled on behalf of existing fund investors but, viewed from the other side of the transaction, recognise that CVs can provide attractive investment opportunities.
CVs can also partly substitute for the shortage of traditional co-investment opportunities, offering exposure to individual assets with a similar cashflow profile. In addition, capital is invested immediately and potentially returned years earlier than an investment in a new fund.
Market dynamics
The reopening of IPO markets provides another potential route to liquidity, although Elio cautions against assuming its impact will be felt equally across private markets.
He describes the June SpaceX IPO as “the perfect advertisement for why you should invest in private markets”, pointing to the huge growth increase in the company’s valuation while it remained privately held.
But such high-profile technology listings do not necessarily solve the wider private equity distribution problem. “We’re talking venture and growth equity,” he notes. “IPOs are going to change liquidity in their world – but it’s not going to change anything in the buyout space.”
Elio notes that buyout distributions have historically fallen sharply during periods of market dislocation. Buyout activity had begun to pick up last year, he says, before bouts of economic and geopolitical uncertainty interrupted the recovery. They again began to creep upwards in the second quarter.
Higher interest rates are often held responsible for holding back dealmaking and distributions, but Elio argues the absolute level of rates matters less than their predictability.
Stable financing costs allow managers to model acquisitions with greater confidence, while sudden changes in rates are considerably harder to absorb. “It’s a misconception that private equity needs low rates to make money,” he says. “What private equity needs is consistency.”
While managers now tend to hold companies for longer, he argues this is because many of them are strongly performing assets. “Managers are holding on to companies that are profitable, generating cash and compounding their returns,” he says. “Instead of selling at 1.5X or 1.7X, they’ll probably get 2X. The downside is they need to wait a little bit longer, so the IRR will be lower.”
DPI is the new IRR
Longer holding periods are preventing LPs from committing to new opportunities, so fundraising remains constrained.
Elio says this is partly a hangover from the rapid fundraising and deployment of 2019–21, when managers often returned with a new fund only 18 or 24 months after their previous fundraise. “We’re still digesting all the capital that was invested,” he says, noting that this needs to happen before investors can resume their previous pace of commitments.
In the meantime, institutions are concentrating commitments among their strongest relationships and becoming more selective about adding new managers.
This includes greater emphasis on evidence that managers can successfully complete the entire investment cycle. “The magic metric is DPI – being able to actually sell a company to return capital to the investors,” says Elio. “DPI is the new IRR.” IRR had already lost some of its standing because it can be affected by the timing of capital calls and distributions, as well as the use of financing. Distributions have therefore become relatively more important in manager assessment.
Elio says manager selection has become particularly important lower down the size spectrum. Whereas the largest end of the market contains a limited number of global managers, there are hundreds of mid-market managers and thousands operating in smaller buyouts.
Yet this is also where he sees greater potential for outsized returns. Purchase multiples remain more reasonable, and debt levels tend to be lower.
The trade-off is greater manager dispersion and potential losses, making the breadth of manager research critical. “You need to ask, what is the true market level? What is the true opportunity? What risk-return premium should I get at the smaller end?”
Emerging opportunities
Investor appetite is also shifting between private asset classes and sectors. Private credit has attracted substantial institutional capital in recent years, but may have passed the peak of its popularity.
Elio makes a distinction between investor sentiment and the underlying opportunity. “Private credit has had its moment,” he says. “I think the ‘bloom is off the rose’ a little bit from an investor perspective, though not from an investment perspective. Private credit is still a good place to deploy capital.”
Part of the sentiment shift reflects investors discovering the limitations of semi-liquid structures when redemption demand rises. Meanwhile, Elio sees greater interest in value-oriented sectors within private equity, with software currently attracting less enthusiasm.
But that caution could itself create opportunities. “For those with the stomach for risk, there’s probably a lot of opportunity in software. All software is being painted with the same brush – everyone thinks artificial intelligence is going to replace all of it,” he says.
Elio expects a more complicated outcome. “There is software that will thrive alongside AI, and there is software that will be replaced by it. You need to understand the difference, and that’s where some investors will do well.”
For much of the small- and mid-market buyout universe, AI exposure is less about owning the technology itself than how portfolio companies use it. “You’re not getting direct AI exposure in any of these businesses,” he says. “It’s really second-order exposure, as they’re all trying to use AI to become more efficient.”
The opportunity set
Geographically, developed markets continue to dominate institutional allocations. Elio says many portfolios have naturally tilted towards the US, reflecting the greater depth of its small- and mid-market manager universe. He is seeing increasing interest in the European lower mid-market over the past 12 to 24 months, but that has not always translated into commitments.
Investors, he says, generally see sufficient opportunities in the US and Europe without taking on the additional currency and geopolitical risks associated with developing markets.
Infrastructure is another beneficiary of changing allocations, particularly in Europe. Elio sees secondaries as especially interesting because investors can acquire mature infrastructure assets that are already generating yield, rather than waiting several years.
“We’re seeing a lot of interest there,” he says, adding that infrastructure’s inflation protection potential also helps in the current environment.
Evergreen vehicles are also becoming a more established part of institutional portfolios, according to Elio. But he questions whether their growth represents genuinely new money to private markets, as banks were already directing client capital into closed-end private market funds through feeder structures.
Evergreens have also found an audience among smaller institutions. Elio says foundations that previously relied on fund-of-funds structures can instead use evergreen vehicles to establish private market exposure without managing a succession of capital calls and distributions.
“It’s a misconception that private equity needs low rates to make money. What private equity needs is consistency.”
The potentially bigger change is the opening of defined contribution (DC) funds to private markets. Elio points to the incorporation of private assets into DC structures in markets including the UK, Australia and Mexico, while the much larger US 401(k) market has yet to invest meaningfully in the asset class.
Looking further ahead, Elio expects the institutional opportunity set to continue shifting without a single asset class dominating. “I think buyout is going to be a little engine that could quietly continue to generate consistent, stable returns.”
He expects infrastructure to continue attracting capital and believes real estate will eventually offer compelling opportunities, with some already emerging in the secondary market.
Private market opportunities are likely to emerge selectively when capital moves away from certain sectors or strategies. As Elio puts it: “When everyone is running out of a room, maybe it makes sense to look in and see what opportunities are there.”
That said, he is sceptical that investors should wait for a broad distressed cycle. “There’s just too much money in the world, and so every time something starts to look distressed, the money rushes in,” he adds.
