December 2, 2024

The Wisdom of Victor Mayer, MD at Pantheon

By: David Downs

Pantheon’s $70B AUM Secret to Private Equity Investing

Palo Alto Partners Perspective:

Understanding Pantheon’s approach to private equity investing reveals key lessons valuable to venture capitalists navigating a highly competitive funding landscape. Pantheon’s emphasis on focusing on small- and mid-cap buyout managers demonstrates the value of targeting segments with broader opportunity sets and potentially higher alpha compared to large-cap investments, which face greater competition and pricing pressures. Their Evergreen fund structure, designed to recycle distributions rather than liquidate assets, aligns long-term returns with investor goals, providing flexibility and tax efficiency that appeal to wealth managers and institutions alike. This model highlights the importance of innovative structures that balance investor needs with operational efficiencies, offering insights into tailoring products for diverse investor bases while mitigating common risks such as adverse selection and over-leverage.

Additionally, Pantheon’s strategy underscores the necessity for differentiation in a crowded market, particularly for venture capitalists aiming to secure quality investments. By curating a selective buy list and maintaining focus on underpenetrated yet dynamic market segments, Pantheon positions itself as a leader in delivering value through specialization. Venture capitalists can take note of the importance of relationship-driven networks, transparency in allocation policies, and a commitment to long-term growth over short-term gains. These principles, coupled with a clear understanding of evolving investor preferences—like the increasing demand for private market exposure among high-net-worth individuals—provide a framework for success in building scalable, resilient investment portfolios.

Episode Preview 00:00

Large cap funds are becoming increasingly larger, resulting in a small number of companies being chased by a large amount of dollars, making it difficult for general partners (GPS) to differentiate themselves, leading to higher pricing and leverage, and potentially lower quality or selectivity ratios 00:06.

This environment is not ideal for private wealth investors due to the combination of higher pricing, pressure to deploy capital, and higher leverage 00:34.

Pantheon looks for buyout managers with a clear focus on four key dimensions, which are part of the characteristics of the 1.2 to 1.4% of buyout managers on their buy list 00:49.

Pantheon is a global integrated fund of funds platform established in 1982, with multiple franchises across private equity, infrastructure, private debt, and real estate, offering primary, secondary, and co-investment capabilities 01:09.

Pantheon manages around $70 billion in capital, with approximately $7 billion being Evergreen Capital 01:28.

The company was introduced to the podcast by Mel Bankovich from Unicorn Strategic Capital 00:54.

Evergreen fund franchise and its purpose 01:32

Pantheon was set up in 1982 and five years later, in 1987, it launched a listed Trust on the London Stock Exchange called PIP, which has been active for 37 years and has nearly $3 billion in AUM 01:49.

PIP is considered one of the first Evergreen vehicles to be launched in the industry 01:59.

In 2014, Pantheon launched a 1940 Act Fund in the US, which is now one of the largest in the industry, focused on secondaries and co-investments in the small cap and midcap segments 02:12.

The US fund has been active for around 10 years and has been successful, leading to the development of an international version of the semi-liquid fund from 2023 onwards 02:22.

The purpose of the Evergreen franchise is to bring institutional experience to smaller institutions and the wealth community, providing access to small cap and midcap investments with compelling returns 02:44.

The Evergreen format is designed to create long-term returns for various investors, including individuals, wealth distributors, smaller institutions, and Sovereign funds 03:00.

The Evergreen vehicles allow Pantheon to serve a wide range of investors in a format that meets their needs 03:09.

Evergreen structure and future outlook 03:11

The Evergreen structure in private equity investing means there is no expiry date on the vehicle, and instead of distributing capital when assets are sold, the distributions are recycled to benefit investors 03:14.

This structure differs from closed-end funds, which have an administrative burden, a multiplication of capital calls, distribution notices, and a need to monitor and spend resources to effectively manage the portfolio 03:32.

The Evergreen structure solves issues such as having a team in place to manage capital, achieving target net asset value, and maintaining significant additional commitments 04:23.

Evergreen funds can achieve a highly funded, diversified portfolio on day one, allowing investors to quickly reach their target net asset value 04:27.

In the small-cap and mid-cap segments of private equity, Evergreen structures can provide access to smaller, often oversubscribed general partners (GPs) that are difficult to access otherwise 04:42.

The user experience of Evergreen funds is expected to be the future, with top-quartile small-cap and mid-cap GPs likely to adopt this structure in the next five years 05:14.

To build an Evergreen program, multiple years are needed to develop the back office, front office, distribution channel, and client servicing, as well as to understand compounding in an Evergreen format 05:43.

Top-performing GPs with consistent returns across multiple cycles may consider adopting an Evergreen structure, but the real question is whether they can achieve it due to the complexity and resource-heavy nature of the undertaking 06:12.

Tax implications and target customers for evergreen funds 06:21

Evergreen funds have different tax implications compared to traditional closed-end fund structures, as unrealized capital gains are held at the vehicle level and the general partner (GP) recycles on behalf of the investors, potentially avoiding capital tax events if investors do not redeem from the fund 06:22.

This tax efficiency may vary depending on individual countries and jurisdictions, and it is essential to consider these differences when evaluating evergreen funds 06:46.

The target customer for evergreen funds typically has a minimum wealth level, income level, and knowledge level, with an understanding of public and private markets, investing activities, and the risks associated with semi-liquidity 06:59.

Ideal investors for evergreen funds are those who comprehend the illiquidity and risks of this type of exposure, including high net worth individuals and institutional investors 07:12.

The target customer base can be categorized into three tiers: tier one includes typical wirehouses such as UBS, J.P. Morgan, Citi, and HSBC; tier two consists of smaller banks with scale or larger asset managers; and tier three comprises family offices, multi-family offices, independent wealth advisors, and registered independent agents 07:26.

Institutions typically allocate 10 to 20% of their portfolios to private markets, while the wealth community allocates around 2 to 4%, presenting a significant opportunity for evergreen funds to tap into the wealth community’s demand for private market exposure 07:47.

The premiums that can be achieved through asset selection for the wealth community are substantial, and there is a growing trend of the wealth community accessing private market funds directly through tier one or tier two banks 07:54.

Addressing adverse selection in evergreen funds 08:10

Private equity funds are often criticized for having their alpha absorbed by institutional investors by the time they reach large wirehouses, leaving high net worth clients with lower returns 08:12.

High net worth individuals may be subject to adverse selection in evergreen fund structures, which can be broken down into different dimensions 08:29.

One main bias is that larger banks are incentivized to raise more capital efficiently, resulting in a focus on large cap funds that are easier to market and can generate good returns 08:34.

The large cap universe is smaller than the midcap universe, and many banks are already distributing small cap and midcap funds, particularly midcap funds 09:05.

The evergreen wave tier one landscape is dominated by large cap single GP branded evergreen funds, which may experience deployment pressure and lower performance due to their commercial success 09:17.

To address this, banks should diversify their shelves to incorporate more midcap and lower midcap alpha, and evergreen funds can play a key role in providing an easy-to-sell and manageable format for clients 09:38.

The wealth community is not only intermediated through banks, but also includes direct access, family offices, multi-family offices, and asset managers, which can be more entrepreneurial and have less inertia than tier one banks 09:53.

These groups are already investing in small cap funds and can benefit from the diversification offered by evergreen funds 10:05.

Pantheon’s investment strategy for bio funds 10:07

Pantheon’s US fund has been scaling quickly, and the International fund is on the same trajectory, driven by investors with an entrepreneurial mindset who understand the benefits of investing in small and mid-cap managers 10:07.

The company’s investment strategy focuses on the fees associated with intermediaries between clients and products, recognizing that more intermediaries can lead to more layers of fees 10:29.

In the Evergreen space, allocation policies are often based on a pro-rata approach, ensuring fairness and transparency among clients participating in deals 10:50.

Pantheon’s thesis on small and mid-market bio funds emphasizes the compelling nature of the mid-cap and small-cap segments, with a larger universe of companies to invest in and grow 11:50.

The mid-cap and small-cap market represents the reality of the economy, with more potential companies to look at and buy, and grow in different sectors 11:56.

In contrast, the large-cap space has a lower number of companies, but they are worth more, leading to a smaller supply of potential investments 12:16.

Large-cap funds are often larger, leading to a struggle to differentiate among GPS, resulting in a focus on pricing, higher leverage, and potentially diminishing quality or selectivity 12:27.

Pantheon’s analysis of companies invested in over 20 years shows that small-cap and mid-cap companies have higher annualized top-line growth and a higher delta between mid-cap and large-cap on the earnings side 13:11.

The company’s investment strategy focuses on a small subset of GPS, approximately 1.2-1.4% of the private markets universe, which exhibit characteristics such as segment focus, sector focus, and regional focus 13:58.

Identifying top buyout managers for Pantheon’s portfolio 14:19

Pantheon’s buy list in private equity midcap segment consists of 1.2 to 1.4% of top managers, with a focus on local managers speaking to locals, split between the US, Europe, and Asia 14:20.

When evaluating managers, Pantheon looks for a stable partnership and team with a healthy culture, no succession issues, and a culture of grooming and developing younger professionals 14:39.

The team should have a proven track record of first and second quartile performance, typically with second-generation funds or later, and a demonstrated ability to exit companies with a controllable downside risk 14:53.

Pantheon also evaluates the manager’s process, including an operating team that can implement a repeatable playbook to create value through operational improvement, such as improving processes, supply chain management, and digitalization 15:20.

The manager’s philosophy is also important, with a focus on small cap and midcap investments, and a sweet spot fund size range of $500 million to $2.5 billion, with most time spent on funds between $500 million and $1.5 billion 15:52.

In terms of enterprise value range, Pantheon looks at companies with values between $50 million and $400 million, which are considered small cap and midcap 16:07.

The buy list is a work in progress, with churn and funds being removed due to performance-related issues, fund size getting too big, team issues, or strategy drift 16:17.

Portfolio construction in small to middle market buyouts 16:39

Portfolio construction in small to middle market buyouts is driven by key requirements, including building diversification of the portfolio, managing the maturity profile, and ensuring efficient deployment of unfunded capital core portion 16:44.

Diversification of the portfolio is crucial, and the maturity profile is important as it allows for better forecasting ability for distributions, which can be recycled into the Evergreen program to create predictability of compounding 16:48.

Efficient deployment of unfunded capital core portion is necessary to create an efficient compounding engine 17:05.

The general house view on the market is to deploy 70% of capital into small cap and midcap, with some inevitable large cap exposure through diversified trades and secondary market purchases 17:15.

Large cap exposure is typically around a quarter, but can be higher, and is often acquired through buying funds that include some large cap assets 17:37.

The fees associated with GPL continuation vehicles, secondaries, and co-investments are not specified, but the blended fees for Pantheon’s funds are mentioned as a topic of discussion 17:47.

Fee structures in various investment vehicles 17:52

The most expensive way to access private markets is through a primary program, where investors pay a full stack of fees to the general partner (GP), typically 1.5 to 2% management fee based on commitments for five years, and a 20% carry over an 8% hurdle on an IRR basis 17:53.

Pantheon buys diversified portfolios of primary commitments four to seven years into their life cycle, which are deployed, have a high funded ratio, and allow for forecasting distributions, enabling the purchase of these assets at a discount 18:19.

The secondary market, including Pantheon, can price in the fee load of primary commitments into the purchase price, benefiting clients with an immediate capital gain on the discount, although fees are still paid 18:41.

Continuation vehicles are less expensive, with management fees typically ranging from 50 to 75 basis points of the assets in the vehicle, and tiered carried interest based on performance hurdles such as IRR, TVPI, or a combination of both 19:04.

Continuation vehicles offer alignment of interest and protection of downside, as the performance fee is dependent on the final performance of the asset 19:25.

Co-investment is a function of the strength of the primary platform, where relationships with GPs are built through primary capital commitments, and GPs treat co-investors as partners, offering access to deals in between fundraisings 19:36.

Primary capital is essential for GPs, as they need to raise funds every three to four years, making predictable sources of commitments, such as Pantheon, valuable partners 19:55.

Co-investment performance tracking methods 20:06

Co-investments received per manager are not a primary selection criterion for future commitments, with the priority being to back the best managers, but it happens that many of the best managers also offer co-investment opportunities as part of long-standing relationships 20:07.

Building relationships with top managers over time and committing to their primary funds has led to the development of creative co-investment relationships, where managers see the benefit of having access to sophisticated capital to help close deals, and in return, co-investors can access deals typically with no fees and no carry 20:21.

This arrangement allows for generating a net performance almost equal to gross performance, as the fees are significantly reduced, and having a quarter or a third of an Evergreen program allocated to assets with no fees or almost zero fees is extremely powerful over the long term 20:45.

In a co-investment scenario, if a general partner (GP) has a maximum investment capacity for a deal but the deal size is larger, they may syndicate the excess capacity to co-investors, offering them the opportunity to participate in the deal without management fees or carried interest in exchange for access to their investment capital 21:11.

The only difference between gross and net performance in this scenario is the expenses of the investment vehicle itself, such as ongoing expenses, administration, and custodian fees, which are much lower than the full fees paid on primary funds 21:48.

This arrangement is beneficial in an Evergreen format, as it allows for bringing co-investment deals to the wealth community with no fees, effectively reducing the total expense ratio and making it more compelling 22:05.

Co-invest strategy and deal selection 22:24

The co-invest strategy involves evaluating deals brought by the 120 managers, with a focus on GP fit, where the deal aligns with the manager’s strengths and positioning 22:24.

The process involves underwriting the asset directly, using a team of dedicated co-investment professionals with M&A or direct investing backgrounds, who have refined their deal selection skills through experience 23:03.

The team has access to a database of deals tracked on a quality basis, which informs their reviews of the industry, sector, or asset, and helps in making informed decisions 23:31.

The co-investment program has its own portfolio construction guidelines, aiming for diversification across various vectors, including geography, sector, stage, leverage, and entry valuations 24:02.

The goal is to avoid accumulating deployment at the peak of a cycle with unsustainable levels of leverage, and to maintain a diversified portfolio 25:27.

The team evaluates deals based on multiple factors, including the GP’s track record, and has a higher underwriting bar for less experienced GPs or those with whom they have a newer relationship 24:41.

The firm diversifies its co-investment program across geography, with a focus on the US, Europe, and Asia, and also considers concentration per sector, stage, and leverage 24:56.

Some GPs have better track records than others on the co-investment side, and the firm takes this into account when evaluating deals, with a higher level of conviction for GPs with a proven track record 25:47.

The firm’s co-investment program aims to maintain a balanced portfolio, avoiding over-concentration in any particular area, and seeks to make informed decisions based on a thorough evaluation of each deal 25:35.

Venture capital evergreen structures 26:16

The Evergreen structure is expected to make its way into the Venture Capital ecosystem over time, despite Venture Capital being a different animal compared to small cap, midcap, and growth due to its early-stage growth focus and private nature 26:16.

Venture Capital can be a “black box” in terms of valuations, with successful Venture GPs not sharing significant details on valuation methodologies, and performance levels, revenues, break-even expectations, profitability pathways, and burn rates often being confidential 26:31.

Evergreen funds require predictable distributions to recycle and compound for the benefit of investors, but Venture Capital can have unpredictable distributions due to the potential for a large number of IPOs at exit 27:20.

Venture managers often generate alpha through public listings, which can lead to locked-up shares, daily valuation profiles, and a lack of control over share price fluctuations 27:40.

Venture portfolios often have a high loss rate, with a good Venture fund expected to lose 40-50% of its capital, requiring the remaining capital to generate at least two times the return to break even 28:21.

The combination of volatility, lack of forecasting ability on distributions, and public exposure valuation volatility can create a highly volatile Evergreen valuation environment in Venture Capital 28:41.

Comparing small buyout and venture capital for LPs 28:54

When deciding between small buyout and venture capital, limited partners (LPs) should consider investing in top-tier groups, but these groups are often heavily oversubscribed, limiting deployment budgets for large institutions 28:55.

To achieve a risk-reward profile similar to small-cap investments in venture capital, LPs need to diversify their venture bucket extensively to mitigate GP risk, sector risk, and idiosyncratic risk 29:30.

Diversification in venture capital is crucial, not only across different general partners (GPs) but also across multiple vintages, as some vintages may perform better than others due to market conditions 29:39.

LPs should commit to a long-term program, typically 5-10 years, to participate inmultiple vintages and minimize the impact of good or bad vintages 29:50.

The notion that small-cap investments are more volatile is a myth, as size does not matter in private equity; instead, the RK spectrum (what you pay, leverage, and growth potential) is more important 30:25.

Small-cap private companies tend to have better alignment with GPs, are often profitable and growing quickly, and are acquired at a lower valuation with less leverage compared to large-cap assets 30:55.

The difference in volatility between small-cap public companies and large-cap public companies does not apply to private companies, where small-cap private companies can offer great alignment, cheaper valuations, and lower leverage 31:27.

The trend of large-cap funds getting larger creates a once-in-a-lifetime opportunity for LPs, as these funds may need to deploy capital by acquiring smaller assets or platforms from small-cap or mid-cap funds 31:47.

Exploring large cap funds and small cap opportunities 32:09

The large cap segment has never been larger and has never been tested at that scale, with the availability of leverage and its cost being a significant factor, especially following the FED pivot, which may reopen the floodgates for large GPS to start investing at scale 32:10.

If large GPS do not have access to leverage, they will have to focus on M&A, small add-ons, and tucks, which works in favor of small cap GPS as they will be leaning into these smaller GPS to buy assets 32:33.

Pantheon is a firm that has the interest of its clients at heart, with a brand established over four decades as great stewards of capital, working with institutional investors to deliver access to small cap and midcap opportunities 32:50.

Pantheon’s positioning as a gateway for larger institutions to access small cap and midcap opportunities is now being brought to the wider community, including smaller institutions, family offices, and multi-family offices 33:11.

Over the last 10 years, Pantheon has brought innovative formats to the market, including semi-liquid products, and will continue to launch new products as it scales, providing differentiated risk-reward profiles 33:22.

Pantheon’s focus is on providing cost-efficient solutions with a small cap and midcap focus, aiming to generate comparable returns and alpha, with a focus on cost-to-return analysis 33:56.

The firm’s focus on cost efficiency and providing the best products is a key part of its DNA, and it is excited to bring its expertise to the Evergreen side as a manager 34:17.