When Fund Selection Is No Longer Enough w/ HarbourVest’s John Toomey

0:02Our mission at HarborVest, as it has been from day one, is to enrich lives through the power of private markets.

0:10John Toomey: That's John Toomey, CEO of HarborVest. For decades, HarborVest has operated on both sides of the private equity market, backing fund managers while also buying stakes from investors looking for liquidity and investing directly alongside sponsors. That gives John a rare view of how capital moves through the industry and how the same asset can look strikingly different depending upon where you sit. At HarborVest, we invested$11 billion into the secondary market last year, the PE secondary market, and half of that, Hugh,$5.5 billion into the CV market. So I don't know that there's another manager that has the experience that we have and the types of archetypes and insights that we use to decide when we invest our investors' capital.

0:53John Toomey: Today on Dry Powder, I'll ask John how that perspective translates into better investment decisions, where HarborVest sees its next wave of growth, and how it plans to expand into areas like growth equity and credit secondaries. I'm Hugh MacArthur, Chairman of Bain's Global Private Equity Practice, and this is Dry Powder.

1:17John Toomey: John, it's a pleasure to have you on Dry Powder. Welcome to the show. To you. Thanks for having me. Wonderful to be here. Now, John, you and I have known each other for a while, but you actually joined HarborVest a long time ago. Take us through your career a little bit at the firm and talk about how the business has changed along the way. Yeah, look, I mean, I'd say one of the first, most important consequential decisions was deciding to join this company that actually didn't have a name at the time. It just completed its purchase from John Hancock because for the first 15 years, it was known as Hancock Venture Partners.

1:53And it was a 30-, 40-person firm headquartered in Boston investing in what was then mostly venture capital. It really wasn't much. The buyout industry in the 90s was quite small. And I just found this wonderful group of people. You know, HarborVest was started by eight extraordinary entrepreneurs who, even though that they were involved in different strategies and different geographies, they decided to be pretty equal across the partnership and put at the center of their philosophy, client outcomes and client success. So a couple of years out of undergrad, you know, like a lot of people in that era, I worked two years in banking and then wanted to get to the buy side.

2:39Sure. I didn't have a great reason for it other than wanting to learn and get closer to the numbers and own my decisions. And here I am 29 years later with the privilege of leading this organization.

2:53John Toomey: It's a great story, and it's really a unique firm, HarborVest. You see a lot of asset classes, but in particular, private equity from a lot of different angles. You've got fund investing. You've got secondaries. You've got co-invest, lots of different things. How would you describe to the audience the market today for private equity? What are you seeing that might surprise people? What's going on in the headlines that you think is right, that you might think is overdone? What's your general take on how is private equity right now? And I'm specifically talking about buyouts. Yeah, sure. I mean, look, it's not often that you get an industry that's 40 years old that's going through this transition.

3:29And so what do I mean by that? I think for the first four decades of this industry, investors around the world would measure their portfolio performance on the basis of which funds did I select in a given year. And the reason why is that was the unit of decision making, right? You would allocate capital at a vintage year. You would make 10 to 15 fund decisions. And then you would actually benchmark those decisions. And if you look at every other asset class, Hugh, as you know, every other asset class, there's a lot of other ways to create returns. It isn't just around which funds did you have access to and invest into.

4:07It's what was your portfolio construction? What was your relative weighting? And today, as we think about things that are happening, such as the continuation fund market, our secondary has become a very important portfolio management tool, both for new investors and existing investors managing liquidity. Now you have a whole series of additional decisions, all of which contribute to the returns that you create in this asset class. And so for me, I think the industry is going through this dramatic evolution and how we do it as practitioners, I think will continue to evolve from what it was, say, for the first three or four decades in existence.

4:50John Toomey: Now, you are an LP at HarborVest. You have LPs at HarborVest, so you know a lot about that end of the market. What are LPs telling you about committing to new funds? And what does a manager you really need to do in your view to demonstrate that they are worthy of an LP's trust and a commitment? Look, I would tell you, as the market has matured, it's become extraordinarily competitive to secure this scarce limited partner capital that exists. HarborVest is a business. We said we have 1 ,300 active institutional limited partners all around the world. We have over 700 active GP relationships, right?

5:26We're a new investor in their funds, big secondary investor, and a direct equity co-investor. and credit and infra as well. And so we sit in this middle point in the ecosystem. And I have actually a lot of business school friends who've been in the industry for 15, 20 years, and they'll have a fund that they manage that has generated a 2.6 times return, a 24 % IRR, the vintage year is probably 2015, 16, 17. And they can't understand why they're not able to attract additional capital is the reason is because that's kind of like a solid second quartile fund for that era and for that vintage year.

6:05So I think what's happening is there's a complexity with how investors have to manage their programs and they're seeking everywhere that they can how to reduce that complexity. And so for some, it's externalizing it to people like us and others that are in the market in the same capacity, or they're shrinking the number of manager relationships. making it even harder. And I would say, Hugh, a popular strategy in the last decade or so, which I think is under a little pressure, is the strategy of investing with the large managers, because those are the names that we all know, and then buying down their cost to invest with free co-investments.

6:47And I think that strategy, which was popular and it worked for some time, I think that's under a lot of pressure with respect to the availability of that for the very large direct GPs. And so a lot of investors are trying to get to the middle market and trying to sort through how they go. But I would say, you know, what's on the menu item for, first of all, performance, like performance, performance, performance. Like if you don't perform better than your peers, you don't have a right to exist. Active equity markets, that happens quickly, right? If you can't generate two or 300 basis points above the indices, like again, capital will flow out.

7:23In privates, it happens, but it happens at this much slower pace. And so first is performance. The second is I think a lot of investors have built out their ability to invest alongside their managers and companies. And so creating that availability for investors who can actually execute on that is a second part. There's this all series of what I would call other, right value-added services i mean for instance we do things with our limited partners where we will share our data in the analytics right in terms of how we make investment decisions we'll have industry white papers we'll have on sites with them we bring our harbor vest university on the road and not all of those are appropriate for individual direct gps but i think you have to continually think about you know what are the other areas that would be of value to our customers beyond performance and exposure, and make sure that you deliver that to them as well.

8:25John Toomey: Now, I know, John, that you guys are very large in the secondary space, and you've spent a lot of your personal time thinking through secondaries. How is that market, or those markets, I should say, how are they changing over time? And let's start with the LP side of the equation, if I can. Are investors, in your view right now, primarily selling because they want liquidity, or are they becoming more deliberate around portfolio, shaping the portfolio and using it as an optimization tool? And are you seeing some interesting opportunities out there on the LP side of the coin? Look, this is, I mean, you're right.

8:55I spent 10 years in this part of our business before I became managing partner. And what a fascinating market. Every other asset class, Hugh, the secondary market is bigger than the primary market. And yet in privates, it's the other way around. And I think it was built on a convention where investors believed that they allocate capital to funds, and then there's no subsequent decision to be made. They simply just wait for the managers to create value, then to realize it and return capital to the investors. Of course, takes course over that full 10-year, sometimes longer than 10-year closed-end fund cycle.

9:36And every other asset class doesn't work that way, right? People have the opportunity to take active decisions. If I go back to like my early days in the secondary business in the early 2000s, if you think of a pie chart of stressed investors, distressed investors, and opportunistic, it might be equally split between those three types of sellers into the market. And today, I wouldn't say that there are no distressed investors. I mean, the university endowments have come under some pressure in the market. Certain organizations were significantly over allocated. So there's, I wouldn't label them as distressed investors, but they are definitely stressed.

10:16There's a reason they're selling. But a lot of the market today are opportunistic sellers who are shrinking their manager portfolio. Maybe they're trying to reshape their vintage year. Maybe they're deliberately trying to create commitment capacity with respect to being able to make new commitments. So the conveyor belt will continue. So today, it's just a very common part of the portfolio management tools. And that market has continued to grow. And to me, like the more fascinating part of it, though, is the LP side has certainly grown as time has gone on. But I'd say in the last decade, it's, you know, the GP part of the secondary market.

10:54It's like we were in a car. we didn't even know there was a sixth gear. It's like, whoa, whoa, what's this down to the lower right? And that's about half the market today. I think the GP-led secondary market was born in an era of illiquidity, but it's not going away. It's now become a bona fide part of the market. And it's another example of where decisions have moved from simply fund selection for investors to are you rolling or are you selling? Are you actually investing more capital? Because it turns out the early data suggests that these are actually pretty good businesses and they generate better than median returns for their respective vintage.

11:40So you should play in this market as an investor. The question really is how and with whom.

11:48John Toomey: Now, you have an interesting vantage point at HarborVest on continuation vehicles or the GP-led side of the coin because you see all sides of these transactions. What does your experience tell you about how they're actually doing in the marketplace now? And what separates a good deal from one you might avoid? The good news is the market has grown to a depth where, like any other market, you have a spectrum of opportunities. And so what do I mean by the spectrum of opportunities? There's a spectrum of manager quality, right? There are some great managers, and then there are some that, you know, are maybe developing still or not quite yet as proven.

12:31There are all spectrum of quality of companies. And so that's important because for us, it allows us to really pick and choose where we play within the market. If I think about maybe the consistent theme in all that we have done, it has been, you know, it's a manager we know. I mean, just given our market position, you know, it's rare that we will invest with a manager that we haven't known for some time, right, that we properly calibrated, have some insight on their capabilities and their track record. These often are companies that are pretty well calibrated. I mean, you've got years of performance.

13:08You can assess how they have performed during that time. And then there's usually a coherent thesis of why a manager, the context is important. Why is a manager considering a move into a continuation vehicle? And then the other table stakes part for us is ensuring that the alignment of incentives are there. And why is that important? We look at things that how much will a manager roll? Are they investing more capital in? Are we protected on a quick flip or a recap, right, where a manager then, you know, subsequently sells the company, you know, 6 or 12 months or 18 months after they've rolled it in a continuation fund?

13:51And I will tell you, we're not trying to maximize the alignment, right? I mean, you would think, like, we want the best possible alignment that we possibly can. Sure. Even if that comes at expense of the existing investors, because if the alignment is too good, then it starts to beg other questions. Like, how do we know we're not going to be on the other side of this in three or four years' time when you go and sell again? And I've seen some managers, you know, take it to that extreme as well. So when I look at our, I mean, we, at HarborVest, we invested$11 billion into the secondary market last year, the PE secondary market.

14:26and half of that, Hugh,$5.5 billion into the CV market. So I don't know that there's another manager that has the experience that we have and the types of archetypes and insights that we use to decide when we invest our investors' capital.

14:44John Toomey: And I need to get your thoughts, John, also on the co-investment market today because I understand you do a lot of that at scale. What do you think the opportunity is today for investing directly alongside of your sponsors Beyond kind of the lower fees, better net economics, what actually drives better returns? And how do you try to make sure that you're getting access to the better investments and evaluate them? Yeah, I mean, that market's developed as well. What I would say is if your participant, like the market's really bifurcated between co-underwriting, I wouldn't necessarily say co-lead, but really co-underwriting, where you're really providing a solution to the lead general partner.

15:25And then the syndication market, right? And it's really, really bifurcated there. A lot of the large managers have built out, you know, capital market desks where they're syndicating. And there are a lot of mouths to feed in that part of the market. Where we tend to have played is historically has been in the middle market where if you're a manager that has a billion dollar fund and you're looking to invest in a situation that requires 200 million of equity, boy, that feels pretty chunky for my fund. And so you're looking for a trusted partner with capital, with a dedicated team, with the track record of executing to work with where we'll co-underwrite it together.

16:04And we'll both syndicate down to their and our investors after the fact. So if you find a manager in the moment of need from a capital standpoint, sometimes it's around a specific company. Sometimes it's things like bridging investments between funds or seeding new strategies for managers. But the good news is for us, when you've got over 700 active GP relationships globally, you actually can unpack and find enough of those opportunities. I think we evaluate between 1 ,200 and 1 ,300 live co-investment opportunities, all of which will be completed by a manager that is very good in the market. And so it allows us to be exceptionally selective and build out diversified multi-manager portfolios that our investors seek from us.

16:55John Toomey: Now, HarborVest has grown dramatically over the last decade. I think you guys are well over$100 billion AUM at this point and headed to$200 billion pretty quickly. Where do you expect the next phase of growth to come from as you look at the horizon and where you desire to take the firm? And how might HarborVest look different, say, in five years or 10 years than it does today? Yeah, I mean, the business today is$165 billion of fee-paying assets under management. I really measure it not in terms of the total assets we've been entrusted with, but it's really how much capital can we reasonably be entrusted with and adequately invest every year, right?

17:34That's the throughput of the business. Right. And the good news is it has grown, but it's at that number, which today is around$25 billion, that grows kind of fairly carefully. As the market expands, as we invest further into our teams, as we expand our manager relationships, as we create efficiencies with how we prosecute deals, right? This is where the benefit of things like AI and tech-enabled assessments has really helped us kind of increase the top of the funnel and prosecute the top of the funnel. And then on the LP side, I mean, our mission at HarborVast, as it has been from day one, is to enrich lives through the power of private markets.

18:18And in order to do that, you need to meet clients and investors where they are and meet their needs. And for some, it's a total outsourced. We just want you to do all of it. And for some, it's complementary solutions or point solutions in what they're doing. But the real phenomenon that has been happening within our business and in the industry in the last few years has been what I call the next great unbundling of our intellectual property to help investors invest the way that we do. We're not advisor, not in the advisory business. We are cash on cash fiduciary investors. and yet many of our clients, when they see the analytics that we use to compare manager performance, to build portfolios and the portfolio construction and why we go deep in some markets and narrow in others and what's the right number of managers or investment size in a given program, more and more of our clients want to do what we do.

19:17And so we have using those analytics for literally decades and building that out. So I think it's the unbundling of RIP to allow more and more investors, both institutional and wealth, with the tools to adequately make good investment decisions and portfolio construction decisions. And I think in many ways the evolution of the public markets is instructive in the private markets. I think when we think about new and privates, people are like, you know, blockchain and like all new ways of doing that. And that'll be a part of the industry. But I think it's quite simple. Sometimes you just look over there to the public markets and think about how investors have invested.

20:01And increasingly, institutional investors, individual investors, they're really looking to buy exposures. Like they just need the 200 to 300 basis points, broadly diversify, which helps you manage risk. I want to stay perpetually invested, and I want to be with somebody who will help me create that excess return over the course of long cycles. And so I think that that's a big part of our future in terms of opening up our analytics and then creating investable products to allow investors to capture just that, the exposures that they need to complement or to entirely outsource what they do in private markets.

20:40John Toomey: And that kind of thinking, John, really strikes me as next stage, mature private markets industry kinds of thinking. Because when you're talking about an actively managed asset class, you want those exposures to do things, but only if you're really partnering with top quality managers that give you great exposure in all of these areas. You could imagine putting together portfolios that actually don't work because if I've got third and fourth quartile managers in an asset class, I don't want different exposures if that's what I'm investing in. And your point about data and analytics, I think makes HarborVest very interesting.

21:11John Toomey: And I'd like you to comment more directly on how investing in funds themselves and in the kinds of secondary transactions that you do, as well as individual companies, make HarborVest stronger because you have all of those different angles and the data and the insights that they provide. Yeah. I mean, it is really the original thesis of the firm, which was by being an investor in all of those parts of the market. And again, I don't mean like in a little bit, like in a kind of a major player in each corner of the market and having a incentive system where we all eat from the same pie, right? There's an integrated economic system here at HarborVest.

21:50So people have an incentive and cultural reinforcement of working together and supporting one another. So how does that play out? So first on the analytics side, For example, we have a tool that we have used for a long time. We call it a GP Alpha. We've now begun to make this available to large clients. And it allows you to distinguish between what I would describe as good portfolio construction contributing to your quartile returns or investment selection. Because our analytics are at the company level. And it allows us to unpack in GPs who might present as a first quartile fund. But when you look deeper into it, their first quartile, because they happen to have first quartile portfolio construction, they happen to be overweighted software in that vintage year relative to all the other industries.

22:42And that's what drove the relative performance. But when we look at their software track record, we compare it to all the other managers' software track record that we have on a contemporaneous basis. It turns out they're fundamentally second quartile software investors. And so unpacking that when we're doing manager selection is one example. You know, the second is, and this is the benefit of having this incredible amount of data for a long period of time. You know, our relationship with Insight Partners, as an example, right, tremendously successful, that initially came through a secondary purchase of a fund back in 2003.

23:21We have a first exposure. And then where did that lead to? It then led to a series of co-investments we've made with the manager, primary investments. And then when we're evaluating new funds or secondary investment, having the secondary analysis on prior funds up to date and current gives you an insight to the underlying portfolio. Being a co-investor in several of the companies gives you an insight into the underlying portfolio. So it allows us, we believe, to make more informed investment decisions, which contribute to, again, we see our clients increasingly looking to buy exposures. But we want to have the right kind of exposures, which is where these analytics help inform our view and really help be a driver of returns for our investors.

24:08John Toomey: Now, speaking of exposures, I think I read that your latest direct investment program or product raised about$4.75 billion. dollars. And I was surprised to see that about a half a billion of that was dedicated for growth investments. It caused me to ask myself, what's driving that demand? Why expand a commitment to growth investing now? What is driving that trend? Yeah. I mean, look, a good number of the 700 active GP relationships are growth equity managers. Not necessarily like your late stage investors, but we have an extraordinary franchise on the venture side and then a wonderful portfolio of managers on the growth side as well.

24:47And what we started to see, again, back to the theme of you have to meet your clients where they are. So we have been making growth equity investments in an integrated co-investment fund from the beginning, right? There's always been an allocation, but from an investor choice standpoint, they could only invest in the one fund and we would determine portfolio construction and allocation for them. And increasingly we had investors who would say either, I want only buyout or more buyout. Or on the other hand, they would say, I actually like growth and I want more growth. And so all that was, Hugh, was just the continued evolution of our business to give more investor choice, meet them where they are, and allow them to access our team's expertise in exactly the way that they want to when they are trying to fulfill their missions.

25:40John Toomey: On the next episode of Dry Powder, I'll ask John where private equity firms are going to earn their returns over the next decade. I've been reading recently, like, oh, there's 37 ,000 private companies held in private equity funds, right? My response to that is, what's the right number? Right. Like, what? Is that a lot? If you were to look at that number over the last 40 years, it's probably gone up every year in 40 years. So you could have written that same article 10 years ago to say, can you believe it? There's 20 ,000 private companies that are still stuck in funds. And yet here we are. I'm Hugh MacArthur.

26:17John Toomey: Thank you for listening.