Arizona navigates spike in capital calls in uncertain private equity market

After two difficult years for private equity in 2022 and 2023, investment activity and exits picked up in 2024 fanned by inflation and interest rates finally appearing to stabilise.

Fast forward to today, however, deal volume has eased back to lower than normal levels again because of the uncertain market.

Speaking during the $57 billion Arizona State Retirement System’s March investment committee meeting and before further volatility rocked markets in early April, Samer Ghaddar, deputy CIO, spelt out the challenges in private equity which accounts for around 12 per cent of total assets under management to Arizona’s nine-member board of trustees.

Ghaddar explained that although IPO activity has slightly improved, it remains sluggish compared to historical levels. Moreover,  the majority of private equity exits are concentrated in sponsor-to-sponsor deals as well as strategic sales. It means liquidity remains “a tough nut to crack” for many LPs and the percentage of net asset value realised has fallen to the lowest level in over ten years.

Although liquidity pressures mean many LPs have had to retrench from making new investments, they are committed to meeting capital calls. Ghaddar said that last year the level of capital calls and distributions at Arizona was almost level in an “extremely helpful” pattern that is reflective of the maturity of the portfolio which dates from 2006.

However, between January and March this year, the fund saw a higher number of capital calls linked to the spike in private equity deal flow. “Capital calls have been the highest in Q1 since 2006,” he said.

Ghaddar noted that the availability of private credit is spurring M&A activity and private equity deal flow. In contrast to recent years, there is now an abundance of credit in the market.

“I’ve never seen such M&A activity and there is a lot of credit in the market. Twelve months ago, if you wanted to fund a deal it was really hard to get funding, but now you get a lot of term sheets,” he said, referencing the documents that outline the key terms and conditions of a potential loan or investment. He said private debt investors had been sitting on the sidelines but have been encouraged into the market because of the stability in interest rates and favourable M&A valuations.

The importance of manager selection

Ghaddar also reflected on the importance of manager selection on Arizona’s private equity returns.

“Underwriting is extremely important,” he said. “The difference between a first and fourth quartile manager is around 20 per cent in IRR.” Arizona has prioritised choosing top-tier managers since a portfolio reboot in 2019, and the impact will start to appear in the returns.

Arizona has its largest private equity allocations with Vista Equity Partners and Veritas Capital.

Ghaddar detailed how the pension fund favours investing with sector-focused managers, particularly healthcare and industrials in strategies focused on operational improvements rather than financial engineering. The investor “stays away” from leverage because of the impact higher interest rates have on borrowing costs. “If interest rates go against you, returns will go against you,” he said.

The mature private equity portfolio is focused on the mid-market. Historically the allocation was primarily large and mega cap, but this was changed on the belief that large funds can erode returns. Moreover, more companies in the US and Europe sit in the mid-market space and the capital availability for these companies is lower and the opportunity for operational value creation is higher.

Arizona’s 12.8 per cent allocation exceeds its 10 per cent strategic asset allocation target for private equity but remains within the allowable policy range of 7-13 per cent. The allocation has outperformed its benchmark on both an absolute basis and in terms of excess return (net of fees) over 5-year, 10-year, and since-inception periods.

However, despite positive absolute returns, it has underperformed its benchmark by 26.1 per cent over the 1-year period and 0.12 per cent over the 3-year period.

The significant 1-year underperformance primarily reflects the exceptionally strong public equity returns incorporated into the investor’s private equity benchmark. When measured against the MSCI Private Equity North America & Europe benchmark, a dollar-weighted IRR peer benchmark, the portfolio’s underperformance is more moderate at 2.35 per cent below the peer group median.

Ghaddar said that the fund is strategically aligned to leverage an expected market easing phase that could reinvigorate public market IPO activity, creating enhanced exit opportunities and improved private equity performance.