A mid-market GP who has raised several funds recalls one of the biggest mistakes in his private equity career: it involved valuations.
The GP, who wishes to remain unnamed, recalls marking an investment too high, and when the asset was sold, it fell below that valuation mark. The missed mark left him with a bad reputation among the firm’s limited partners.
“If you mark a company at $500 million and sell it for $400 million, the LPs will get really [frustrated], because they have to show a loss,” the GP says. “If you keep doing that, showing losses against your marks, your marks will have no credibility.”
What the GP is illustrating is the balancing act private equity managers have to maintain when it comes to providing their fund investors with quarterly asset valuations. It’s a system of checks that, while seemingly allowing for the appearance of transparency, may have little to do with how a firm ultimately resolves an investment.
Valuations have risen to the top of the list of concerns for LPs, and in some cases, created frustration. Opinion is divided as to whether the industry should be taking steeper losses as the broader economy is buffeted by external shocks. (StepStone estimates in a recent report that PE will be down 6.9 percent for the full year 2022, significantly less than public markets.)
No red flags
Some limited partners who spoke with Buyouts say they are comfortable with the valuation processes used by their GPs. And importantly, they have seen no red flags that indicate something is amiss. Others express frustration that private equity valuations do not seem to be matching declines in the public markets, throwing their investment portfolios out of balance and forcing them to make tough decisions about their programs.
“Aside from having the denominator effect, these quarter-to-quarter or year-to-year valuations are sort of moot at the end of a fund’s life when the managers are going to time their exits in a way that generates really strong returns”
Jill Shaw, Cambridge Associates
Most sources also say they are anticipating write-downs to come as the broader economy teeters on the edge of recession. And companies that are well-capitalized today could find themselves struggling against falling sales, rising cost of debt and dwindling sales.
“If we go through a recession and company performance starts to drop, companies start burning through more cash and suddenly they need to go out and raise another round of financing, it’s going to probably happen at a down round, and then we will start to see the valuations pull back, but we’re not really there yet,” says Jill Shaw, managing director, endowments and foundation, at Cambridge Associates.
The nature of private equity makes it tough for firms to consistently provide up-to-date valuations, unlike in the public markets. The advent in 2007 of Financial Accounting Standards Board Rule 157 essentially forced private investment managers to make their best efforts to mark their investments to market. For private equity, this translates to: if you were to sell the asset today, what would its value be?
This flies against one of private equity’s core tenets, which is to hold investments longer than other asset classes – somewhere in a range of three to five to even 10 years in some cases. That lengthy hold period means a manager will be overseeing and growing an investment through market swings and can’t get too caught up in daily changes.
Because of this, most GPs have arrived at a practice where they try not to mark their investments too high in good times, or too low in bad times. The name of the game is smoothing volatility in the portfolio, rather than trying to reflect current market
“It’s tricky because you want your managers to take a long-term view. This is long-term investing, where you go through these periods of ups and downs. Private managers tend to be conservative in their valuations from the start, at least the ones we like to invest in, so when the public market pulls back, naturally the private managers don’t have as much to pull back because they haven’t written up their investments,” Shaw says.
“Fast forward six years from now, assuming there is a recovery, any down marks we are seeing today are kind of irrelevant if the company is held and ultimately exited in the better environment. Aside from having the denominator effect, these quarter-to-quarter or year-to-year valuations are sort of moot at the end of a fund’s life when the managers are going to time their exits in a way that generates really strong returns.”
“The tendency on the private market side is to adjust slowly and stick with older valuations until evidence forces them to remark the companies again. It’s very possible that they’re slow to mark up in a bull market, too. So you see the smoothing effect on both sides of it”
Michael Crook, Mill Creek Capital Advisors
PE valuations that don’t rise too high or fall too low can have consequences for limited partner institutions. As public markets have fallen over the past year, many LP institutions have become overexposed to private equity. Because private equity valuations change only gradually, the asset class as a percentage of an investment fund will sometimes increase when public markets pull down the fund’s overall value, which has been happening over the past year.
LPs contending with overexposure need to find ways to rebalance their portfolios, which sometimes means selling out of PE holdings at discounts on the secondaries market, or simply slowing their pace of new investing in the asset class.
Fundraising slows as commitments dry up, which means less money for deal activity, which likely also slows exit activity. As exits slow, LPs have less money returning from distributions, providing yet another barrier to new commitment activity. These factors are causing LPs no lack of agida and some of them look to GPs for an answer.
“Earnings growth has continued to be robust. We’re seeing double-digit type returns on average in the buyout space. Even public market companies have had decent year-over-year earnings growth, but it has been outstripped by how private companies are performing,” says Drew Schardt, head of investment strategy with Hamilton Lane.
Michael Crook, the CIO of Mill Creek Capital Advisors, which advises private clients, foundations, endowments and pension plans on investment strategy, says: “The tendency on the private market side is to adjust slowly and stick with older valuations until evidence forces them to remark the companies again. It’s very possible that they’re slow to mark up in a bull market, too. So you see the smoothing effect on both sides of it, and that makes it hard to say if the marks are accurate or inaccurate.”
“It’s an issue that people worry about: ‘How can this fund be up when everything else I own is down?’ You can almost hear behind the words, ‘Are you cooking the books? Are you making stuff up?’ The answer is no”
Brian Murphy, Portfolio Advisors
LP concern is now focusing on Q1 marks, which could start to show the kind of pain investors have been expecting for months. But what is more likely is that if pain is coming, it will be gradual, and occur over a number of quarters, rather than one catastrophic plunge.
The seeming resilience of private equity investing in the face of macro tumult has caused controversy and no shortage of opinions on why the asset class is superior to all others, or according to critics, why unsophisticated LPs allow themselves to be duped by billionaires.
“It’s an issue that people worry about: ‘How can this fund be up when everything else I own is down?’ You can almost hear behind the words, ‘Are you cooking the books? Are you making stuff up?’ The answer is no,” says Brian Murphy, managing member and managing director at Portfolio Advisors.
Regulators also keep an eye on valuations, especially due to the concerns about the process.
“Quite frankly, none of us want to go to jail,” says Ron Kahn, a managing director with investment bank Lincoln International who specializes in valuations.
How it works
Private equity firms value assets in their funds using three main metrics: public market equivalents (PMEs), discounted cashflows and precedent transactions.
The first is by comparing each company with their public market equivalent, if that can be found. Sort of like pricing a house against other houses in the neighborhood. Each house may have similarities, and yet come with their own unique flaws or attractive qualities. So prices, generally in the same range, will fluctuate.
Some PE portfolios include public companies, and those investments are already marked. But private assets need a bit more forecasting.
PMEs do not necessarily provide a straight comparison, though, according to Neil Barlow, a partner in private equity at law firm Clifford Chance. Public companies often have larger overheads and costs than private companies, he says.
“Quite frankly, none of us want to go to jail”
Ron Kahn, Lincoln International
Public market comparables also provide for the flexibility in how managers mark their assets, leading to situations where two managers mark the same asset differently. In this case, “there might be 10 potential comps, with the average comp trading for 12x, one trading for 20x and one trading for 6x. One GP might say, ‘We’ll use the straight average’, and another might say, ‘We’ll drop the high and the low and the average isn’t 12, it’s 10, because the high one distorted it’. Who is right? If it’s a close enough range, that’s ok,” Murphy says.
Some question the value of using PMEs to mark private assets, as incentives for both are different.
As famed economist Benjamin Graham said, the stock market behaves like a voting machine in the short term, which is made clear when traders make large moves on the day’s headlines. But private funds, with their lengthy hold periods, act as a weighing
Stock markets are vulnerable to large-scale day trading and investing trends like meme stocks, distorting a company’s fundamental performance.
“At times, we have inflection points and weird moments in transition, where we’re all trying to absorb how the interaction of conflicting economic news is going to lead us forward. It’s no wonder there’s schizophrenia in the public markets, and they are so volatile,” says John Bowman, the executive vice-president of CAIA Association, which offers the Chartered Alternative Investment Analyst designation.
Along with PMEs, GPs will also use recent transactional activity to help build a value. A recent financing round is a way to get a valuation, of course, but also external transactions of similar companies.
“There is a big distance in prices and values assigned by buyers and sellers. That’s creating a lack of price discovery, which complicates the valuation process”
George Tsetsekos, Drexel University
“That can really fluctuate. This time last year, you could have run an auction process quickly, or pre-empt the action with one or two bidders that wanted to move early, and the business flew off the table,” Barlow says.
“Things today are more cautious and processes are taking longer to get off the ground. You might have to step back and say, ‘that company sold eight months ago, could we get the same multiple today? Probably not.’”
Transactional activity is affected by the broader markets, with wide bid/ask spreads potentially distorting value, says Drexel University finance professor George Tsetsekos. “There is a big distance in prices and values assigned by buyers and sellers. That’s creating a lack of price discovery, which complicates the valuation process,” says Tsetsekos.
The third metric involves the fundamentals of the individual company and its financial projections for the future. Each portfolio company provides its financial numbers like revenues, EBITDA, capital expenditures, working capital, taxes and projected cashflows to the private equity owners, which can accept them or push back.
There is flexibility here, as well. “The area where the biggest flexibility comes in is what we call adjusted EBITDA,” says Jim Pittman, global head of private equity at British Columbia Investment Management Corporation.
“If you take a bigger multiple on a severely adjusted EBITDA, a moderately adjusted EBITDA, you can still hold it. Do I think that’s really the value? Probably not. I think there’s 5 percent to 10 percent of overvaluation that’s in the market, probably even 15 percent in a number of GPs.
“But it’s up to the investors. It is called the limited partnership from the viewpoint that the partners get to see what the valuations are. But they don’t really get to vote, they get to sort of opine on it. It’s the GP who delivers,” Pittman says.
Discounted cashflow can be unpredictable and affected by macro shocks. Third-party valuations experts and auditors play a large role in providing accurate discounted cashflow models as they typically have worked with companies of various sizes across various industries.
There are also differences in how a mature industrial company with a track record of many years and companies that are “pre-revenue” are valued.
“Take a drug company that’s on the market and it’s waiting for FDA approval. If the FDA approves its drug, then how much the company is going to be worth is unimaginable. But if its drug isn’t approved, it’s a zero. It’s much harder to value those companies. It’s more of an art than it is a science,” says Kahn.
Reporting best practices
As always with private equity, firms vary in how they report their numbers to fund LPs. Most PE firms have a “valuations committee” consisting of senior level executives who review the numbers from the portfolio companies.
Smaller firms may have no committee in place, which can be an issue, especially when LPs consider committing to the next fund, sources say. In a tough fundraising environment, every detail counts, even if past performance is strong. The lack of a consistent and transparent valuations process can be the difference between a big commitment or a hard pass by an LP.
Kahn says: “There’s no way I could tell you that a manager with an independent valuations team and a manager that doesn’t will have equally robust marks. I like to use the saying, ‘Everybody thinks their baby is beautiful.’ Every deal team thinks their deal is phenomenal, and they might be inclined to be less skeptical than somebody sitting on another floor of the building tasked with valuations.”
In these situations, the CFO of a manager is the one who ultimately signs off on a valuation, Kahn says. “You would hope the CFO would have the integrity to overrule the process and tell the deal team they are being a little too aggressive in what they’re doing.”
Best practice would have a GP sharing valuation information, including underlying company data, with, at the very least, the fund’s LP advisory committee in some sort of organized format, rather than in a data dump fashion.
LPs look for GPs with rigid and well documented valuation processes, using independent third-party auditors or valuations firm, and performing this sort of analysis on a regular basis, according to Neal Prunier, senior director of industry affairs with the Institutional Limited Partners Association.
“They have conversations with the LPAC and with their LPs, they have good separation between the valuation committee and the deal team, they provide clarity as far as alignment, they showcase the track record of the valuations and how they performed relative to the ultimate sales prices.”
Additional reporting from Kirk Falconer and Gregg Gethard