As a buyer of limited partner interests in private equity funds, we have seen many articles about best practices in secondary sales. While the nuances of the transfer process are of some casual interest to buyout professionals, in this difficult environment, many general partners are really only interested in one question: How do I keep my LPs from selling?
Even when there is no chance of a future investment by an LP, GPs often fear that secondary sales will distract them from the business of managing and sourcing their investments. Moreover, too many secondary sales in a fund risks triggering publicly traded partnership classification and its related negative consequences. Since my firm’s founding more than twenty-five years ago,
The Denominator Effect
For many GPs, 2008 was the first year of implementing the new GAAP provision for mark-to-market accounting (FAS 157). Under the new accounting rules, funds must value portfolio companies at their current “fair value” as determined by the GP and certified by the fund’s auditors. However, there are a number of valuation methodologies for GPs to choose from, including comparable companies analysis, discounted cash flows and option pricing. Within any given model there is tremendous judgment introduced through selecting comparables, discount rates, volatility and other criteria. Since FAS 157 provides GPs with this flexibility, valuation of portfolio companies can vary widely across funds.
Our experience over the last year has been that GPs have tended to choose methodologies and assumptions that lead to higher valuations. Many GPs argue that some sectors of the public markets are irrationally depressed. They therefore tend to emphasize variants of cash flow analysis while de-emphasizing comparable public companies. Even taking into account the stock market rally in early 2009, many private equity portfolio companies remain valued higher than their public-market brethren. For highly levered companies, market EBITDA multiples often leave little equity value to the private equity backers.
As shown in the chart accompanying this story, we saw typical write-downs of 10 percent to 20 percent from Dec. 31, 2007 to Dec. 31, 2008 for private equity funds. Third-party research from Cogent Partners showed a similar decline of 18.8 percent in buyout funds and 14.0 percent in venture-capital funds. This compares to declines of almost 40 percent in the S&P 500 and the NASDAQ during the same period. The higher private equity valuations, combined with the lack of distributions, has meant that many institutions are substantially above their private equity allocations. The second chart shows a sample endowment fund based on the National Association of College and University Business Officers endowment allocation survey of 774 endowments. Assuming the returns shown in the asset classes represented in column C, the typical endowment could be nearly 20 percent above its previous private equity allocation. The imbalance caused by the stickiness of private equity valuations is usually referred to as “the denominator effect.”
Private Equity NAVs Trail Public Market Declines
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Many Endowments Topping Their Allocation Targets
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Had private equity GPs, on average, marked down their portfolio companies in line with the public markets, there would certainly be less pressure on institutions to sell private equity. While GPs cannot control how other funds value their investments, they can reduce their own vulnerability to secondary sales through proactive write-downs. Private equity funds that have maintained relatively flat valuations will become a larger percentage of total assets. These funds may be most susceptible to secondary sales since their removal has a dramatic effect on portfolio allocations. By contrast, funds that have already written down their investments will have a limited impact on the denominator effect and may therefore be seen as less attractive sales.
Consider the impact of two different write-downs on Endowment X, a typical University fund with a $300 million private equity allocation, invested in two hypothetical funds, one called MARKET FUND, the other called DCF Fund, that both invested $30 million in similar companies. MARKET FUND chose to mark down the portfolio to $18 million (40 percent write-down) based on declines in public market comparables. DCF FUND chose to keep its valuation of the portfolio relatively unchanged at $27 million (10 percent write-down), reasoning that there was minimal change to the DCF analysis. Endowment X is then given a mandate to reduce its private equity holdings by 20 percent. Endowment X is likely to receive similar offers for MARKET FUND and DCF FUND since the underlying investments are similar and secondary funds will look through to the underlying portfolio companies. All other things being equal, Endowment X is more likely to sell DCF FUND since its $27 million NAV would reduce the private equity allocation by approximately 50 percent more than a sale of MARKET FUND.
Writing down portfolio companies will also build credibility with LPs, some of whom have begun to question the implementation of FAS 157. While most LP sales today are driven by liquidity needs or allocation issues, we continue to see a steady flow of LPs who are selling due to frustration with a GP. The conflict is usually due not to an investment gone bad but to a failure to acknowledge and admit mistakes or changes in market conditions. For example, we are aware of a case where a GP initially failed to recognize a poorly performing asset and then, rather than acknowledge that the investment had deteriorated, the fund guaranteed some of the debt of the company, leading to an even worse situation.
LPs understand that it is a difficult time in the economy. It is important to have a realistic view of a portfolio. Many of the GPs of funds in our portfolio have dramatically increased communications and disclosure in their LP communications. We consider these managers to be models of best practices in today’s challenging environment. One common misconception held by GPs is that they should not discuss potential secondary sales with their LPs. They mistakenly believe that raising liquidity issues with LPs runs the risk of planting the idea to sell in an investor who might otherwise have been content to hold. The reality is that LPs are often being called on by secondary funds or advisors. Rather than encouraging an LP to sell, a call from the GP can help the fund to more actively influence the sales process. For example, a GP can restrict the process such that highly confidential information provided to an LP is not widely distributed.
The most common concern for GPs is that write-downs will make fund raising challenging. There is no doubt that this is a difficult fund-raising environment for all funds. In the long run, interim private equity valuations are unimportant—investors only can spend cash distributions. Indeed, concerns about the pliability of FAS 157 have led to a focus on realizations. Investors are increasingly turning to cash-on-cash analysis, which eliminates any discretion from performance evaluation. This has been especially true in the venture-capital market, where many funds are showing strong “paper returns” despite an industry-wide lack of realizations.
Funds that aggressively write down investments now will be have greater potential to be among an institution’s top-performing assets during future good times. Consider the impact of write-downs to the future performance of MARKET FUND and DCF FUND from our earlier example if Endowment X decided not to sell either fund. If Endowment X receives $40 million distribution from both funds in a bull market, MARKET FUND will show a $9 million greater gain than DCF FUND. MARKET FUND will be showing a large profit at a time when the public markets are likely to also show strong gains. By contrast, DCF FUND will only show a modest gain in a potential bull market–exactly the time when institutions may be looking to commit more to private equity.
It is undoubtedly difficult to write down portfolio investments. Private equity investments require a tremendous personal investment by the fund managers over a period of many years. Historically, write-downs might have been seen as an admission of failure. And even with aggressive write-downs there will inevitably be investors who will need to sell. But this is an unprecedented period in financial markets. In many cases, assets that were thought to be uncorrelated or even negatively correlated have precipitously declined in tandem; yet many of the NAVs we receive from GPs imply that private equity has been largely immune to the economic chaos of the last year. GPs must adjust their viewpoints. In this environment, actions, like write-downs, that received wisdom has generally considered detrimental may in fact be beneficial. Write-downs can help GPs relieve strain on their LPs’ asset allocations, provide a realistic assessment of a difficult market, and create the opportunity for greater realizations in the future while reducing the likelihood of secondary sales in the present.
David Tom, CFA, identifies and advises on investment opportunities for VCFA Group, which pioneered the secondary private equity market. VCFA is currently investing a $250 million buyout secondaries fund and a $250 million venture secondaries fund. David can be reached at firstname.lastname@example.org.