Debunking the write-down myths

Write-downs may not be linked to the divorce rate, but they are a fact of life in a difficult economic environment, writes Nadim Meer, partner at law firm Dundas & Wilson.

Buyout industry insiders indicate that many private equity firms are preparing themselves for material write-downs in the value of their assets.

At this point it is worth mentioning a particular urban myth that circulates in the private equity community. The story goes that write-downs are attributed more to a pending divorce of one of the key members of the general partner's management team than a real impairment in the asset value – the write-down supposedly being driven more by the financial settlement linked to the divorce than any real change to the asset's actual value. However, given the divorce rate since the credit crunch seems to have actually dropped, we need to look beyond that scurrilous urban legend and see what the real drivers and impacts are.

It seems that with the recent stock market crash over the summer of 2011, reminiscent of the dark days of 2008, GPs are having to face up to writing-down their portfolio assets to take account of trading performance and the realistic price that they could expect to achieve on an exit.

The International Private Equity and Venture Capital valuation guidelines give some guidance to managers in valuing their portfolio companies and provide consistency in valuation standards. Private equity often invests in companies with stock market comparables so whenever the markets crash, the valuation of a portfolio asset is likely to take a hit as well. Equally, when the capital markets recover (as we have seen to a degree in the last few weeks), so does the valuation of private equity portfolios.

Arguably, the valuation of an asset does not make much difference during its life in the portfolio. What matters is that the investor manages to achieve a good exit for the asset relative to its acquisition price. Whatever its valuation during its life in the portfolio, its exit valuation is the only thing that really matters – that is what the general partner will be judged on.

However, if an asset is marked down, there can be an impact. The general partner may be more likely to hold the asset until it believes valuations have recovered. This will potentially delay exits (and the return of funds to limited partners) which, in turn, could delay future fundraisings if the general partner is unable to demonstrate a series of successful exits in its previous fund and hasn’t returned money to its investors.

Whilst in many cases, LPs may be persuaded of the merits of holding on to assets a little longer in order to achieve the best exit, this might not always be possible. This could create opportunities for acquirers of portfolios of private equity assets to step in or, in the worst case scenario, wind-up the fund. However, the advantage that private equity investors generally have over investors in capital markets is the ability to exert more control and influence over their investment assets. This gives them a greater opportunity to directly manage their assets to a path of growth and, hopefully, to a successful exit at a higher valuation.

Coming back to the urban myth we began with, when valuations do recover (whether as a result of an uptick in the markets or canny management and investment strategy imparted by private equity owners) the current logic would assume that divorce rates amongst private equity professionals may jump – on the basis that their spouses may have also been biding their time to exit when valuations had recovered…

Nadim Meer is a partner at law firm Dundas & Wilson, specialising in private equity (but not divorce law).