Don’t get too excited over write-ups

Hopes of a sustained recovery in the market were raised after Q2 figures showed the first increase in fund values since 2007, but recent history indicates that valuations may have to go through another period of declines before that happens.

Although recent statistics showed fund values earlier this year experienced their first surge since 2007, private equity executives shouldn't get their hopes up for a sustained recovery just yet.

As Private Equity Manager reported last month, private equity valuations were written up by an average of 5.48 percent in the second quarter this year, following five consecutive quarters of valuation write-downs. Those figures were compiled by the State Street Private Equity Index, which tracks more than 1,600 private equity funds on a dollar-weighted basis.

The uptick in Q2 valuations may indicate to many market observers that private equity fund performances are poised to reverse their recent declines. During the four quarters of 2007, the last year of private equity’s heyday, fund values were written up by an average of 5.76 percent, 8.55 percent, 2.26 percent and 3.18 percent, respectively.

However, State Street Private Edge Group's Pro Jason Mao says the Q2 surge in 2009 was more likely a temporary bounce in reaction to the severe write-downs in previous quarters. Fund valuations decreased by 6.46 percent in Q1 2009 and a whopping 16.32 percent in Q4 2008.

In addition, he says a historical comparison with the last major recession in 2001-2002 indicates the industry may have to hit another economic “bottom” before a proper recovery. Mao says that following the dotcom crash the private equity industry experienced a “W-shaped” recovery, first hitting a bottom in Q4 2001 – when quarterly returns fell by 3.11 percent – then recovering before hitting a second bottom of -5.50 percent in Q3 2002.

It was after the Q3 drop in valuations that the industry began seeing a sustained recovery, and such history may be repeating itself again in the current economic climate. Even the rosy valuation numbers from Q2 were tempered by the fact that private equity’s pooled, dollar-weighted long-term IRR of 9.08 percent in the same quarter was well below institutional investor projections.

Mao says the biggest difference between now and the 2001-2002 period is the fact that private equity firms are sitting on about $500 billion in unfunded commitments waiting to be deployed. A “V-style” recovery that would see significant, continued gains in Q3 of this year and beyond could be driven by new investments, as well as more IPO opportunities and M&A activities.

But the fact that managers are largely not deploying their dry powder, perhaps because they anticipate another economic bottom, may ironically make a “W-style” recovery even more of a certainty. In either event, even if there is not another significant drop in valuations, Mao says that it will likely take longer for the market to recover than many in the industry are hoping.