When buying a house, you send in an agent to ensure the property is worth what the seller said it was. When an item goes up for sale at auction, its value is estimated prior to the start of the bidding process. The same can be said for private markets: when an LP considers a new GP relationship, it needs to know that its capital will be used responsibly, and that the manager has a track record of valuing assets fairly.
Private equity managers have grappled with huge market uncertainty in the last 12 to 18 months, with public market valuations falling by around 50 percent in some sectors. In light of dislocation largely resulting from the pandemic and the war in Ukraine, the International Private Equity and Venture Capital Valuation (IPEV) board published its updated valuation guidance in December, offering new advice on the impact that valuations may face in distressed markets. The roadmap also outlines additional considerations on bridge financing, debt instruments and impacts from structuring.
The guidelines highlight that even in highly volatile markets marked by geopolitical or macroeconomic events, the premise of fair value remains the same. Most importantly, the valuation process should be consistent.
“We always take a ‘facts and circumstances’ approach to any valuation,” says Richard Olson, a managing director in Lincoln International’s valuations division. “And that means taking an appropriate approach to determine fair value.”
Olson says the investment banking platform looks at comparisons of valuation methods, such as the ‘income’ method (discounted cashflows) or ‘market’ method (market or transaction multiples), and tries not to solely focus on one approach.
“We typically won’t say: ‘This is the perfect method for this particular business.’ We prefer to incorporate as many methods as possible. For example, a company will have a set of future cashflows that we can track performance against and that we can [use to] determine the present value. We can start to calibrate that and see how that calibration might adjust over time.”
Olson points out that it’s essential to pick as many data points as possible. “Both on the upside and on the downside, if you’re taking multiple methods and applying those and averaging them, essentially any average is going to be smoother than the noise that might be present in any particular method.”
Valuation is crucial, as it’s the best information investors have as to how the portfolio is doing. It also informs secondaries market trading and portfolio rebalancing considerations. It is, however, not that easy to do. There are many methodologies, and there’s also a lot of subjectivity at play.
“Investors are putting pressure on GPs to value assets in a more standardised way”
Market participants may apply a market approach, which can include using a multiple of earnings or revenue, an industry valuation benchmark or available market prices. They may also use a discounted cashflow method, which derives the enterprise value of the company using estimations of expected future cashflows or expected future earnings. Lastly, managers may also use a net assets valuation technique, where fair value is determined based on the company’s assets and liabilities.
Alex Barker, a principal at HarbourVest Partners, notes that managers historically had a broad and liberal application of mark to market – an approach that sees the value of an asset adjusted to match current market conditions. That has since changed: with the introduction of the IPEV and Institutional Limited Partners Association (ILPA) guidelines, the process has become more standardised.
“Investors are putting pressure on GPs to value assets in a more standardised way,” Barker says. “Fifteen to 20 years ago, it was very common to see GPs applying heavy liquidity discounts to their valuations. This is much less common today.”
That said, there remains a range of applications on valuation approaches. LPs need to have a degree of experience in interpreting and scrutinising GPs’ valuations, he adds.
IPEV does take note of this subjectivity in its guidelines: “[Valuation] is inherently based on forward-looking estimates and judgements about the investee company itself: its market and the environment in which it operates; the state of the mergers and acquisitions market; stock market conditions; and other factors and expectations that exist at the measurement date.” As such, care should be applied when using publicly available information regarding other entities in deriving a valuation, the guidelines note.
Barker, who looks primarily at the buyout space, notes that most managers use the mark to market methodology. “It stood the test of time. You do get occasions when valuations are found to be inaccurate, but on the whole, they are the exception rather than the norm.”
He adds that managers have been fairly effective in terms of their mark to market valuations, with some being “very strict” about keeping the same basket of comparable public market companies over time.
Barker does note, however, that he finds the discounted cashflow approach “too subjective” and that it “involves the use of too many assumptions”.
He adds: “In my opinion, it’s not giving you a true, accurate attempt to value the business based on today’s performance, and [it] lacks reference to comparable valuations. Mark to market at least brings that relative valuation element.”
“You have to allow a degree of flexibility – it’s hard to be too prescriptive and take away that ability to be flexible,” says Barker. “Think about a high-growth company – a business that’s growing its EBITDA by 25 percent a year. If you value that business based on last year’s earnings, are you giving a truly accurate impression of the value of that business if you discount the growth that’s taking place?”
Barker notes that GPs need to have the freedom to make a judgment call around the appropriate earnings figure. At the same time, LPs also have to have the experience and know-how to evaluate those valuations and, over time, take a view of whether the GP is being overly aggressive or conservative, he adds.
In some situations, LPs might revalue a GP’s investments – especially if they hold the view that underlying investments are not valued consistently with IPEV guidelines, the International Financial Reporting Standards, the United States Generally Accepted Accounting Principles (US GAAP) or other GAAP. However, industry participants tell Private Equity International that these cases are infrequent, with no notable uptick in such requests in light of the current market environment.
Industry participants also note that LPs take comfort in their relationships with their GPs and build familiarity with their approaches to valuations over time.
Olson points out that LPs’ conversations with their GPs are crucial to getting an understanding of how assets are valued. “We do get requests occasionally via access letters or other non-reliance type documentation where LPs will ask for reports. But it’s very much case by case – it’s really the GP that controls the valuation relationship with LPs.”
GPs, at the end of the day, work on behalf of their stakeholders, and fund boards are set up to take everyone’s interests into account, Olson adds.
It is important to remember that valuations are just that: an estimate of value. The unrealised value of private equity portfolios doesn’t necessarily translate into the price an asset trades at, nor what is ultimately distributed to LPs. Among other things, fund performance is measured both in terms of what has been crystallised, or distributed to paid-in capital, and total value to paid-in, which includes distributed and remaining value.
Particularly over the last 12 months, the resilience of private markets valuations relative to the public markets has left some investors with allocation headaches.
“The issue is that, with unrealistically high valuations, yes, the performance may look good, but [they] will lead to LPs being overallocated, as the portfolio is tied up in highly valued unrealised assets that aren’t showing signs of liquidity,” says Steve Byrom, founding partner at LP advisory Potentum Partners and former private equity head at Australia’s Future Fund. “This will lead to allocations being cut for 2023 and future vintages, until such time as these investments work their way through the system.”
What’s more, the figures being provided to LPs may not deliver the full picture on how their portfolio is performing. Unrealised value tends to understate private equity’s potential returns; GPs would rather their LPs be pleasantly surprised by an exit than disappointed that the asset sold for less than expected.
“You should assess prior funds to see if this manager is aggressive with the marks,” says Christopher Schelling, a former director of private equity for the Texas Municipal Retirement System and founder of investment adviser 512 Alternatives. “I try to track where deals exit versus [their] valuation one quarter prior. Generally speaking, good GPs will exit 20 percent to 30 percent above where it is marked; bad ones will push marks unrealistically high and often sell below marks or [will] need down rounds.”
“Unrealistically high valuations… will lead to LPs being overallocated, as the portfolio is tied up in highly valued unrealised assets”
The big picture
Given that unrealised value isn’t necessarily a precise measure of how private assets will perform, how much attention does it merit from LPs? Some believe the discrepancy between public and private valuations over the past year has rendered it a less relevant metric for certain strategies.
“The unrealised marks give us an indication of how the companies in the portfolio are travelling,” says Byrom, “although, in this volatile valuation environment, less weight needs to be placed on that measure than in other operating environments.”
Nevertheless, unrealised value remains an important consideration for most investors. It can, for example, provide a useful measure of growth for assets at certain stages of the business life cycle, says Alvin Tay, chief portfolio adviser for Asia at Mercer.
“At the end of the day, unrealised valuations of each investment will provide LPs with an indication of how the investment is developing,” he notes. “It typically is more useful for more mature investments when the value creation activities of GPs have time to work themselves through and the companies have time to experience these benefits.”
With this in mind, unrealised value can prove an effective measure of a GP’s value creation contribution, Henry Ching, head of Asia private markets at Mercer, adds. “You don’t change the value of a portfolio company – public market swings aside – if you haven’t done anything to the portfolio company and its fundamentals haven’t changed,” Ching says.
“A GP may mark valuation up if the GP has expanded sales, [added] new product lines, and/or reduced cost for its portfolio company,” Ching explains. “And if the company suffered a major revenue reduction due to an expected client loss, it also has the responsibility to mark valuation down. So for us, we look at how the markets have impacted their portfolio investments, and where and how the [GP has] affected value.”
In other words, unrealised value is most useful when assessed in conjunction with the underlying assets, rather than as an all-encompassing indication of portfolio performance. “A sophisticated investor will go asset by asset through the unrealised portfolio and assess how the companies are actually performing,” Schelling says. “You should look at revenue, EBITDA, cash burn rate, unit economics, how stable/cyclical the revenue is, what similar firms are trading for in private markets, and what a likely exit would look like.”
Although valuation uniformity does exist within private equity, the application of standards varies. This means a scrupulous eye is often needed from investors.
The standard of fair value – which aims to reflect the estimated price at which an asset is bought or sold – is defined by Accounting Standards Codification 820 in the US and the IPEV guidelines in Europe. These standards are used when GPs provide the value of their funds’ underlying investments to their LPs on a quarterly basis, as is industry standard in most limited partnership agreements.
“Framework-wise, we’re on, I’ll say, a uniform global standard,” says David Larsen, a managing director in Kroll’s alternative asset advisory practice. “The application thereof is where there can be some diversity.”
The nuance comes from what financial metrics a GP uses to land on a fair value. Public market comparisons or precedent transactions could be used, as could discounted future cashflows – or a combination of all three, says John Stake, managing director and co-head of Hamilton Lane’s fund investment team.
Industry experts and fund of funds managers explained to PEI at great length the drivers behind marking distinct asset classes or pockets of the market with different financial metrics. Hans-Christian Moritz, a managing director at Munich Private Equity Partners, notes that there is good cause for lower mid-market and mid-market managers, for example, to not focus too strongly on public market comparables given the considerable size difference. This in itself generally calls for a size or illiquidity discount. Venture capital firms, meanwhile, tend to rely on prior rounds on top of public market comparables and precedent transactions, Stake explains.
Two sides to the coin
The process of firms using individual judgements did lead to some situations in 2022 where valuations may have looked mismatched.
“[Two managers] with the same information may exercise their judgment differently and come to a different value”
As volatility hit markets last year, managers were making longer-term assumptions on what the market outlook would look like and how this could affect their portfolio companies. Giving a hypothetical situation, Larsen says it’s plausible one manager that owns a stake in a company may have taken a more pessimistic view on being able to pass on costs to consumers, thus assuming there would be an impact on that company’s EBITDA. As a result, it would take a 5 percent haircut to its projections.
Conversely, another manager that invested in the same asset could have taken the view that market volatility may have an impact on that asset, but it was not a certainty. That manager may then have made the call that it wouldn’t be prudent to whipsaw the value for its investors’ sake.
“Those two same managers with the same information may exercise their judgment differently and come to a different value,” Larsen explains. “There [was] a good deal of potential difference between managers during 2022. That’s where you… get some of these anecdotal comments where they say, ‘All right, we get to the end of the year and maybe the auditors will force us to do the – quote/unquote – right thing’.”
Maninder Saluja, partner and head of private equity funds and co-investments at Quilvest Capital Partners, agrees: “The role and importance of subjectivity increases during more volatile periods as there isn’t always a simple right or wrong, which can lead to the various components or frameworks being debated.”
Investor due diligence
LPs can use the net asset value reported by their GPs as the starting point for valuing their own portfolios if they’re satisfied that they’re getting a good underlying fair value report on individual investments. They are achieving this via periodic due diligence, Larsen explains.
There is a transparency consensus among investors when it comes to GPs presenting how they reach valuations and the level of detail they provide. At one extreme, some managers are willing to hand over full methodologies and research; at the other, some GPs maintain a more secretive approach.
As an investor, there are certain rights for limited partner advisory committees (LPACs) within limited partnership agreements or in side letters that allow detailed look-throughs and valuation approvals, Saluja says. However, in practice, “the actual information exchange is based on good working relationships and the trust developed between GPs and LPs”.
“The greater the transparency and the more open the dialogue, the easier it is to find consensus around the rationale put forward during difficult valuation discussions in challenging times,” Saluja adds.
LPs are comparing the performance of similar funds within their portfolios. If there is an outlier vehicle within that, that could pose a red flag, Larsen says.
It’s a process that Hamilton Lane is all too familiar with, says Stake. Most commonly, the firm spends a lot of time evaluating the EBITDA or revenue multiple that is being applied to create a valuation on each portfolio company within its portfolio of underlying managers. It reviews and compares the valuation across industry norms and the market in which the company operates, he explains.
“The greater the transparency and the more open the dialogue, the easier it is to find consensus… during difficult valuation discussions”
Quilvest Capital Partners
If the marks feel too aggressive or too conservative, Hamilton Lane spends time with the manager asking for additional information. For smaller LPs, looking at a manager’s exit history – including partial exits – can give valuable insight into its approach to exits in the current environment.
LPs with concerns around a managers’ valuations can address the issue in regular update calls, or even flag them to the LPAC and ask it to bring the concerns to a manager’s attention, Moritz says. If concerns are not addressed appropriately, investors can make it clear that they won’t reinvest with a manager. Alternatively, they could try to sell their stakes on the secondaries market.
When Hamilton Lane speaks to managers about their valuation approach, the firm guides GPs towards having a process that is consistent, Stake explains. The valuation process should not be “trying to come to a predetermined outcome, but [it should be] a process that derives an outcome and whatever that outcome is, it is”.
Even for sophisticated investors, valuations are, to some extent, an art, not pure science, Moritz says. Ultimately, managers know they are going to be audited – so, generally speaking, they are trying to reflect and use the right valuation methodologies, he adds.
A secondary approach
One window into how investors are thinking about the fair value of a fund’s assets comes via the secondaries market. The LP secondaries market – the trading of second-hand stakes in limited partnerships – was worth around $57 billion last year, according to data from investment bank Greenhill. It’s an area that has more than doubled in value in the space of a decade.
Could this growing market of second-hand fund stakes act as a proxy for valuing a given GP’s portfolio, in the same way that current share prices are used in public markets to value listed companies by their market capitalisation?
It’s a compelling thought exercise, and one that PEI has put to various market participants. At the heart of the thesis is this: fund sponsors do not value their portfolios on a daily basis in the same way that the stock market – itself a secondary market – provides a live market price for a given listed company. Yet when LPs trade in and out of a private equity fund, they trade at a price that is typically relative to the fund’s latest NAV – at par, a premium or a discount. Could existing trades such as these be used to give a more accurate valuation of the assets held in a given GP’s fund?
Take Blackstone’s 2011-vintage Blackstone Capital Partners VI fund, for which second-hand stakes traded at a 9 percent discount to NAV in the six months to Q3 2022, according to data compiled by Palico. Does this imply that Blackstone should mark its assets held in BCP VI down because the market believes it is worth 9 percent less than its latest valuation? Similarly, should Apax Partners – which had successful trades of a 7 percent premium to NAV in its 2016-vintage Apax IX fund over the same time period – mark its fund’s portfolio up by 7 percent?
“The secondary market is a proxy for preferences; it’s not a valuation proxy,” says Adrian Millan, partner at advisory firm PJT Park Hill. He notes that there are at least two main reasons why secondaries market trades in private funds cannot act in the same way as public markets do when valuing listed companies: first, there still isn’t enough trading volume for any meaningful observations to be drawn. While some popular funds may be subject to multiple trades per year, other funds may not be subject to trades at all. Second, the way a buyer approaches underwriting the assets in a fund when purchasing an LP interest is nuanced around a certain point in time and the specifics of the situation, such as whether the seller is in distress and looking for a quick sale.
“You have so many disparate factors that it’s tough to draw the analogy [with public markets],” Millan says.
“The secondary market is a proxy for preferences; it’s not a valuation proxy”
PJT Park Hill
Dushy Sivanithy, managing director and head of secondaries at CPP Investments, says that buyers of second-hand fund stakes will price in many factors to a bid beyond what they simply think the underlying companies are worth. This consideration comes in addition to the fact they are often buying and holding a passive, minority position.
Such factors include macroeconomic conditions, exit prospects, trading volatility, GP alignment, manager track record, return requirements, risk tolerance, diversification and portfolio construction, he says.
Further complicating the issue is the delayed nature of the valuation date upon which second-hand fund stakes are typically traded. Most trades are based on a valuation date which is, at best, 45 days old and, at worst, several months old. In the time since the latest valuation, the exit environment could have changed significantly.
Ted Craig, a partner at law firm Paul Hastings, points out that most LPs commit to funds and hold onto their fund stakes. To these LPs, a GP’s fund valuation doesn’t act as a pricing tool for them to know when might be a good time for them to sell out of the fund – rather, it is an indication of how the portfolio is performing.
“It’s an overview of what LP money has been spent on,” Craig says. “A GP isn’t of course guaranteeing it is going to sell any of these companies for any of these numbers – not least because it’s going to hold them for another, say, five years or so.”
What secondaries market pricing is actually indicative of is a particular viewpoint on the ability of a GP to exit its assets within a specific time period, as well as the exit potential of
Secondaries transactions and discounts are a proxy for the quality of GPs and their investment portfolios on a relative basis, according to Millan. A fund stake trading at a discount to NAV is a barometer of how much of a haircut a secondaries buyer would need when underwriting the trade in order to get from the fund’s latest valuation to a current NPV of the fair market value of those assets’ exit, he adds.
“The secondary market is taking a view on the duration to exit and the quantum of uplift,” Millan says. The valuation – the current NAV – reflects what the GP believes it could receive for an asset if it sold it today in a strategic sale or other exit path, he adds. “They’re two separate events.”