LPs inform themselves on valuations as uncertainty stalls dealmaking: Story of the Year

Private equity managers expect longer holds for some of their portfolio companies as investors run the rule across portfolio valuations.

Macroeconomic uncertainty has impacted the setting of valuations this year, slowing down both fundraising and dealmaking.

There’s a bigger divide between winners and losers across all sectors when it comes to assets that are able to transact. Businesses that continue to outperform will command high valuations. Market participants can also expect more take-private and carve-out opportunities as a result of market volatility.

For those businesses that fall outside of this winning category, there is heightened uncertainty around setting a valuation that all parties can get comfortable with – particularly with debt options sparser than in previous years.

Valuations are driven by growth, cashflows and a projection of the value of those cashflows using the weighted average cost of capital, Milwood Hobbs Jr, managing director and head of North American sourcing and origination at investment manager Oaktree Capital Management, told Private Equity International as part of our December deep dive into the current macro environment. “If a company’s cost of capital is going up, and that’s your denominator, your valuation will likely just go down.”

For a buying private equity firm that has high borrowing costs and isn’t sure it wants to put forward a large equity cheque for that business, Hobbs imagines the buyer saying: “‘I’m going to pay less for that business,’ and [the private equity firm] selling has to then evaluate: ‘Do I want to extend my hold period, which also reduces [IRR], or do I want to return cash to investors and cycle that cash into something else?’”

For those assets, managers anticipate longer holding periods. “We are hardly parting with what was, and still is, our perception of the fair value of this company, and we are less agreeable for this to be discounted,” said Robert Knorr, managing partner at MidEuropa. He added that his firm is rarely under enormous pressure to exit, and is taking a wait-and-see approach.

“What that will translate into is a slower pace of distributions to the LPs. Again, this could be just over the next three to nine months. It could be a little bit longer depending on how long it will take to [make] this adjustment,” Knorr said.

What correction?

Many managers have maintained an optimistic outlook for their portfolios when it comes to quarterly mark-to-markets, contributing to LPs’ ongoing denominator effect headache.

Such lofty valuations alongside decreased distributions to investors this year is further exacerbating the slowdown in fundraising.

Teacher Retirement System of Texas’ private equity funds head Scott Ramsower said the pension is digging in more on valuation methodologies, relative valuations among managers, and how the portfolio is performing from an operating perspective – reviewing revenue, EBITDA, multiples and debt levels, for example.

Analysing fundamental operating performance of the portfolio companies is “more important in a down market, because there are absolutely companies that on paper look like they’re doing well in terms of the valuation that they’re held at, but when you dig in, it could appear as though the valuation is unjustified or unwarranted. So we’re kicking the tyres a lot on the fundamental operating performance of portfolio companies,” Ramsower told affiliate title Buyouts.

There are concerns that private equity managers have been slow to mark down asset valuations and may not be accurately reflecting the reality of the broader economy. Marks dated to the end of June have exceeded expectations, which led some LPs to doubt their accuracy, according to a report from Equable Institute, a non-profit, bipartisan organisation that focuses on improving the long-term financial security of public pension systems.

“There are enough yellow and orange flags, if not red flags, that show valuations may not reflect what an orderly market transaction should reflect,” said Equable Institute executive director Anthony Randazzo.

“It would be discouraging if it takes end-of-year auditor remarks for funds to mark down their assets. I can understand some level of hesitation to not mark things down more than they could be. But the incentives private equity managers have to be slow in markdowns are not the same as pension funds, which need to have their portfolios accurately measured at the end of fiscal years,” Randazzo added.

Indeed, some LPs have become outspokenly critical of the asset class. “I’m as bearish on private equity as I ever have been in my career. We just haven’t seen the correction in private equity like we have in public markets,” Alaska Permanent Fund CIO Marcus Frampton said at a December board meeting.

Using information from Pathway Capital Management and S&P LCD, Frampton showed PE multiples using enterprise value over EBITDA currently stand at 11.8x and have steadily grown since 2009, when multiples were 8x, Buyouts reported.

“There is a lot more institutional capital chasing private equity now. Every state pension fund has really large private equity allocations, which is very different than in 2001 and 2007. It’s possible we could go into a recession and not see the appropriate correction in multiples,” Frampton said.