May I borrow your fund interest?

David Snow explores the idea of shorting private equity valuations.

Dear Investor,

May I ask a favour? May I borrow from you an interest in a private equity partnership?

I promise to give it back. In the meantime, I’m going to immediately sell it and pocket the proceeds. I then plan on buying it back in the middle of 2009 at a far lower price. My friends in the public markets call this “short selling”.

I think I can make a decent rate of return on this strategy, but success is dependent on a few conditions. The first is GP unwillingness to fully embrace fair value. As you may be aware, many general partners have been reluctant throughout 2008 to aggressively write down the valuations of their private equity investments. This is because they have confidence that these investments are in good shape for the long term and have value that those with less sectoral expertise fail to see. And anyway the deals are not for sale right now.

The second condition that needs to be in place in order for my strategy to work is finding a buyer right now who has faith in the current GP-assigned valuation. This is a tough hurdle, but there’s got to be somebody out there who will pay me something close to NAV for this fund interest I’ve borrowed. I mean, who knows the value of this thing better than the GP? Why even haggle?

On to the next stage in my strategy. The GP whose fund interest I’ve just borrowed and sold at close-to-NAV gets into an epic screaming match with his auditor at yearend. The auditor, eyeing public valuations and debt-to-equity ratios, thinks the GP should write down his equity to nearly zero. The GP thinks this is nonsense and says so using colourful language and what parents of small children sometimes call an “outside voice”. Cognisant of the career risks she faces by not getting tough with her client, the auditor wins, or gets the valuation most of the way to where she thinks it should be.

When the 2008 annual report comes out in the Spring of 2009, the NAV of my shorted fund is crushed. At that point I have little trouble buying back (at a big discount) an interest in the same fund I borrowed from you the previous Fall, and return it to you (unless you want to me hold on to it for a while and make a few capital calls).