Secondary opinions

In all markets, buyers and sellers must agree on a value to effect a transaction on an asset and the secondary market for alternative assets is no different. However, due to the lack of transparency in the secondary market and the lack of experience of many sellers of alternative assets, it is no great surprise that there is often a notable discrepancy between valuations placed on a given asset by buyer and seller.

The seller is concerned with what the asset is worth today and its view is typically some distillation of the current net asset value (NAV) ascribed by the general partner. By contrast, as the buyer receives the future cash flows of the fund in return for the purchase of the asset, it is much more focused on what the asset will be worth in the future. 

In order to determine the value of an asset, and the price they are willing to pay for an asset today, most buyers of secondary assets will conduct a discounted cash flow (DCF) analysis. The DCF uses several factors to arrive at the cash flow stream: expected exit value and exit timing for the current portfolio investments, projected future capital calls and the return on the future investments made using those capital calls, the legal structure of the fund and the return the buyer would like to earn on the transaction (the target return or discount rate).

Whereas buyers are most concerned with the price they should pay to achieve their target returns, sellers are much more concerned with the buyer valuation relative to the fund’s net asset value (NAV) as provided by the manager. This is particularly the case when a buyer is offering to purchase a fund at a discount to the fund’s most recently reported NAV, thereby creating a loss on the seller’s books. While no seller ever looks favorably on a loss, alternative asset investors might be particularly unwilling to accept losses due to compensation issues (personal compensation tied to performance) and political concerns (investors that have to report publicly).

Many sellers are not equipped to perform a typical buyer-style valuation. However, those sellers that do perform such analyses often end up with substantially different valuations from buyers. Sellers will typically use more aggressive assumptions than buyers. This is partly due to comfort with the assets and partly due to psychology. The seller has likely been in constant contact with the fund manager for the life of the fund and may be more familiar than a buyer with a given company’s prospects, thereby allowing more confidence in an aggressive assumption. The seller may have also made the initial recommendation to make the fund investment and may be anchored to a positive outlook for the investment.

Another major difference in a seller valuation can be the discount rate used. Sellers, like buyers, typically have a target rate of return for a given asset. However, seller targets are often lower than buyer targets, which will cause a seller’s valuation to be higher than a buyer’s. Even larger discrepancies can be seen when an organisation uses its cost of capital, which should always be lower than the target rate of return, or when pension funds use target rates of return which must be quite low for actuarial reasons. However, the reasons for selling typically would increase the required rate of return for the seller. If a sale is planned for liquidity reasons, the target rate of return for the asset is no longer particularly relevant and the discount rate should be increased in proportion with the size of the liquidity problem. If the seller wants to redeploy the capital from the sale into another asset with a higher expected return, the discount rate should also be increased for the asset being sold to be in line with the desired return in redeployment. Seller discount rates can normally be moved in line with buyer targets when the circumstances of the sale are fully taken into account. 

This is an excerpt from an article in The definitive guide to Private Equity Valuation, full details of which can be found at www.peimedia.com/pevaluation