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Don’t look down

Private equity funds have been slow to adjust their valuations to volatile public comparables in 2022. As end-December NAVs are reported, that could be about to change.

This article first appeared in the February 2023 Valuations Insights Report

Private equity funds have been slow to adjust their valuations to volatile public comparables in 2022. As end-December NAVs are reported, that could be about to change.

Private equity is not known for its knee-jerk reactions to macro volatility. Fund LPs – most of whom have capital locked up for years – don’t dwell on daily or weekly price fluctuations in the public markets as long as the fund can deploy capital ahead of a profitable exit.

When price fluctuations in the public markets start to resemble something more fundamental, those same LPs may get twitchy. Their private equity fund may be near maturity and suddenly facing a less profitable exit or their new fund commitments may be held back by the denominator effect. 

Since the end of last year, an increasing number of private equity LPs have been twitching. While the enterprise value of firms held by private-equity funds globally rose 1.9% in Q3 2022, leaving them up 3.2% for the year to date, the S&P 500 fell 22.3% in the same period, according to Lincoln International. 

Is this mismatch between the value of private equity funds and the public market a cause for concern? According to a survey by Private Equity Wire, for some it is. Over 21% are concerned, and 30% are “somewhat” concerned. 

“It’s difficult to understand how valuations on private assets haven’t moved when public markets are down double digits last year,” says Patrick Ghali at investment advisory firm Sussex Partners, “So to me, there’s a disconnect there. I understand they have extended liquidity and hope that by the time funds come to the end of their lives, markets will have recovered and caught up but whether that’s going to happen remains to be seen.”

At the time of writing, the 2022 year-end net asset value (NAV) marks for private equity funds were still being reported. According to sources, the majority of managers held off from making substantial downward revisions to their Q3 NAVs where the performance of their portfolio companies remained stable. 

Sharper pencils

“While valuations, as of September 2022, are yet to take meaningful write downs or adjustments to 2022 public market comps, this is not unexpected – we have historically seen a meaningful lag from public to private market correction, often taking at least three quarters, if not more,” said Dana Haimoff, Managing Director and Portfolio Manager, Private Equity Group, JP Morgan Asset Management in December. “This indicates PE valuations will likely be adjusted downward, as full year 2022 LTM earnings are captured among other factors, reflecting a softness well into 2023.”

The 2022 year-end marks represent an important flashpoint in a volatile year. Unlike the quarterly NAVs before them, year-end marks tend to be externally audited and therefore often more reflective of changed economic conditions, says Dan Aylott at Cambridge Associates. “There’s more scrutiny, pencils are sharpened, so you could say more realistic valuations will come through here. I think the general expectation is that we’ll see further downward revisions. I’m not going to say it will be a spiral because I don’t think it’s quite as dramatic as that, but I think the downward trend will continue from year-end into 2023 across the board.”  

The majority of respondents to the Private Equity Wire survey expected private equity funds to revise their NAVs in line with the public markets in one of the three quarterly opportunities they will have by mid-year 2023: end-December, end-March 2023 and mid-year 2023. 

Revising upwards

At a conference held by the British Private Equity & Venture Capital Association (BVCA) in December, the general view from an industry panel was that 2022 year-end valuations would be either flat or down around 5%, but in the same way the public markets contain a range of different valuation assumptions, it is difficult to make general observations on private equity fund NAVs across different fund maturities, manager strategies and sectors. For example, while EQT’s fund valuations for infrastructure and real assets remained stable or even increased between December 2021 and December 2022, they were almost all down by a range of between 0.3x and 0.1x for EQT’s Europe and North America private capital funds, according to the firm’s 2022 year-end report.  

There are also good reasons why many private equity funds would not revise their NAVs downwards and may even do the opposite. 

Some managers argue that the valuation of their funds was disciplined when public market equivalents increased so a corresponding decrease is less necessary. Some might appear to be slow at marking down investments, but they were also slow to mark up, they say. 

A second, more fundamental point is that – for many managers – their portfolio companies still remain profitable and have not yet been impacted by the general macroeconomic conditions of 2022. 

Portfolios perform

Paul Newsome, head of investment solutions at Unigestion said in a note at the end of last year that the vast majority of portfolio companies in Unigestion Direct II Fund recorded positive EBITDA growth for the 12 months to 30 June 2022 versus the same period a year ago. “These companies are typically highly cash generative and able to pay down debt. Thus, even with multiples going down in certain sectors such as technology, overall performance remains positive,” he says.

The strong performance of portfolio companies during the first half of 2022 may justify elevated valuations but the risk of a recession eating away at earnings still remains in many cases. According to Licoln International in November, only 54% of private companies experienced year-to-date EBITDA growth as cost pressures proved difficult to overcome. Most LPs in a recent survey by Capstone believe the impact of a recession in 2023 will be long-term. More than two thirds anticipate volatility in valuations for more than 12 months, while nearly 20% envisage 18 months or more of disruption. Europe will be the most impacted, say almost nine out of 10 LPs. 

A fall in public markets does not trigger new private equity fund NAVs in and of itself, it is the reason for that fall in the first place. A discounted cash flow (DCF) approach to valuation, which estimates the current value of an investment based on expected future cash flows, may present an alternative view. From this angle, significant write-downs are much harder to predict, says Iyobosa Adeghe, partner at Coller Capital.

“Between pressure on earnings and movement in public multiples, markdowns across buyout funds would be expected but it isn’t clear that audits will be the primary driver of any movement. Managers have always been able to place reliance on a range of datapoints beyond just public comparables and to change the weighting put on those various datapoints,” he says. “Given the significant scope for use of judgement, I would expect any movement to Q4 to be modest.”

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