It all started with an offhand remark from a CIO at a run-of-the-mill investment conference.
Speaking on a panel before an audience of institutional investors in New York, Rockefeller University investment chief Paula Volent noted that two of the endowment’s private investment managers held pieces of the same portfolio company — and that those managers had assigned that company completely different valuations.
It turns out this is a common phenomenon within private markets, where valuations aren’t tied to the daily swings of public market sentiment. But in a year dominated by debate over private equity’s so-called illiquidity premium, the comment struck a chord.
How could one company be worth two different valuations? And if a duo of private investment firms — both undoubtedly boasting a bevy of qualified professionals to run the numbers — could come up with two different figures for the same asset, what does that say about private investment returns?
The first question has some easy answers. “The same portfolio companies can be invested in multiple funds in multiple ways,” says Brian Schmid, managing director at Burgiss. “One may have gotten in early-stage, another late-stage.” And, according to EisnerAmper partner Anthony Minnefor, a private equity firm that owns a controlling stake of a company could attach a “control premium” to the valuation.
Finding an answer to the second question, however, led Institutional Investor down a valuation rabbit hole that revealed not only the process by which private equity firms put price tags on their portfolio companies, but also the potential problems with those valuations — and what they mean for allocator portfolios.
Private equity valuations have become a lightning rod for investors over the past year, as many have pointed out the lag in performance reporting: Private equity firms don’t report returns to their limited partners until 45 to 90 days after a quarter ends. This practice, coupled with the fact that these firms are not subject to the whims of a public market, has made it seem like the asset class has posted better returns with less volatility than its public equity peers.
The truth, though, is much more complicated than that.
The question of how to determine a portfolio company’s valuation doesn’t have a simple answer, as a math problem might. There is no X times Y equals Z.
Instead, ascertaining value starts when a portfolio company is acquired. The private equity firm making the acquisition settles on a fair value with the seller based on multiples of EBITDA, earnings, revenue, and sales; comparable-company valuations; and external factors like competing offers for the portfolio company. This is a clear-cut process: Whatever the portfolio company sells for is meant to be reflective of its underlying value.
“If you talk to the kind of valuation gurus, what they’ll tell you is there’s nothing more relevant than actual transactions in the marketplace,” says Dan Zwirn, chief executive officer and chief investment officer at Arena Investors.
But what happens between a private equity firm’s acquisition of a company and the future sale of that asset is more complicated. The process begins with analysts and associates at private equity firms, who input the company’s financial data into software programs. The firm’s investment committee and valuation team then check that work to ensure that the valuation is appropriate and aligned with a portfolio company’s true worth.
From there, the company’s valuation gets updated on a quarterly basis, with an outside auditor brought in to sign off on it once a year. For example, if a private equity firm holds an asset for seven years, it will recalculate that portfolio company’s market price 28 times. To do so, the private equity firm typically uses one of two approaches to determine that price — or combines the two, according to David Larsen, managing director at Kroll, a risk and financial advisory company.
In what Larsen calls the market approach, a private equity firm evaluates a portfolio company by gathering a list of comparable companies. It may sound simple enough — but it’s only the first of many gray areas in the process. Let’s say a private equity firm is valuing a fast-food hamburger chain and selects McDonald’s, Burger King, Chick-fil-A, Wendy’s, and Taco Bell as “comps.” These are all among the largest fast-food chains, but each sells a different type of food. It might make sense to compare a burger joint to McDonald’s and Wendy’s, but does the same hold true for Taco Bell? What if one of these fast-food companies is owned by a larger organization that has snack and beverage divisions? How does the hypothetical burger slinger line up then?
“The hard thing is that there isn’t necessarily a correct or easy answer to this,” explains Steve Novakovic, managing director for CAIA Curriculum. He adds that some general partners are willing to discuss their approach with limited partners — but that’s not always the case.
“What you really don’t want to have is a GP from quarter to quarter saying one of these companies had a huge write-down in valuation so that’ll hurt ours, so we kicked them out,” he says. “That’s obviously cherry-picking.”
Still, there are times when it would make sense to drop a comp from the valuation process — for instance, when a company’s valuation is more than a year old or when it no longer operates as a peer, Novakovic says.
Once a private equity firm settles on a list of comparable companies, it uses data on those companies — particularly multiples of EBITDA, revenue, or sales — to estimate where its own portfolio company’s valuation lies. Part of this process involves being honest about any changes that have been made since the acquisition. If a private equity firm buys an asset one quarter and public markets spike in the next, a GP must assess whether it can rightfully raise its multiple in line with public markets, according to Larsen — especially if it has made no material changes to the portfolio company.
The other valuation approach that general partners typically use is an income-based process, which measures an asset’s discount rate. This involves projecting a portfolio company’s future cash flows, then discounting them based on the risk-free rate of return, the size premium, the country-specific premium, and debt-to-equity ratios.
“Generally, you use both approaches,” Larsen says. “If they diverge, then you’re wrong about one or both. When you’ve got a GP that is being rigorous, they are using multiple methods.”
From their choice of comps to the specific methodology they use, private equity firms have a degree of wiggle room when they choose how to evaluate their assets. In general, the experts interviewed for this story say that private equity firms tend to take a conservative approach to the valuation process.
“Ultimately, what you find is that some firms tend to be more conservative; they’ll mark things down more, but then sometimes you get these big jumps when they actually make distributions because there was embedded value,” says one allocator, who spoke on the condition of anonymity.
These jumps may just be part of an effort to manage limited partners’ expectations, according to Brian Neale, chief investment officer at the University of Nebraska. “It’s better to underpromise and overdeliver,” he says.
A growing body of research shows that this holds true, at least in general, points out CAIA’s Novakovic. However, data also shows that when firms are in the fundraising process, they “may become a smidge more aggressive with their valuations,” Novakovic explains. “They want their existing funds to look a little better from a marketing standpoint. The thing that’s really important for investors is to have that much more scrutiny toward valuations.”
But that may be easier said than done. “It’s a bit of an information vacuum,” the anonymous allocator says. “Most of the time, you’re not going to have enough data to really analyze that yourself. You’ll have to look at some headline results and take their word for it.”
Private equity firms are subject to some outside oversight. Law requires their returns to be audited on an annual basis, by December 31. According to one chief investment officer, these end-of-year numbers are the most credible.
“If you look at all the marks, the fourth-quarter marks are the ones you’d put the most faith in,” Neale says.
The period between Labor Day and New Year’s Eve is an auditor’s busy season, notes Larsen. Not only do auditors verify each private equity firm’s numbers, but they also check how they value their portfolio companies. However, general partners can — and do — defend their own accounting processes and valuations, Novakovic says.
Says Minnefor, “Auditors by definition are skeptical. We’re trained to be skeptical. We’re always on the lookout in those analyses for bias that may have influenced the mark.”
In a year like 2022, when assets are marked can matter just as much as how they are marked.
In 2021, when private valuations steadily rose alongside the public markets, the lag barely registered. The proportion of LP portfolios invested in public companies and private funds stayed relatively stable because markets were relatively stable. And regardless of whether June 30 marks were the most accurate reflection of a private investment fund’s return, allocators were posting high-flying returns that dominated the headlines.
This year, the lag was much more obvious. When limited partners aggregated their June 30 reports, there was a glaring disparity between their public and private returns. In most cases, the delayed private marks meant that private equity portfolios reported positive returns — returns that didn’t necessarily reflect the actual health of those portfolios. Most organizations do note the lag in their annual reports, albeit often in the footnotes.
Where the lag matters more is in a limited partner’s asset allocation targets. Predetermined by a board and an investment team, these targets are set percentages of capital that allocators can have invested in each asset class. When an asset class like public equity drops significantly, the proportion of an asset owner’s portfolio invested in public equities also falls. And when private market valuations are slow to be marked down, that causes the proportion of the portfolio allocated to the asset class to balloon. Called the denominator effect, this phenomenon can force a limited partner to slow or even stop allocations to private equity until valuations come down in line with publicly traded assets.
“If you’re an LP and you’re trying to maintain your pacing plan and your budget, that’s where things get more complex,” Neale says. “If you look at last fiscal year, you can’t swing a dead cat without hitting a GP that was up 50 percent over the year. That becomes more of an allocation issue for an LP to consider.”
As Cambridge Associates consultant Andrea Auerbach points out, this slowdown can lead investors to miss out on interesting opportunities. “You do want to maintain a steady pace of investment into the private markets,” she says. “You can’t go in and out. You can’t time the market.”
For investors whose careers began after the 2008 financial crisis, the denominator effect is totally new. After all, there hadn’t been a true recession in more than a decade. The Covid-19 crash in 2020 was somewhat of an anomaly, particularly for private investment firms, as the market dropped and rebounded within the same quarter.
“We haven’t really seen this kind of bear market in a long time,” the anonymous allocator says. “A lot of the people in the industry on both sides haven’t necessarily experienced it.”
AQR’s Villalon notes that the valuation lag during the pandemic quarter helped shield private investors from volatility, perhaps enforcing the idea that they earn a premium for taking on illiquidity. “Markets whipsawed so quickly, many didn’t have to mark to market during that drawdown,” he says. “They could do it afterward. It masked the volatility.”
Research shows that that premium did manage to hold up during the 2008 crisis. Funds raised in 2004 were generating a 26 percent net return, according to data Auerbach and her team analyzed. During the financial crisis, those returns were marked down to 8 percent. Today those vintages are returning 12 percent.
But some limited partners weren’t lucky enough to stick out those long-term investments. Facing the denominator effect in 2008 or 2009, they had to sell their assets on the secondary market. “That’s kind of when the illiquidity risk comes to bear, when you’re forced to do something with those assets,” Villalon says. “The haircuts they took were kind of egregious.”
As 2022 comes to a close, GPs have still been slow to mark down assets. Although some LPs have taken to the secondary markets to get their allocations back on target, others have simply paused new private equity investments and are waiting until the new year to deploy fresh capital.
Auditors, meanwhile, have less than two weeks to finalize their deep dives into private equity valuations — after which some LPs could see a shift in private equity returns. According to Auerbach, it could realistically take months beyond that to see the full effects of the bear market on private equity assets. But as those effects become evident, it will be clearer that some portfolio companies haven’t preserved their high-flying valuations.
Until then, the illiquidity premium debate rages on: Are allocators really getting paid to take private equity risk, or do the funds simply not reflect the day-to-day reality of the underlying assets? It depends, of course, on who you ask.
As Larsen puts it: “Volatility is always there, whether or not you measure it.”
