Should there be a better way to value private equity assets? It's a question that's been on my mind since last year, when public equities took a massive dip, but private market valuations remained high.
I started working on this story in late February, just a couple of weeks before the failure of Silicon Valley Bank brought wider banking instability issues into stark relief.
With the specter of a new financial crisis looming over all asset classes, the question of how to value private equity investments rings even louder than before.
To answer this question, I took a deep dive into the methods PE firms and auditors use to estimate the value of the companies they buy. I surfaced with a deeply unsatisfying conclusion: they're generally accurate only sometimes and on a case-by-case basis. Great.
Are the prices right?
When public equities fell last year, private market valuations remained elevated, fueling skepticism around PE asset valuations and the processes behind putting a price tag on these assets.
In recent months, the gap has narrowed slightly, but private market returns remain elevated.
Looking at the numbers, from Q1 2020 to September of last year, aggregated public benchmark performance—an average of a number of indexes—generated an 18.8% return, according to data from Morningstar. Meanwhile, private equity saw an NAV increase of 84.9% over the same time period.
That represents a 66.1% difference between public and private equity NAV performance. The gap is striking and certainly a concern for investors. In a survey of 150 investors representing over $2 trillion in combined assets, 68% of respondents said high purchase price multiples are somewhat-to-very-concerning, and the top concern for investors in both 2022 and 2023.
While the public-private spread is par for the course—not least because of the hands-on, long-term approach of private market investing—the divergence between public and private valuations can in large part be attributed to the way PE assets are valued.
How do valuations actually work?
Basically, PE firms value their assets in three ways:
The market approach: When valuing a private company, firms use comparable company analysis, where they compare their assets to similar publicly traded companies. Here, an analyst at an investment bank or PE shop will put information into a comps table, including things like public competitors' EBITDA, earnings, share price and market cap. Using a series of multiples, the comps sheet spits out an estimated valuation for the private company.
Precedent transactions: A precedent transaction analysis is similar to a market approach—they both are considered relative valuation techniques—except instead of comparing similar companies, this technique compares the target company to similar companies that have been sold or acquired.
Appraisers also apply a discount to relative valuation method called discounts for lack of marketability (DLOM), which accounts for the illiquidity of the private company in question.
The DLOM results in a muting effect, where private market returns trail publics, typically by about 60%. So if public markets jump 20%, we'd expect private markets to go up 12%; if public markets drop 20%, we'd expect privates to be down 12%," said Jeffrey Diehl, head of investments at Adams Street, a private market asset manager with $52 billion in AUM. "Now, it takes a little time because of the lag effect of quarter over quarter, but that's generally what we see."
But this isn't what's happening now. In 2022, the public market indexes fell, with the S&P 500 down 19.4% and the Dow Jones Average off 8.8%, respectively. Meanwhile, Blackstone, with nearly $300 billion in private equity assets, was down only 0.6% for 2022.
Most firms would rather opt to wait for a more favorable market rather than marking down their portfolios at the expense of a bear market.
Discounted cashflow method: The DCF model looks slightly different from methods #1 and #2. Unlike the relative valuation techniques, DCF is considered an intrinsic valuation technique, meaning the value of the target asset is calculated using internal information about the company.
This method forecasts the private company's unlevered free cash flow using financial information about the company, like its revenue, expenses and profit. The cash flow is discounted to account for the changing value of money over time.
There are also 10 supplemental methodologies, said Ariel Fischman, founder of 414 Capital, a financial advisory and investment banking platform that offers valuation services. GPs can use a mix of these, take their own approach or start with a strategy and back up their estimations with another methodology. The way that PE firms or third-party appraisers like 414 Capital go about the valuation process depends on the company that is being valued. "You can't value the asset until you know the asset," Fischman said.
PE firms follow friendly suggestions
In the US, PE firms and independent valuation services follow sets of guidelines from third-party groups like the International Private Equity Valuation board and the Institutional Limited Partners Association, which offer best practices for valuing alternative assets.
These guidelines are consistent with the accounting principles dictated in International Financial Reporting Standards and United States Generally Accepted Accounting Principles, collections of widely followed accounting principles. While PE players aren't legally obligated to adhere to these guidelines, they generally follow them in order to clear the audit process.
"It's not a legal [obligation], but in order to get an audit done, you need to follow those guidelines,” said Craig Ter Boss, a partner at EisnerAmper advisory group. Boss is responsible for reviewing PE firms' valuations. On the PE side, he said most firms that his company audits try to follow these guidelines in their valuation processes.
"They're following the guidelines—[but] not 100%. They're following parts of it, and then, some of the suggested stuff—it's time and money constraints. You can't have a perfect package for every investment," Boss added. The process is far from impartial, Brian Baik, an assistant professor of business administration at Harvard Business School, told me.
"It boils down to the fact that PE funds are hiring the auditor," Baik said. "If the GPs can back up the assumptions they're using, there’s a chance the auditors OK that."
For example, funds could use one valuation method over another to make an asset look more favorable, or GPs could cherry-pick the comparable companies they use in their public comp analysis, selecting companies with the highest valuation multiples.
Again, these approaches aren't illegal, but they're not best practices. In general, Baik said LPs should keep an eye out for GPs who have historically used a public value multiples-based approach and suddenly switch to valuing their assets at cost.
"I think that's a pretty big red flag there," Baik said.
So, are PE valuations inflated?
The short answer: It depends. Baik worked at Houghton Street Partners, a mid-market buyout fund focused on Southeast Asia, where he learned about the asset valuation process. While the firm wasn't doing a ton of valuation mark-ups, Baik noticed that his colleagues had a heavily weighted say in which valuation method was used.
In his 2022 Harvard dissertation, Baik looked into whether or not private equity fund managers inflate their interim fund valuations during fundraising periods. He found evidence that "low reputation" GPs—PE managers with less robust performance track records—tend to increase their valuation multiples and portfolio company earnings while fundraising.
Still, some industry participants maintain that the concerns around private market valuations are overblown. In Hamilton Lane's 2023 market overview, the private market asset manager said valuations are generally accurate across most industry sectors, citing its own data showing that exits in 2022 were above valuations despite the public market downturn.
The firm attributes the outperformance to the flexibility in private companies' governance structure.
"In the PE world, you buy the company, you control it, you control the board, you can align incentives, you can put a capital structure in place that's going to give you flexibility to live through choppy times and good times and bad times," said Drew Schardt, head of investment strategy at Hamilton Lane. "And you're not forced to buy or sell anything, because the assets are private."
Ultimately, PE is not like other asset classes and therefore cannot easily be measured by the same yardstick. Yet, while a certain level of divergence from public markets is expected, it is important valuations remain grounded in reality.