Investors stuck in private valuation limbo as recession looms

Private-equity firms over the past year have endured a convergence of factors that threaten to make businesses they own less profitable and less valuable, including a steep rise in interest rates, higher inflation and a decline in the value of public equities. However, many general partners have written down the value of their assets only slightly, kept them flat quarter-on-quarter or marked them up, according to several institutional investors and advisers.

For institutional investors in private-equity funds, this creates dissonance between the data that firms are providing and what the investors feel is happening in their portfolios and in the wider economy, according to Jennifer Choi, chief executive of the Institutional Limited Partners Association.

“For the purposes of internal reporting, do investors take the marks as written, make adjustments or do they do something even more comprehensive?" asked Ms. Choi, whose organization represents nearly 600 institutions with combined private equity assets of more than $2 trillion. “It’s challenging to operate in a place of limbo where there’s a lack of consistency, so there’s a desire for more transparency into managers’ assumptions and methodologies."

The way private-equity firms value their portfolio companies is as much art as science, giving managers a lot of leeway. Typically firms use three main methods: comparing their portfolio companies with similar publicly traded businesses, comparing them with similar companies that have recently been sold, or using discounted cash-flow, or DCF, models to estimate the current value of the business based on expected future cash flows.

In most cases, managers are allowed to change the emphasis they place on each of the methodologies if they believe it gives a truer picture of value, and the fund’s advisory board and auditor agrees.

After the financial crisis of 2008 and 2009, when comparable transactions dried up and public market equivalents crashed, many managers shifted to the more speculative DCF valuation model, much to the consternation of their investors, said Brad Young, global chief investment officer, private markets, at pension consultant Mercer. That hasn’t been widespread this time around, but if it becomes so, investors will be ready.

“The LP community took away from the [global financial crisis] a lesson learned," said Mr. Young. “You don’t want to keep having to change the way you do things. On balance, most LPs want to get a true idea of what something is worth."

For some fund backers, an unwillingness of managers to write down assets is causing portfolio construction headaches, said Jim Pittman, global head of private equity at Canadian pension manager British Columbia Investment Management Corp., or BCI. The decline of public stocks has caused private equity to become an oversize part of many investor portfolios, restricting their ability to make new investments at a time when more managers are seeking capital for new funds.

“If the GPs took a harsher look at their portfolios, it would alleviate maybe 50-60% of those pensions’ overallocation problems and they’d be able to allocate more money," said Mr. Pittman, whose program has 24.8 billion Canadian dollars, the equivalent of around $18.9 billion, invested across private-equity funds and direct investments.

The refusal to write down asset values blunts another tool that LPs could employ to free up capital—the market for secondhand fund positions. Last year, average pricing of stakes sold on the secondary market hit a 10-year low of 87% of net asset value, The Wall Street Journal reported. Selling LPs have to take a steep discount to the reported value of a stake to get a deal done, indicative of the mismatch between how assets are being valued and what buyers are willing to pay for them.

There are several reasons why managers aren’t writing down the value of their assets.

It can take time for managers to mentally process that their portfolio companies, on which they have staked their reputations as well as their money, are worth less than they were a year ago, said several investors, pension consultants and placement agents.

“They love their assets like their children. They really don’t want to write down those assets," Imogen Richards, partner at global private markets firm Pantheon, said during the recent IPEM private markets conference in Cannes, France.

Those seeking capital for new funds may also be reluctant to mark down current investments for fear it will make their new fund offerings less attractive, a lesson many firms learned during the tech-stock bust of 2001.

“After the dot-com boom, some firms cut the valuations of their portfolios by 30% across the board while others expressed confidence in their ability to stick with the [original investment] timeline and didn’t cut," said a managing partner with a London-based buyout shop. “You can guess who was rewarded by LPs."

Some managers and intermediaries contend that private-equity firms aren’t writing down portfolios because many of those portfolios are holding up well even as public stocks have declined. Blackstone Inc., for one, said in its most recent earnings report that the value of its corporate private equity portfolio rose by 3.8% in the fourth quarter of 2022.

Of a sample of more than 4,500 fourth-quarter private company valuations worked on by investment bank Lincoln International, 85% of European companies saw revenue increases and 62% saw increases in earnings before interest, taxation, depreciation and amortization

“The Ebitda increase is not keeping pace with revenue, which tells us that some margins are falling, but it’s not all private companies," said Richard Olson, a managing director in Lincoln’s valuations division. “A vast majority are in the better-off category."

As the pressure on revenue and cash flow margins grows, however, and rising debt costs force valuations for new investments down, it will become increasingly difficult for some managers to hold off.

“I think it’s just a matter of time before portfolios of GPs have to admit that the valuations aren’t quite the same as they were in 2021," Stéphane Etroy, head of European private equity at Ares Management, said at the IPEM private markets conference.