Private company valuations have been at a record high since the Covid-19 pandemic, with the UK financial regulator expected to conduct a review imminently amid claims firms aren’t writing down assets to reflect market conditions.
High interest rates and roiling buyout prices have led to a yawning price dislocation in investors’ portfolios, where depressed share prices have made public stocks appear comparably undervalued.
Industry specialists argue private assets are less vulnerable to market headwinds, yet with further turbulence in store from the conflict in the Middle East there is no visible end in sight for the pricing gap.
According to economists and investment managers, the disparity between private and public valuations is due to monetary policy and rising interest rates.
Constantin Gurdgiev, Associate Professor of Finance at the University of Northern Colorado, said “monetary tightening, lack of clarity on monetary cycle evolution and mixed signals from the real economy have led to renewed weaknesses and volatility in the global markets for, virtually, all asset classes”.
Data provider Preqin has tracked the widening gap between the public and private markets performance since before the pandemic, and its data shows private valuations are the highest they’ve been since records began in 2007.
Its most recent performance indices, which capture the average return earned by investors, show private equity returns are ranking much higher than the total S&P500 return at 506.8 to 381.2, as of March 2023.
This is a marked shift since before the pandemic, when in December 2019 the two indices were broadly on par, with private equity returns scoring 299.4, not far off public market returns of 284.2.
Despite high hopes that the valuation gap would close this year, Morningstar data provider Pitchbook said in its latest quarterly venture capital report for the third quarter “public listing value remains the most depressed this year, with buyouts showing the most resilience”.
“There has been a headwind in the public equity markets, more than one headwind really, almost a perfect storm of global levels of nervousness around rising interest rates and the impact that might have on virtually every asset class,” said Richard Hickman, Managing Director at HarbourVest Global Private Equity Limited.
But is this pricing dislocation a concern for investors?
“Knife-edge”
The private market valuation hike has caused panic among pension funds, as the value of assets in the UK’s £1.5 trillion defined benefit pension fund sector has fallen despite buoyant private valuations.
Non-traditional investors such as sovereign wealth funds and hedge funds have increasingly allocated investments towards private markets due to weaker public equity valuations, according to Pitchbook.
Pension funds now risk losing money on so-called illiquid assets that cannot be sold quickly, with many reportedly selling assets at discounts of up to 40% compared to the underlying net asset value (NAV).
For investment trusts that invest in private assets, depressed share pricing and comparably high private valuations have led to broader discounts.
“This is a more complex picture of dynamically stressed valuations and markets, signaling a combination of risks at play, including collapsed flows to Emerging Markets, growth ex-large cap tech and deterioration in some asset classes post-Covid19 and in the face of monetary cycle nearing its peak,” Gurdgiev said.
“Most of the pressure on NAVs is tied to the monetary policies environment, while the general view of the global economy as being on a knife's edge when it comes to recessionary risks is driving volatility.”
Banks and institutional investors were hit by the “2022 bond markets rot” and a drop in unrealised asset values for commercial real estate (CRE) that alone wiped US$1.5 trillion to US$2 trillion off the US banks, Gurdgiev added.
“It is impossible to look past the same levels of losses, exacerbated by lower quality of liquidity, for the specialist funds and trusts,” he said.
“Priced-to-perfection"
Not everyone agrees that valuations are out of whack, or that private valuations are disproportionately high.
Anthony Leatham, research analyst at stockbroker Peel Hunt, said certain pockets of the private equity universe have been “priced-to-perfection", particularly for private companies completing funding rounds at peak multiples before listing and disruptive early-stage tech.
The International Organization of Securities Commissions said in a report in September that “private valuations are inevitably stale”.
It blamed the gap in valuations on a lack of “standard methodology for valuing private equity investments,” which it said could lead to “inconsistencies in the reported valuations of different firms”.
But that does not tell the full picture about how private assets are valued, according to investment managers.
They say valuations are audited at least annually, and that managers follow strict International Private Equity and Venture Capital Valuation (IPEV) guidelines that have been in place for many years.
Managers often use a basket of comparable instruments to price their assets that include public equities, as well as private transactions, and ‘precedent transactions’ that set a market precedent, they added.
“The valuations that these companies are held at in portfolios have been scrutinised and, where necessary, adjusted,” said Leatham, who said adjustments are made with input from the board, third-party valuers and auditors.
General partners do not have an incentive to inflate or overvalue assets because they are incentivised on realisations, according to Hickman.
“That’s where performance is paid. What we tend to see is uplifts to carrying values on exit,” he said.