Accuracy of private equity valuation is topic of age-old debate that always opens up in times of public market volatility and is now finding itself in the supervisory spotlight. The industry experience is that valuation process and governance in private equity buyouts have long been robust and, in particular, have materially improved since valuation methods were first developed decades ago.
Private equity firms are still typically selling companies in their portfolios at a material valuation uplift on their most recent carrying value, yet misconceptions around subjectivity in the valuation process and potential conflicts of interest still, frustratingly, haunt us. The growth of private equity shows little sign of slowing and it is in everyone’s interests to be more familiar and comfortable around private equity valuations and to get there we need to challenge misconceptions. Debate and scrutiny helps us do this.
One example of a strongly held misconception we need to change is that sceptics who witnessed 2022’s considerable falls in public equities loudly questioned why the value of private equity assets did not mirror or exceed this decline, saying that the industry had been ‘burying its head in the sand’ on valuations. However, there was less noise when public markets outgrew private equity valuations on average the following year in 2023.
The rather unexciting fact is that private equity valuations are not as correlated with public markets as many people think and, consequently, they don’t tend to follow the public markets all the way up nor all the way down. Market-moving events cause large swings in public market prices, but private equity managers tend to be more conservative with their valuations, taking a more measured approach to writing assets down in a down market and being slower in writing them up in a rising market.
Governance and incentives
Also not always understood is that modern-day private equity managers operate within strict governance parameters and have tens, if not hundreds, of knowlegeable institutional investors – they cannot simply refuse to mark down their portfolios without a plethora of educated investors questionning this.
In the valuation process, buyout firms are looking to calculate the ‘fair value’ of their portfolio companies; essentially trying to value each of these companies as if a controlling stake were to be sold at the date of valuation. This is unlike the public markets, where daily share prices typically equate to the price that the market is willing to pay for a marginal share at a specific date, rather than the value of a majority holding in the entire company, were it to be sold to a listed competitor or taken private.
Firms also have a multi-layered process of valution verification. As an example, and this is typical in the industry, the managers within our own Patria Private Equity Trust (PPET) portfolio undergo a quarterly revaluation on a bottom-up basis in line with International Private Equity & Venture Capital Valuation (IPEV) guidelines and IFRS/US GAAP accounting standards. The managers have their own valuation committee, often seek advice from external valuation experts and their investment valuations are audited at least annually.
On top of what happens at an underlying level, PPET’s auditors also review a sample of its largest investments annually for an additional layer of oversight. This is on top of a separate review of valuations undertaken by the Manager and Audit Committee on a quarterly basis. This is a time and resource intensive process with several different parties scrutinising the valuations of underlying assets to ensure methodologies are sound.
This process did not spring up overnight – it has evolved and been refined over many decades of private equity investing, with input from generations of industry practitioners, and has been tested every time an investment is realised.
The other side of the coin is the way in which private equity managers are incentivised to ensure vested interests are kept out of the valuations process.
Private equity funds typically charge management fees on fund commitments and investment cost, not on the value of their underlying holdings. Carried interest, our equivalent of a performance fee, is only paid on the cash received following an asset sale. As managers are rewarded based on realisations not valuations, there is little incentive to artificially inflate the value of an unsold portfolio asset plus it only makes it more difficult to secure a buyer at that valuation later on – if anything, our experience is that valuations lean towards the conservative.
Proof at point of sale
The ultimate test of valutions is the valuation change when a private equity-backed company is sold.
Our own experience within PPET, and this is mirrored across the industry, is that we see a long-term average uplift of c.25% compared to the valuation two quarters prior to sale. This trend has existed for well over a decade through a range of market cycles.
Alan Gauld
Patria Private Equity Investment Trust
Member, Invest Europe
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