The valuation conundrum
Malcolm Goddard, COO of Zetland Capital, questions whether the industry built up to assess PE valuations is fit for purpose.
It seems there has been a good deal of scepticism of late put on valuations. Economic downturns and rising interest rates have put strain on what is produced – but has this been accurately reflected?
We all produce 'fair values', as ILPA says we have to, but how fair is fair? How much of an art form is this? Does estimated unrealised P&L based on this mean private equity NAVs defy gravity as a consequence, and what is the effect?
In part this is an accounting standard issue, in part a transparency issue, and all a bit pointless. To make things worse, there’s an entire 'assurance' industry built up around this, which charge and can assess but can’t guarantee a number. Fair value introduces unrealised P&L, which in most cases is a subjective number and creates noise.
Most funds charge management fees on committed or invested capital and carry upon cash returned to investors. Real numbers. There is no rolling subscription or redemption NAVs; equalisation is generally defined and interest-based; and no elective redemptions. So, valuations don’t affect what LPs pay for management or what they pay to come in or receive to leave.
All of this is based on real or realised numbers. Unrealised numbers aren’t relevant to this so don’t have a financial consequence. Yet, spending money on valuations to support unrealised returns comes out of returns, which does. So why is this necessary and why do we then tie ourselves in knots over it?
In part, it's down to accounting standards: IFRS and ASC are 'fair value' standards. The definition of fair value under both conventions, along with the tiering systems (levels one, two and three) are broadly the same. What is the price of a sale in an orderly market? Here’s where the fun comes in.
Level one is easy. Observable inputs. Screen price; traded market, so beloved of our hedge colleagues, meaning there’s a mark you can sell at. Hence, fund structures are open-ended, redemptions are possible and fees are on realised and unrealised NAV.
Private equity is different. Most assets are level three. So, no observable inputs and an estimate of fair value based upon reasonable methods needed to fit the price of a sale definition. Okay. That’s a start. Beyond that it’s subjective, and here’s the rub. Accounting standards (as the name suggests) exist to introduce uniformity into reporting to allow comparison. However, once into the weeds of level three, there is no 'standard' – valuation policies, procedures, models, discount rates and anything in between are not uniform.
This level of subjectivity means it is difficult to make true comparisons between funds. It is perfectly possible for one party in a private transaction to mark their position at a different rate to another party, and nobody is the wiser without a deep dive on both. And while there are guardrails (an independent valuer for EU-domiciled funds, plus the audit requirement), these aren’t foolproof or uniform.
Governance and moderation around valuation also varies between institutions, so marking your own homework risk exists. But provided you’ve got the sign-off...
Compounding the issue to a degree is the investment company exemption from consolidation. Helpful from an accounting standpoint, but perhaps a check removed. As underlying entities aren’t consolidated, the entire valuation rests on the fair value. What lurks in a subsidiary’s financials is interesting but not necessary to be included. One hopes there’s a reconciliation between these and valuation models, but again, it doesn’t have to be the case.
ILPA’s view is to follow the accounting standard with some best practices (but not standards). IFRS 39 and ASC 820 are fair value standards, so to this extent there is no choice.
Equally audited statements are prepared to these standards, so to hold at anything other than fair value risks a qualification. Never a good look.
So why? Supposedly, it gives a comparison between fund and investment performance – but is it flawed?
It remains the conceptual case that the manager is best positioned to assess it as they understand the details, including the exit. However, this remains a subjective view of
the manager, notwithstanding assurance, who may have other motives.
So, it puts pressure on the users of the information – prospective and actual investors, finance providers, etc – who may choose to do their own validation work on the unrealised element (and no doubt use the same assurance providers). Sensible, but it is recreating the wheel, and different outcomes may not be reflected. Plus, I’m sure not all do. This being the case, why bother?
There are other consequences. Most operational suppliers charge on NAV. Some hedging policies are based on NAV. Isolated examples but both potentially amplify costs on numbers that may not be solid.
The best guide to performance is realised P&L and cash returned. Yes, these tend to be long-term investments that can’t easily be realised, but predicting the future outcome in a non-standard manner is fraught with problems.
We are coming out of a stable environment into one that is less predictable. Anecdotally, we hear that funds are holding investments for longer, fundraising is more problematic, and there is more tail-end activity around funds. So, the risk is that what is realised will diverge markedly from what the marks are, which does nobody any favours.
Has this been reflected? Perhaps not in its entirety, as people hope for the best. After all, it doesn’t impact fees.
The hedge community has taken the pain. Markets accurately reflect performance, yet the opacity of PE valuations leads you to wonder whether PE has. If this is not the case, and if execution standards aren’t uniform (potentially creating competitive disadvantages so influencing behaviour), then gravity will not be defied forever – which will cause the industry great harm.
So, valuation or governance around it has to be standard, prescribed, set and transparent, so that the playing field is level for all. Either this or a rethink is needed.