Worries over private equity valuations are overdone
Aaron Stocks is a Partner at Travers Smith
Whether I am speaking to investors, private capital funds, or companies being bought or sold by private equity managers, everyone is busy trying to plot the likely trajectory of the economy over the next few months. How high will inflation go? To what extent must rates rise to choke it off? Will there be a recession? Uncertainty like this means activity in the private equity market is likely to slow down in the second half of the year, with fewer deals and less fund-raising. It also means discounts on listed private capital funds – the gaps between net asset value and share prices – have widened substantially. But to what extent should investors worry about them?
First of all it’s important to understand how the net asset value, or NAV, is derived. Critics like to pretend it is plucked from the air, with privately owned companies benchmarked against the priciest stocks in the frothiest public markets. But this is not so. The bifurcation of asset values in global public markets that saw a few mega-cap tech stocks pull away from ‘regular’ blue chips has distorted the apparent valuation of public equities. Most businesses owned by private equity funds are not racy tech start-ups burning capital and attracting crazy multiples. Instead they span a range of sectors that attract more defensible multiples and have a clear investment case delivering cash flow on a much shorter time horizon – and this reduces the sensitivity of their valuation to higher market interest rates.
Listed private capital companies are obliged to apply prudent valuations
What’s more, private equity funds including listed private capital companies are obliged to apply prudent valuations. They do not register assets on the balance sheet at what they hope to get when they sell them, but instead look at how much they paid for a company and make conservative assessments of how much value they have unlocked as they work through the process of transforming its business. The nature of this transformation is such that the fruits often mature after a number of years and then rapidly improve, following the so-called hockey-stick pattern. This is why the price for which private equity managers sell businesses is nearly always greater than the NAV on the balance sheet.
So what should private investors do today? I do not advocate attempting to time the market – you have to be right twice and that’s difficult! But history suggests the current gap between share prices and NAVs will close. And though NAVs may come down a little as periodic valuations catch up with wider financial conditions, the gap is more likely to close by share prices recovering when uncertainty in the market eventually dissipates. This presents an opportunity for private investors. Normally only institutions have the chance to acquire private assets at juicy discounts in the frequent so-called ‘secondary market transactions’ that take place outside the listed private capital sphere when sellers want an early exit from a stake and are prepared to take a haircut. In today’s market, discounts to NAV on listed private capital companies mean this opportunity is effectively open to private investors too
Investors should remember that private equity is not a short-term investment…… investors can afford to ignore discounts and simply look beyond periods of market disruption
Most important of all, investors should remember that private equity is not a short-term investment. That means that investors can actually afford to just ignore discounts and simply look beyond periods of market disruption. The investment case for a private equity manager depends on value being unlocked over several years, not from one week to the next. This is how private investors should behave too.
