Heading for a fall?

Valuations appear to have defied gravity. Why is this? And what might we see over the coming period?

As public markets declined in 2022, many investors had expected private markets marks to reflect this over time. Yet valuations appear to have defied gravity. Why is this? And what might we see over the coming period?

Private markets valuations have been among the biggest topics for LPs over the past year. Most expected these to fall over time to reflect the correction in public markets seen through 2022 and a more challenging economic backdrop, but this hasn’t yet happened. While some LPs believe this is rational and reflects the unique characteristics of private markets, others are more wary about what is around the corner. Here, we present the views of five seasoned fund investors.

1 There are structural reasons for private markets charting their own valuation path
Mitesh Pabari, Principal, Fund Investments, Hamilton Lane

“Private markets valuations tend to be under most scrutiny when public markets are volatile – and that was certainly the case throughout 2023. But there are four main reasons why private markets valuations have remained resilient.

“The first is the difference in sector mix. In public markets, a handful of large stocks drove the decline earlier in the year and actually, if you look at the S&P 500, 30% of companies increased in value while others fell. Private markets are more exposed to these sectors and less weighted towards the lower performing sectors. The second is that private markets valuations are held at a discount to public markets valuations and as these came down, that only ate into that cushion.

“The third is that private markets portfolios just tend to perform better because of their active form of governance, greater alignment across stakeholders than in public markets, and because decisions are made by company insiders who know the business best. We see this in our own data – earnings and revenue growth has been higher in private markets. And finally, we see a premium to marks at exit. In 2021 and 2022, the average premium on exit was 20% to where companies were marked in the portfolio for the four quarters before exit.

“Part of the issue is that there is no perfect comparable company set because most private market assets are small and growing faster than public companies. But if public markets are driven fundamentally by performance – and over the long term they tend to be – we can rely on them as comparables. It’s over the short-term that this becomes more tricky as public markets can be prone to sentiment and irrational behaviour.”

2 Valuation methologies may need to change to reflect current market conditions as an interesting cloud forms on the horizon
Victor Mayer, Managing Director, Pantheon

“Small-cap GPs tend to be very conservative in their valuations and often don’t mark up their positions before they sell. When they exit, we can see big uplifts and it’s a great source of comfort for us as investors because we know we have embedded value in our portfolio.

“Yet I do think we need GPs to return to methodologies they abandoned in the low interest rate environment. Ten to 15 years ago, most GPs would use a third public comparables, a third private comparables, and a third discounted cash flows (DCFs). They stopped using DCFs because public and private comparables were up so much and the cost of leverage was low. Today, the weighted average cost of capital has risen significantly and that should lead to some moderation in valuations. I think some of that will come back to private equity valuation methodologies.

“Regardless of public company valuations, we will start to see mark-downs. That will happen when higher leverage costs start to impact companies’ free cash flows. Some of these were relying on M&A that would have had to be debt funded – many of these M&A deals no longer make financial sense and so companies will achieve fewer synergies, less topline growth and fewer opportunities to up-sell and cross-sell than anticipated. That is an interesting cloud forming on the horizon.

“We’re also on the cusp of seeing whether some of the larger private markets managers have been reasonable with valuations. At some point, GPs will have to sell because otherwise there will be too much pressure on their IRR and their carry will evaporate. It will be interesting to see where the efficient frontier lies in terms of returning capital to LPs while not diluting their track record too much.”

3 The need for companies to refinance debt in private equity and to raise follow-on rounds in venture capital will add pressure on valuations
Ralf Gleisberg, Partner, Unigestion

“Private equity has a resilient business model, which comes through especially in more difficult times. It is perfectly positioned to transform and strengthen companies. The main change over recent times is the rise in interest rates and I’d expect some trouble ahead of us as a result.

“Parts of the private markets that are more sensitive to interest rates are likely to see more trouble – where there is high leverage and a wall of refinancing ahead of us, we haven’t yet seen these reflected in valuations. I’ve been surprised that valuations have remained so stable. However, there will be some correction to this through 2024 and this will be linked to debt refinancing.

“Venture capital is the most sensitive area of private equity to the interest rates because of the discounted cash flow valuation model. Here, the change in valuations has not yet been digested and that’s because companies don’t do financing rounds every quarter. Many companies have been pushing out financing as far as they can. When they do need to raise follow-on capital, we’ll reach the moment of truth on valuations.”

4 Past comparables may not be relevant for today’s environment
Kee Tilghman Rabb, Managing Director, Private Equity, Apogem Capital

“We believe higher interest rates will put more pressure on portfolio companies and the cash they generate will go to paying down debt as opposed to growth. Most lenders will agree to amend and extend as they have in the past so the refinancing wall may not be a significant issue. But most GPs need to think about how they are marking their portfolios if their companies’ growth rates are not the same as their private market comparables they are using. If they were expecting a 10% growth rate and now that has slowed to 2% to 3%, that should have an impact.

“GPs will want to keep their valuations stable, though. It’s challenging to have mark-downs and then go out to LPs to ask for capital for your next fund.”

5 Lower volatility in private markets valuations can be an advantage – it’s realised returns that matter
Jessica Sellam, Head of Private Markets Group, Rothschild & Co Wealth

“Family offices and individuals often consider private markets for their resilience. They tend not to have their eye on valuations at all times and are more concerned about exits and realised returns. They have come from an environment where exits were abundant and so are really focused on what’s happening with DPI and TVPI rather than interim valuations.

“Many see there is a benefit to the lag in reporting for private markets and the smoothing of valuations. It’s more logical from a company perspective because the fundamentals of a business don’t generally change from quarter to quarter and so families and individuals are more interested in the real value of a company or asset. I think we have to recognise that public markets often don’t reflect company values over the short term. Today, for example, it’s hard to value businesses because we don’t have much visibility. That’s why we consider longer term private markets valuations more accurate than those of public markets.”