Private equity NAVs to fall further, but 80% discounts are unjustified

While the net asset values (NAVs) of private equity funds have been spared the steep declines taken by major indexes, the reporting lags inherent in private equity fund valuations should unveil double-digit losses for the first half of 2009.

According to research from Barwon Investment Partners, an Australian alternatives boutique, the NAV of the average diversified private equity fund on a global basis, declined between 15 and 25 per cent in the second half of 2008, when listed markets fell by about 40 per cent.

But reporting lags in private equity valuations meant this NAV would probably fall by a further 18 per cent by the end of the first quarter, Barwon wrote.

And if weak earnings continued, an additional decline of about 12 per cent would be likely in the second quarter.

“Given the reporting lags, the full impact of the weaker Q4 2008 earnings has still not been reflected in NAVs. The impact of Q4 earnings falls will be partly reflected in Q1 2009 and partly in Q2 2009,” Barwon wrote.

“We can thus expect valuations to fall a further 18 per cent by the end of Q1 2009 for portfolios.”

There are more than 300 listed private equity securities worldwide. In January, they traded at an average discount to NAV of more than 75 per cent, suggesting that future valuations could fall well below Barwon’s expectations.

However, the manager thought these securities were being oversold.

“Discounts of 70 to 80 per cent are unprecedented,” Barwon wrote.

The manager wrote that these valuations were “probably excessive” and reflected “disorderly or distressed markets more than they do underlying private equity portfolio fundamentals”.

“The fundamentals, however, continue to deteriorate so only time will tell if this is the case.”

However, it noted that in the past, attractive returns had been made by investing in listed private equity funds at 30 per cent discounts to NAV.

Finding Fair Value

In its research, Barwon analysed the effects of “fair value”, or mark-to-market, valuation methodologies, which provide a market value for a private equity portfolio so that it can be sold at the measurement date.

This method was first practiced in the private equity industry in 2003 by Australian managers, and was then taken up by European firms in 2005. US managers followed in 2007.

The valuation lags account for the relative outperformance of the private equity fund NAVs against public markets in 2008.

For example, in the fourth quarter of 2008, the S&P 500 returned -22.6 per cent while a US private equity index, compiled by US investment consultant Cambridge Associates LLC, returned -15.6 per cent.

“Prima facie, you would expect to see similar falls in the NAVs of private funds and investments, as they face the same economic challenges and conditions,” Barwon wrote.

But there was a ‘material gap’ in the relative valuations in public and private equity. This was probably the result of inherent lags and valuation multiples in fair value accounting.

Barwon also observed that some private equity managers had not adjusted down valuation multiples, by an average of 1 to 1.5 times, for companies bought between 2006 to 2008.

‘We are observing managers taking the view that listed market multiples have fallen to extreme levels not reflective of true fair value.’

The chief executive of Wells Fargo, John Sumpf, illustrated this view when he told the US House Financial Services Committee in February that a mechanistic mark-to-market approach was “mark-to-craziness”.

Barwon argued that an immediate mark-to-market valuation of a private equity portfolio provided a narrow indication of its worth, as it neglected the possibility that valuation multiples can improve in the future.

“If a company is still servicing its debt, not breaching loan covenants and has no requirement to refinance, then private equity managers can continue to hold the investment with a view to realising it at a later date when the EBITDA or valuation multiples have improved.”

“In simple terms, the equity can be considered to have the value of a call option with the strike price being the face value of a company’s net debt.”