Unlike picking stocks, private equity investing is something of a black-box exercise. Select a GP, entrust that manager with committed capital and hope that they diligently curate a portfolio of assets that reap rewards over the coming decade. Secondaries, meanwhile, put investors in a far more transactional, hands-on role. This is where it is important for investors to fully understand the dynamics between current reported value and the potential for future upside.
One perspective is to look at discounts and premiums to net asset value (NAV), which we at Palico track and publish on a regular basis. Pricing is useful for underscoring micro-trends, such as which particular funds in the secondary market are in highest demand. Our research has shown that positions in Blackstone Capital Partners VII, Thomas H. Lee Equity Fund VII, and Vista Foundation Fund II were all highly coveted in the six months through September 2019, all of which have traded at least 10% above par.
Further, measuring discounts/premiums reveals wider, more macro market trends. Currently, we are in a fully priced market, although there are signs of a tilt, if not an all-out flight, to quality in recent months. Our Secondary Pricing Report Q3 2019 shows that some 50% of funds in secondary transactions sold at par or better over the last six months, versus 63% in H2 2018 and 64% in H1 2019. As concerns mount over future economic growth and market stability, the gap between highly sought after funds and their less in-demand peers is widening.
Such price analysis is an indispensable means for LPs to track the market and benchmark their bids, whether they are buying or selling fund interests, or both. However, a significant blind-spot remains the reliability of NAV reporting itself. It is one thing to bid on a fund interest, but what if it’s not clear what the real, baseline value of that fund interest is?
GPs typically value fund NAVs quarterly, but there is significant room for interpretation here given the inherently private, illiquid nature of the underlying assets. Fund managers have a number of options and can use these in combination to determine the average value of companies in the fund, and therefore the fair value of the fund itself.
GPs can take a ‘mark-to-market’ approach, matching their private portfolio companies like-for-like with public market comparables, or ‘comps’, in the same industry, geography and of roughly the same size, using their EBITDA multiples as a guide. As might be expected, finding direct comps can be tricky.
Another option is to evaluate deals, whether in private or public markets, to see what multiples buyers have been willing to pay for similar companies. This method, known as ‘precedent transaction analysis’, again relies upon the availability of recent examples of closely related companies changing hands.
Finally, GPs can employ a discounted cash flow model, a valuation method used to estimate the present value of an investment based on its future cash flows, taking into account anticipated revenue and earnings growth and EBITDA multiples. It goes without saying that this approach is based on a number of assumptions that are open to interpretation.
Again, what weighting the GP gives to any of these three methods is at their discretion. Ultimately these are approximations that can, at best, lead to inaccuracies.
Smoke and mIRRors
Recently, NAV calculations have come under the microscope of academics, with some notable revelations. One landmark paper that analyzed 761 fund investments made by Calpers, the largest US investor in private equity, found that on the whole GPs have a tendency to manage expectations. That is, fund managers on average understate NAVs (based on the size of subsequent distributions from exiting companies in the fund) by 35%. Certainly, this trend of downplaying valuations can give LPs comfort when paying over the odds in today’s currently full-price market environment.
A more concerning finding from that same piece of research, however, was that NAVs fluctuate depending on when they are calculated. NAVs tend to be higher come fundraising time, the implication being that value appreciation and the promise of attractive future returns are used as a marketing tool to attract investors into follow-on funds.
Secondary buyers should take heed. If they make a purchase at the time of these ‘NAV bumps’, which was found to occur in the pre-first-close phase of the follow-on vehicle, this will — relatively speaking — negatively impact upon their eventual return. No investor wants to buy an asset after it has been positively revalued.
These findings are, of course, an average. Some GPs will inflate and deflate NAVs more than others. This is why it is critical in single fund transactions that bidders understand a specific GP’s NAV reporting tendencies. It may be possible to develop a picture of this from prior primary investments with said GP, or by speaking with LPs in the fund being auctioned.
Buyers should always analyze the quality of the underlying assets in a fund and this may involve running an independent audit of portfolio company valuations to determine the accuracy of the fund’s reported NAV. And, given that timing is everything in this equation, the smart money says to price secondary bids more conservatively if the GP in question is gearing up for their next fundraise.
Investors in secondary sales ultimately need to be mindful of what is sitting in front of them when they prepare their bids.