Private markets have woken up to a new reality during the pandemic: the need to mark their assets to publicly listed assets affected by significant drops in prices. Much criticism has been aimed at the time lag, staleness and smoothening of the net asset values of private funds compared with those of listed stocks. It is time to set the record straight.
We should banish the idea that listed markets are the ‘right’ reference for pricing assets and that private markets are the odd exception. Listed prices are unreliable for at least two reasons. First, a third of daily transactions take place outside of the exchanges. So-called ‘dark pools’ are dedicated to the trading of significant blocks of shares, the latter being equivalent to what private equity funds effectively do in private markets. The formation of prices on the open market is thus far from being a pure and perfect summary of the offer of and demand for listed shares.
Second, calculating market capitalization by multiplying the share price by the number of shares is at best a distant proxy of the value of a company. If the whole company were sold, the price would likely be very different. The latter point is of particular importance and explains why the fair value of any asset differs from its transaction price. This is where the ‘odd’ market teaches the self-righteous advocates of public markets a lesson.
Appraising the fair value of an asset is more than a question of mimicking a price that is supposedly in equilibrium. Fund managers know, for example, that there is such a thing as a majority premium (or a minority discount). Two funds can therefore own a part of the same company and value their relative stakes differently. When they acquire companies, LBO fund managers routinely negotiate warranties. Getting them implies paying a higher price, as some of the risks stay with the seller. If not, the transfer of risks implies a lower transaction price. A single company can thus simultaneously have different prices: the framework of the transaction is what matters.
Likewise, venture capital fund managers know that valuations do not matter much. They are ego contests between entrepreneurs. What matters is the nitty gritty in shareholders agreements, such as veto rights and liquidation preferences. Anyone can invest 10 million at a 100 billion valuation, if in exchange the shares embed a liquidity preference of three times the amount invested. The only thing that matters then is: can we sell the company for at least 30 million?
Fair value is not a trick, nor is it a fairy tale. It is the result of regular appraisals of company stakes by a multiplicity of fund managers with different views and shareholder rights. It is therefore a subjective exercise – and it is not the only one. Environmental, Social and Governance (ESG) criteria are also an exercise in subjectivity. This does not raise any eyebrows, notwithstanding the lack of guidelines and measurement of ESG performance. Why would there be double standards for ESG reporting and fair value? Why would fund managers be trusted on the first and not the second? And why would listed markets tell us better about private assets than the people actually investing in and monitoring them?
Our take is that private markets should continue with current practices and increasingly adapt them to their own needs. Crucially, this should be done in direct and far closer coordination with regulators. As the asset class grows, this approach will ultimately be vindicated – and public markets might learn a few things from the odd ones out.
Cyril Demaria is a partner and head of private markets at Wellershoff & Partners; he is also an affiliate professor at EDHEC Business School and the author of Introduction to Private Equity, Debt and Real Assets (Wiley, third edition, 2020)