The private equity industry is waiting for fourth-quarter valuations, which some believe will finally reveal the true pain firms experienced in 2022 as public markets spiraled and PE marks held steady.
However, it’s possible that even the much-anticipated audited fourth-quarter valuations won’t show the kind of steep write-downs some limited partners are expecting, according to Bain & Co’s latest global private equity report, published this week.
And if that’s the case, LPs could be dealing with overallocation issues in the portfolios for longer than perhaps they are comfortable with.
LPs have been anticipating adjustments to their PE portfolios once year-end, audited marks are published starting around March. That’s because public markets continually declined last year, while private equity valuations held steady, down in the range of around 6 percent. This caused frustration among some LPs, who believed PE marks were not reflecting economic reality.
However, a few factors are at play that may help explain why PE valuations could stay steady.
If history is any guide, the audited marks may not be as dramatic as some expect. It is true that year-end adjustments tend to be the most significant, likely because year-end is when most firms choose to present audited numbers.
Even so, Bain & Co, citing Burgiss data, said that over the past decade, around 60 percent of the time the fourth-quarter adjustment has been less than 10 percent up or down. Change greater than 20 percent occurs 21 percent of the time, Bain & Co said.
Burgiss also found that public and private marks have been diverging. Private and public valuations have generally “shadowed” each other since the Financial Accounting Standards Board issued its “fair value” 157 rule in 2006. “That has set the expectation that bad news regarding the valuation of private holdings is only a matter of time,” the report said. “Many LPs are bracing for the worst.”
However, private valuations since 2019, especially in tech and healthcare, have consistently outpaced those set by public markets in the US and Europe, according to the report.
Part of what drives PE’s outperformance is firms’ ability to construct portfolios insulated from economic shocks. Many private equity firms tout their ability to find cycle-resistant companies even in volatile growth sectors like technology, according to Hugh MacArthur, chairman of the global private equity practice at Bain & Co.
“Looking back, since 2019, valuations of private and public assets have been diverging. GPs who invest in [for example] software businesses and healthcare businesses say that’s because we’ve been investing in sub-sectors and assets that do not get buffeted about,” MacArthur said in a recent interview.
“GPs say, ‘We’re not investing in Facebook and Google… we’re doing mission-critical software that people don’t turn off, they can’t turn off,’” MacArthur said. “Whether that is ultimately true, we’ll see. Maybe private assets aren’t going to be marked down the way publics have been.”
Around 88 percent of tech investments in buyout funds are in software, mostly mature SaaS enterprise businesses with stable cashflows, according to Bain & Co’s report.
And, “private portfolios are also balanced by healthcare companies, which tend to hold up well in a recession,” the report said.
While this is good news for the industry, marks that don’t move much will ensure that LPs continue to face overallocation issues in the portfolio.
One phenomenon emerging from last year’s downturn was the denominator effect – when an institution’s public holdings drop, their illiquid private investments with fairly steady values naturally come to represent a larger percentage of the total fund. In some cases this can put an LP’s PE program over its allocation limits, forcing it to consider various options to rebalance.
One option is to simply wait until public markets recover, or private marks get written down, which would allow the portfolio to naturally rebalance. Many LPs are content to follow this more measured approach, rather than making dramatic moves like unloading big chunks of their PE portfolio on the secondaries market.
But if PE marks stay strong, and public markets continue to fluctuate, many LPs will remain overexposed to private equity. Overexposure to PE, along with the slower pace of distributions flowing back to limited partners (which the report also found), ensure LPs slow their PE programs. Fundraising, then, will remain challenging.
“As in any downturn, the scarcity of capital will mean roughly a quarter of funds now in the market won’t raise again,” the report said. “Funds that can demonstrate they are the smartest player in a given space by finding high-quality deals and delivering them to investors are the ones standing out in a crowded field.”