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Private markets don’t ‘launder volatility’, honest

We’ve been mean about fantastical marking of private capital in the past, so we asked Cyril Demaria, an affiliate professor for private capital at EDHEC Business School and the author of several books on private markets, to write a defence of the industry’s practices.

Last October, Narv Narvekar of Harvard’s $51bn endowment said private market funds did not reflect “general market conditions” and warned of “substantial markdowns” to come. AQR’s Cliff Asness has gone even further, and argued that private market funds are “volatility laundering” their valuations.

Are all the critics right that private capital is a game of self-serving, reality-defying make-believe? No. The critics are missing some crucial dimensions of private market investing (though the fault mostly lies with private capital fund managers, who should be a lot more transparent).

It’s true that public financial markets suffered a bruising 2022 with deep losses from both stocks and bonds, while private market funds have been noticeable and eye-catching exceptions.

We don’t have full-year data on private funds yet, but in the first nine months of 2022 the net asset value (NAV) of US and European LBO funds fell 4.4 per cent and 2.5 per cent respectively. It’s understandably tempting to therefore assume that NAVs are fantasy. The reality is more complex.

Many people are simply over-extrapolating from the experiences of 2007-2009, when NAVs did lag hugely behind public markets, and were also far more modest in their downgrades — at least until the brutal end of 2008 forced a reckoning.

The evolution of the net asset value of American and European LBO funds and major indices (2008-2009) © Author, based on Cambridge Associates data.

But there are some good explanations for why.

Firstly, the composition of most major stock indices differs substantially from the typical LBO portfolios. Public markets in 2008 were heavily exposed to banks that were brought low by the financial crises, and auto manufacturers or airlines, some of which had been bailed out. These four types of companies were mostly absent from LBO fund portfolios.

Secondly, LBO funds tend to invest in more resilient companies in unloved stable sectors — such as funeral homes — to collect dividends and pay the debt used to acquire these companies. These sectors are less affected by macroeconomic shifts than their larger listed peers in more cyclical industries.

Thirdly, the 2008-2009 period actually illustrates the situation before and during the implementation of a new mark-to-market valuation framework. In 2007-2011, regulators required institutional investors to implement accounting rules FAS 157 and IFRS 13 to assess the true value of their holdings.

In November 2008, the International Private Equity and Venture Capital Valuation Guidelines (IPEV) were published so that fund managers could assess the fair market value of private assets. The fourth-quarter 2008 NAVs illustrate this: annual audited reports reflect the impact of market conditions on the portfolio companies of LBO funds.

Things are different today. In 2019-2022, NAVs no longer significantly lagged the evolution of public markets. When replicating the investment patterns of private market funds with listed indices (the “modified public market equivalent” method), NAVs are adjusted upwards and downwards in a similar fashion to listed indices.

Evolution of the multiple of invested capital of American and European LBO funds and major indices © The author, based on Cambridge Associates data. The method of the modified Public Market Equivalent (mPME) replicates cash flow patterns of private market funds with index. This supports a rigorous like-for-like comparison.

Yes, the ebb and flow is still more muted than what you see in public markets. But that’s because private fund managers are prudent when assessing their holdings, both on the upside and the downside. As a result, the NAVs move more sedately than stock markets — especially when you consider that NAVs are effectively calculated gross of performance fees (the 20 per cent “carried interest”).

Active private LBO funds created between 2010 and 2021 currently perform better than the historical average (1986-2004). The former uses the mark-to-market approach, while the latter relied on historical costs.

The funds created before and during the global financial crisis (2005-2009) progressively applied the new accounting rules. Overall, they registered a lower performance than the historical average. It is only after seven years of activity that these funds have distributed 50 per cent of their value. The rest (the NAVs) is still appraised conservatively — but naturally reflect recent events.

Multiple of invested capital of American LBO funds before, during and after the implementation of IFRS changes © Author, based on Cambridge Associates data.

If you zoom in on active LBO funds you can see that the stock market recovery of 2020-21 has been reflected in the NAVs — as well as the bear market of 2022.

Multiple of invested capital of active American LBO funds by vintage year and quarter © Author, based on Cambridge Associates data.

Is this approach wrong? It’s pretty clear that public markets overreact to information, and can diverge substantially and durably from their fundamentals. Instead of calling it “laundering volatility”, perhaps private market NAVs actually bring a healthy dose of prudence and reason to an otherwise wildly gyrating financial system?

I’d argue that these NAVs should even be seen as a valuable source of independent financial information — although still available on average with a three- to six-month delay.

Ultimately, however, the usefulness of these NAVs will depend on the quality of the data used and how well they’re constructed. And this is where fund managers can do much better.

The IPEV recommends using recent similar transactions — along with listed comparables — as the best method of valuing private companies. Academic literature concurs. However, using similar deals data is tricky because of a frustrating lack of transparency.

Investors fear that they are now over-allocated to private markets. This should be the top concern to address by investment managers. Private markets have matured hugely over the past decade, and the level of financial information should reflect that. It’s therefore high time to improve (significantly) the quality and the granularity of data surrounding private investments.

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