Private equity valuations holding firm but the investment bar has risen

Private market valuations can often be a polemic topic among investors. By their very nature, private companies are not required to present quarterly earnings reports and do not have a daily stock price to refer to.

Instead, PE sponsors must apply different valuation methodologies when reporting to their investors. These include the market approach, where sponsors compare their assets to comparable listed companies, or the discounted cash flow model approach to calculate a company’s net present value based future free cash flows.

Both are approximations, and as such are left open to interpretation.

In times of market stress, as witnessed last year, this lack of transparency can sometimes leave investors in a predicament, unsure as to how much their private equity investments may, or may not have fallen, relative to their public equity exposure. This is something that new investors must contend with, as they diversify into private assets.

Even though public markets fell 20% last year, this has not been the case for private markets, broadly speaking. McKinsey’s Global Private Markets Review 2023 shows that PE buyout entry multiples declined only slightly in 2022, falling from 13.2x EBITDA to 12.9x EBITDA year-on-year.

Ed Conway, BlackRock’s global head of alternatives, recently told Bloomberg that PE valuations remain high, making exits difficult. That’s not true of venture capital, which last year saw Klarna experience an 85% fall when it raised $800 million. More recently, CB Insights reported that Cybereason, a Boston-based cybersecurity firm, raised $100 million from SoftBank at a 90% discount to its $3 billion valuation.

As investors deal with the fallout of last year’s volatility in capital markets, they are relying more than ever on private market GPs to provide as much transparency as possible on the value of portfolio assets. As McKinsey partner Brian Vickery told Private Equity International in March 2023, “It’s hard to say if there’s more PE pain in the future”.

“While public markets have decreased, particularly for loss-making tech stocks, the impact on private market valuations are difficult to generalise,” says Naoki Ohta, a member of the Diversified Alternative Equity team at Barings.

Hamilton Lane’s 2023 market overview points out the importance of data when discussing valuations and notes that contrary to anecdotes, PE valuations have remained strong. They note that whereas nearly 40% of Russell 2000-listed companies had negative earnings through Q3 2022, that figure fell to less than 8% for private companies.

“Valuation is an art, not science, and hence is situation specific,” adds Ohta. “Businesses which are decorrelated from GDP and serve fundamental needs with pricing power have, in general, continued to perform well. Such examples include mission critical software or in our infrastructure portfolio, an ash recycling business in the energy-from-waste industry.”

Davis Noell is Senior Managing Director at Providence Equity, which manages $35 billion of PE capital commitments.

“You maybe saw PE multiples come down slightly in 2022 but not much,” says Noell, “but you have to bifurcate between venture capital, growth equity and classic private equity. As interest rates go up the net present value of cash flows for unprofitable businesses falls. Then, as their forecasts for growth (and future cash flows) go down, it means the valuation multiple also moves lower.”

Those two factors impacted unprofitable fast-growth tech companies, he says, “which were frankly the hottest part of the market in 2020 and 2021”. That’s why some managers have had to mark down their portfolios quite substantially; particularly in venture capital.

One way for investors to protect against market volatility, and seek out new opportunities, is to focus on more niche areas. This is something that US manager, Cloverlay, is pursuing in its strategy that focuses on what it calls “Adjacent Private Markets”.

“We deliver a portfolio of “Diversifying Private Assets,” providing exposure to niche strategies frequently absent from traditional private equity programs,” explains Omar Hassan, Partner and CFO. “On the intangible asset side, such as litigation finance, IP rights or royalties, where there is historically less capital, we are seeing some capital voids and creative ways to extract value.”

The narrative Hassan is hearing, from a financial reporting perspective, is that auditors are not signing off on valuations as quickly or as easily as they did a year ago.

“They want to see that you're getting to a similar answer using various types of valuation techniques,” says Hassan. “The pressure on cap structures today requires evaluating valuations from the perspective of downside protection, so that there’s a leg to stand on.”

Challenged markets create buying opportunities

As LPs threw themselves into private equity in 2020 and 2021, many did so underwriting a model of steady realizations (or distributions to paid-in capital). However, these dried up last year as exit volumes fell. This has also been a factor – aside from the time lag of PE managers reporting their marks to market – in why some have found themselves over-committed and exceeding their target allocations relative public equities; the denominator effect. Although fundraising is expected to slow in 2023 as a result, investors are now starting to see some of those realisations.

“Our pipeline of deals for the back half of the year looks stronger than the back half of 2022,” says Noell, adding that many are trying to increase their target allocations to continue making commitments to funds in the market.

“Oftentimes, the best commitments are done in tough years when the market is hot. They want access and we are seeing that too in the PE secondaries market, as investors look to buy existing LP interests.”

Investors like Ohta echo this view: “We have seen valuations trend to more reasonable levels in specific circumstances and will look to ramp up our co-investment or GP-led secondaries activities.”

As they seek out new opportunities in this economic climate, the Cloverlay team is spending time looking at intellectual property deals with Hassan stating: “In times like these, we think such assets are underutilised and undervalued.

“Cloverlay is specifically skilled at finding intrinsic value in assets that have not yet become fully

institutionalised. In earlier cycles (when the cost of capital was next to nothing) we would seek emerging segments of established industries to find that void of capital and upside potential. Today we see more opportunities from assets in dislocation.”

There is, it seems, a general agreement among managers and investors that PE valuations have dropped slightly, but no where near as much as public markets. The bar has certainly risen when considering new deals, and the future profitability of companies. But when markets are challenged, it can often lead to the best investment opportunities.

“This year we are finding attractive growth relative to valuations, and we are excited about some of the investments we’ve been able to make; including a take private deal for UK-based exhibition business Hyve Group,” concludes Noell.

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