Recent market volatility has many investors searching for assets that can deliver a smoother ride. Public equity markets are known for their transparency and real-time pricing, which can be significant volatility drivers, especially during periods of crisis when emotional investing runs high. In contrast, private markets are opaque, highlighted by relatively long hold periods, a lack of observable market prices, and quarterly, rather than real-time, reporting.

Private equity funds are intended to take a long-term view that allows them to execute multi-year value creation plans and capitalize on longer-term market trends, making day-to-day movements less relevant. While private market valuation methods can appear less transparent and slow compared to public markets, they also tend to be more measured. As a result, private equity investments have historically been less volatile, including during recessions. The following charts illustrate how private equity funds performed relative to public markets during the dot-com bubble in the early 2000s, as well as during the Great Financial Crisis (GFC) later that decade.

During both time periods, private equity fell less precipitously and recovered with less volatility than public markets. Over the full cycles, private equity funds have outperformed public markets. This suggests that private investments can provide both higher returns and lower perceived volatility than their public counterparts during a recession.

Today’s market appears to be following a similar pattern. Preliminary data gathered by Hamilton Lane suggests that private funds marked their portfolios down by about 10.9% on average in the first quarter of 2020.  By comparison, the S&P 500 Index was down by approximately 19.6% for the quarter. While public markets regained a significant portion of those losses during the second quarter rally through mid-June, the rebound has come with high levels of volatility, which we do not expect to see from private investments.

Private Valuation Methodologies Typically Follow a Consistent Framework
A lack of observable prices means private equity managers must use a variety of other inputs to determine the fair value of their holdings. To accommodate this process, most private equity managers use Financial Accounting Standard 157 (FAS 157), which offers consistent framework for valuing assets in the absence of observable, quoted prices. The main inputs used in this process are 1) public market comparables (comps), 2) private transaction comps, and 3) discounted cash flow models.

Public market comps look at a set of similar publicly listed businesses operating in the same sector as a given portfolio company to determine the average price/earnings (P/E) ratio at which they trade. That number is generally then applied to the trailing 12-month EBITDA a private company to estimate its fair value.

Private transaction comps take a similar approach, but look at the purchase price multiples of private deals for similar companies. The average multiple of purchase price-to-EBITDA across that dataset is then applied to the portfolio company’s EBITDA to strike a value. In many cases, this can be the best indicator of a company’s value, as an adequate set of publicly listed businesses with truly comparable business models may not exist.

Finally, the discounted cash flow model estimates the fair value of a business by calculating the present value of its future cash flows. To do this, a manager must project the earnings of the company over the next several years, as well as its terminal value at exit. The model would then apply a discount rate to these amounts, which represents the required rate of return on the investment. The resulting figure gives the manager an approximation of the asset’s value.

Most private equity managers use a weighted average of these three methods to assess the value of each portfolio company, offering a degree of consistency across the industry. In the decade following the GFC, auditors have generally applied greater scrutiny in examining the subsets of public and private comps that are used by managers.

Why Private Equity Valuations Lag Behind Public Markets
The process of striking a net asset value is conducted on a quarterly basis and typically takes several weeks. This means that new data regarding a company’s performance is not reflected in actual valuations until statements are released, typically 45-to-60 days after quarter-end. During normal market conditions, this reporting lag does not generally draw much attention, however in times of high volatility, it can be both a source of some relief from the market swings and anxiety as the quarterly valuations are finally disclosed, revealing the actual impact.

In response to the current pandemic, many businesses were forced to shut down in March 2020, leading to a sharp decline in revenues. While public markets were quick to respond by selling off risky assets, the effects of the pandemic were not seen in private market valuations until mid-May or later. In the meantime, many private equity managers were just finalizing valuations from Q4 of 2019, which were not only much rosier, but were no longer relevant and created confusion for some investors. Further, when Q1 valuations were released, they only reflected the tip of the iceberg, as most businesses were operating as normal for the first two-plus months of the quarter. The real impact of the pandemic will not be seen until Q2, but those financial results will likely not be fully reflected in valuations until August.

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