Private equity fund valuations should fall by almost one fifth by the end of the first quarter, and could fall another 12 per cent in the second, according to research from alternatives boutique Barwon Investment Partners. While major indexes worldwide fell by roughly 40 per cent in 2008, the reporting lags inherent in valuing the net asset values (NAVs) of private equity funds meant the average vehicle declined between 15 and 25 per cent in value in the second half of 2008, and would continue to descend until mid-2009, Barwon wrote in a recent paper, Private equity NAVs: where are they heading?
These reporting lags were a major factor in Barwon’s prediction of a widespread decline in private equity NAVs in the first quarter of the year (by approximately 18 per cent), and also in the second, if weak earnings continued. “The full impact of the weaker fourth quarter 2008 earnings has still not been reflected in NAVs. The impact of fourth quarter earnings falls will be partly reflected in the first quarter of 2009 and partly into the second quarter of 2009,” the manager wrote.
The lags explain the relative outperformance of the private equity fund NAVs against public markets in 2008. For example, in the fourth quarter of 2008, when the S&P500 returned -22.6 per cent and the ASX200 -26.5 per cent, a
US private equity index, compiled by investment consultant Cambridge Associates, returned -15.6 per cent. “Prima facie, you would expect to see similar falls in the NAVs of private funds and investments, as they face the same economic challenges and conditions,” Barwon wrote.
But the manager saw a “material gap” in the relative valuations of public and private equity. This was probably the result of inherent lags and valuation multiples in fair value, or mark-tomarket, accounting practices. The research analysed the effects of the valuation methodology, which provides a market value for a private equity portfolio so that it can be sold immediately on the measurement date, and is being used for the first time in a period of poor returns across the private equity sector.
The method was first practiced in the industry in 2003 by Australian managers, and was adopted by European firms in 2005 and then by US managers in 2007. Barwon observed that some private equity managers had not adjusted valuation multiples downwards by an average of 1 to 1.5 times for companies bought between 2006 and 2008. “We are observing managers taking the view that listed market multiples have fallen to extreme levels [that are] not reflective of true fair value,” the manager said.