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

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.

chief executive of

financial institution Wells Fargo, John Sumpf, crystallised this view when he
told the US House Financial Services Committee in February that a mechanistic mark-to-market
approach was “markto- craziness”. Barwon argued that an immediate fair value
assessment of a private equity portfolio provided a narrow indication of its
worth because it neglected the possibility that valuation multiples can improve
in the future. “If a company is still servicing its debt, not breaching loan
covenants and has no requirement to refinance, then private equity managers can
continue to hold the investment with a view to realising it at a later date
when the EBITDA or valuation multiples have improved,” Barwon wrote.

“In simple
terms, the equity can be considered to have the value of a call option with the
strike price being the face value of a company’s net debt.” The paper argued
that the current trading prices of listed private equity funds on global
markets, which in January hit at an average discount to NAV of 75 per cent,
reflected “disorderly or distressed markets more than they do underlying
private equity portfolio fundamentals”. There are more than 300 listed private equity
securities worldwide. These “unprecedented” discounts to NAV implied that
future valuations could fall well below Barwon’s expectations for the first
half of 2009. The manager, however, thought these securities were being


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