Navigating private equity valuations: Are we approaching the end of the journey?

We view the current investment environment as more constructive than during most of 2022, given much of the valuation correction across both equities and bonds occurred last year in tandem with rapidly rising central bank policy rates. However, with the focus ahead now on the economic and earnings outlook, this month we retain our tactical preference for fixed income over equities, a relatively cautious near-term view. We continue to view alternatives as a key defensive ballast for portfolios, given the likelihood of ongoing geo-political and inflation volatility, as well as the diversification benefits they bring.

While we don’t tactically allocate to alternative assets, due in part to their illiquidity, the evolution of our clients’ portfolios over recent years toward a 20% long-term allocation has provided significant protection during the past year’s valuation shock for traditional bond and equity assets. However, there has recently been significant investor and media focus on the relative valuation of private equity assets, a significant share of our clients’ alternative exposure. In this month’s Core Offerings, we sort through the noise, to better understand private equity valuations and how far we are through the adjustment journey.

The rising importance of alternatives has encouraged a focus on valuations

Over the past seven years, LGT Crestone investor portfolios have evolved meaningfully, notably with the significant growth of alternatives assets, which now total over 20% of assets under management. The largest component of this (alternative) portfolio is private equity, inclusive of more traditional buyout, alongside growth equity and venture capital.

If media rhetoric is to be believed, private equity broadly has a valuation issue relative to public (listed) equity. In certain cases, there is an argument to be had. But in the majority of cases, valuation approaches, whilst nuanced, appear fair and appropriate. Ultimately, we must seek to better understand the context and cut through the noise (related to valuation approaches) to ensure that portfolio actions (and thus outcomes) continue to be managed appropriately. Below, we delve into this context, and frame how we should be thinking about private equity valuations relative to their listed counterparts.

Understanding the components of private equity

First, it’s important to lay some groundwork, as it sets the scene for the valuation conversation. While private equity can be divided into a larger array of segments, the following best represents our discussion in terms of how these companies are valued.

• Early-stage venture companies—These companies are typically valued based on their last credible funding round (i.e., when they were funded by a reputable counterparty). Given the nature of these very young companies, this approach is arguably the most appropriate, as they often have limited revenue, are unlikely to be profitable, and are, at times, not far beyond an idea. It is simply not possible to value these companies in a traditional manner, where earnings are key. It’s for this reason that a credible counterparty (and venture specialist) sets the valuation, and that valuation remains until the same or another credible counterparty, or a broader funding round, updates it (up, down, sideways or to zero).
• Buyout companies—These companies make up the largest percentage of the private equity universe. They are mature businesses that have meaningful corporate structures, actual earnings and profitability in most cases, and are, therefore, valued like traditional (public) businesses. They are typically valued on a quarterly basis with external oversight from accountancy firms, and in line with globally recognised valuation standards (for private companies).
• Late-stage venture companies—These are companies that sit between early-stage venture and traditional buyout. They include late-stage venture, early-stage growth and, to some degree, pre-IPO strategies. As private companies have progressively stayed private for longer, the level of and need for capital sitting in this segment has grown significantly. Most late-stage capital initially stemmed from early-stage venture funds looking to hold on to their biggest ‘winners’, and because of this, the early-stage valuation methodology for these companies persisted. However, it is debatable whether these companies should still be valued off the latest funding round once they grow to a point where traditional valuation metrics apply.

With meaningful excesses in late-stage venture peaking in 2021, followed by meaningful sector-wide downgrades, there was little action through mid-2022 to mark down valuations of these late-stage venture companies.

With meaningful excesses in late-stage venture peaking in 2021, followed by meaningful sector-wide downgrades, there was little action through mid-2022 to mark down valuations of these late-stage venture companies. However, when you look at where new (deal) entry multiples are for late-stage venture businesses (below), or where secondary fund or company transactions are actually being traded, pricing is down some 35-50% from 2021 highs. As such, while there will always be a wide variability in valuations, it’s fair to assume that actual valuations for much of this segment were inflated through 2022 relative to where new transactions were occurring.

Quarterly median pre-money valuation by stage (Q4 2021 to Q4 2022)

To avoid any implication that this approach is a function of higher fees, it’s important to note that management fees are typically charged on committed or invested capital (not net asset values (NAV)), and performance fees are on exit only. So, these valuations don’t impact fees paid at a fund level. In other words, funds are not making more money by not marking positions down. However, in a portfolio context, where fees are charged off NAV, the valuation of a given fund does, in fact, impact investor outcomes, which is one of the reasons why there has been so much rhetoric around how superannuation funds mark their private portfolios.

Pleasingly, and demonstrating the mis-valuation point quite clearly, the local venture and superannuation community set a healthy precedent in 2022, when it collectively marked its Canva (and other late-stage portfolio companies) position down using an external valuer. This is despite Canva not raising a subsequent funding round. For a company that would have been in the S&P/ASX 20 at its Q4 2021 valuation high, it was certainly a sensible development. 

In summary, given nuances around how this segment is valued, we can argue that some of the rhetoric around over-valued private companies has been fair. However, it’s important to stress that late-stage venture is not representative of the larger private equity landscape, despite that being the picture often painted.

Private equity valuations have declined but they have outperformed public markets

Across the broader private equity landscape, valuations are certainly not immune to market conditions and have clearly declined in 2022 as shown in the left chart below. However, private equity meaningfully outperformed its public counterparts, something that it has done consistently, including during major market downturns. Interestingly, long-term data from Hamilton Lane shows that three-year excess returns of all private equity relative to US equities ranged from 6-8% during declining, flat or moderately positive regimes. During public equity regimes where returns have been in excess of 10% per annum, the three-year excess of return of private equity has been tighter, but still positive, ranging from 1-5%.

Why did private equity outperform public markets?

Factors driving private equity relative outperformance include:

• Better operational performance and transaction comparisons. Additionally, data shows that exits typically occur at mark-ups to holding values, implying a conservative holding valuation approach on the part of private equity.
• Better ownership control and alignment to long-term objectives, both of which drive better performance outcomes. As the above right chart shows, private companies outperformed their public counterparts meaningfully across revenue, EBITDA and enterprise value through 2022, which should lead to better performance outcomes.
• Less excess in valuations. The chart on the next page shows that across most sectors, private market valuations started 2022 at a significant discount to public equivalents, where communication services was the primary exception. It should be noted that large public telecoms are very different from high-growth digital media companies that make up the private sample of companies. The move through the year (i.e. brownto dark blue) shows that valuations converged. Put another way, public valuations were far higher at the start of the year and had further to fall than private

Finally, median exit mark-ups in 2022 were positive across the board when compared to holding values in the previous one to four quarters. According to data to 30 September 2022 supplied by Hamilton Lane, median TVPI (total value to paid-in capital) at exit also increased during a period of equity market declines. The following chart provides an example where there was a meaningful uplift (above average) in valuations at exit due to a conservative valuation approach. It shows gross multiples at exit of platform-wide portfolio companies for a large European private markets firm. This is compared to valuations one year before.

When we remove the understandable noise around late-stage venture capital, the data certainly doesn’t suggest that private equity valuations have been or are grossly overstated. However, we would again re-iterate the fact that portfolio companies and, therefore, private equity valuations are not immune to market conditions. If we see earnings decline as economic growth slows, we expect to see some softness in private equity valuations too. This is implied by private equity being our least preferred component within alternatives. Our most preferred sectors are hedge funds, private debt, and unlisted infrastructure.

So, how should we be thinking about existing and new allocations to private markets?

First and foremost, we’re invested in private markets for the long term (especially given the relative illiquidity of the asset class), and as we explained in Timing private markets, vintage diversification matters (i.e., we can’t time the market, so don’t want to miss a vintage). To that effect, investors should be staying invested through the cycle, and across all three components of the broad private equity segments.

However, in light of ongoing economic weakness that could have a greater impact on existing positions and their valuations, we maintain a preference for new commitment structures (where available and appropriate) and/or those that are actively and cautiously investing new capital into the current environment. Entry valuations are at much healthier levels today, and while it is impossible for anyone to pick the bottom of the market, vintages post or during market downturns tend to perform strongly. Where deploying into open-end, fully invested private market strategies, consistent with our deployment stance for public equities in last month’s edition of Core Offerings, a range of 40-60% would be an appropriate.

From an opportunity perspective, one area we think looks increasingly attractive is the secondary market for private equity funds, particularly in venture, where both performance and venture’s association with the Silicon Valley Bank collapse have added to uncertainty and increased discounts. Not all of these transactions are created equal, but for those that can access secondary opportunities from leading venture funds and/or their portfolio companies, Q2 onwards should provide a ripe hunting ground to build an attractive portfolio of mid- to late-stage global start-ups.