Private markets don’t “wash” volatility, honestly

We’ve been mean in the past about the fantastic valuation of private equity, so we asked Cyril Demaria, an associate professor of private equity at EDHEC Business School and author of several books on private markets, to write a defense of industry practices .

Last October, Narv Narvekar of Harvard’s $51 billion foundation said private market funds do not reflect “general market conditions” and warned of “significant discounts” to come. AQR’s Cliff Asness has gone even further, arguing that private markets funds “wash their valuations through volatility.”

Are all critics right that private capital is a self-serving, reality-defying sham? No. The critics overlook some crucial dimensions of private markets investing (although the fault lies mainly with private capital fund managers, who should be much more transparent).

It is true that public financial markets endured a bloody year in 2022, with deep losses in both stocks and bonds, while private market funds were notable and conspicuous exceptions.

We don’t have full-year retail fund data yet, but in the first nine months of 2022, the net asset value (NAV) of US and European LBO funds fell 4.4 percent and 2.5 percent, respectively. It’s understandably tempting to assume that NAVs are fantasy. The reality is more complex.

Many people simply extrapolate from the experience of 2007-2009, when NAVs vastly underperformed the public markets, and were also much more modest in their downgrades – at least until the brutal end of 2008 forced a reckoning.

The evolution of the net asset value of US and European LBO funds and major indices (2008-2009) © Author, based on data from Cambridge Associates.

But there are some good explanations as to why.

First, the composition of most major equity indices differs significantly from typical LBO portfolios. Public markets in 2008 were heavily dependent on banks, which were brought to their knees by the financial crisis, and automakers or airlines, some of which had been bailed out. These four types of companies have largely been absent from LBO fund portfolios.

Second, LBO funds typically invest in more resilient companies in unloved stable sectors — like funeral homes — to collect dividends and pay off the debt used to acquire those companies. These sectors are less affected by macroeconomic changes than their larger publicly traded counterparts in more cyclical industries.

Thirdly, the period 2008-2009 actually illustrates the situation before and during the introduction of a new mark-to-market valuation framework. In 2007-2011, regulators required institutional investors to implement accounting standards FAS 157 and IFRS 13 to determine the true value of their holdings.

In November 2008, the International Private Equity and Venture Capital Valuation Guidelines (IPEV) were published to enable fund managers to assess the fair market value of private wealth. The NAVs for the fourth quarter of 2008 illustrate this: Audited annual reports reflect the impact of market conditions on the portfolio companies of the LBO funds.

Today things are different. In 2019-2022, NAVs no longer lagged significantly behind the performance of public markets. When replicating the investment patterns of private market funds with exchange traded indices (the “modified public market equivalent” method), the NAVs are adjusted up and down in a manner similar to exchange traded indices.

Development of invested capital multiples of US and European LBO funds and major indices © The author, based on data from Cambridge Associates. The modified Public Market Equivalent (mPME) method replicates cash flow patterns of indexed private market funds. This supports a rigorous like-for-like comparison.

Yes, the ebb and flow is still more subdued than what you see in the public markets. But that’s because private fund managers are cautious about valuing their holdings, both upside and downside. As a result, NAVs are moving more smoothly than equity markets — especially given that NAVs are effectively calculated net of performance fees (the 20 percent “carried interest”).

Active private LBO funds raised between 2010 and 2021 are currently outperforming the historical average (1986-2004). The former uses the mark-to-market approach while the latter is based on historical costs.

The funds created before and during the global financial crisis (2005-2009) gradually applied the new accounting rules. Overall, they underperformed the historical average. These funds only paid out 50 percent of their value after seven years of operation. The rest (the NAVs) are still valued conservatively – but of course reflecting recent events.

Invested equity multiples of US LBO funds before, during and after the adoption of IFRS changes © Author, based on data from Cambridge Associates.

If you zoom in on active LBO funds, you can see that the 2020-21 stock market rebound was reflected in the NAVs – as was the 2022 bear market.

Multiple of Invested Capital of Active US LBO Funds by Year and Quarter © Author, based on data from Cambridge Associates.

Is this approach wrong? It is quite clear that public markets overreact to information and can deviate significantly and permanently from their fundamentals. Instead of calling it “laundry volatility,” perhaps private market NAVs actually inject a healthy dose of prudence and sanity into an otherwise wildly volatile financial system?

I would argue that these NAVs should even be considered a valuable source of independent financial information – although they are still available with a lag of three to six months on average.

Ultimately, however, the usefulness of these NAVs depends on the quality of the data used and their construction. And this is where fund managers can do much better.

IPEV recommends using similar recent transactions – together with listed benchmarks – as the best way to value private companies. The scientific literature agrees. However, using similar business data is difficult due to a frustrating lack of transparency.

Investors fear they are now over-allocated to private markets. This should be the primary concern of investment managers. Private markets have matured tremendously over the past decade and levels of financial information should reflect this. It is therefore high time to (significantly) improve the quality and granularity of the data relating to private investments.