The debate over private market fund valuations and volatility has returned to the fore.
To quote Mohamed El-Erian, some private equity managers believe that “their asset class would avoid taking into account that stocks and bonds have been exposed this year because they were structurally immune to disruptive changes in the investment landscape.” El-Erian says this “may turn out to be misplaced self-confidence,” while Cliff Asness describes it as “volatility laundering.”
From a capital market perspective, how can investors value net asset value (NAV) valuations and efficiently transfer their eventual risk?
We have developed an active framework.
The best way to offer investment feedback is to follow the conversation and take part in a trade. If you think a NAV is undervalued, you should buy at that price. If you think it’s high, you should sell. There should be an adequate mechanism to reward such forward-looking relative value trades. As a consequence, an investor could monetize a higher or lower return (a positive or negative risk premium) compared to other allocations over a given time horizon.
The problem
Private market valuations are still opaque, making it difficult for investors to determine the value of private assets. Unlike listed markets, private market prices are not publicly available and the methodologies by which valuations are derived are often a mystery.
Still, private market investments cannot hide their true results. Their self-assessment structures are inherently objective. Volatility cannot be washed away indefinitely. In the end, the total value produced over time will be converted into cash.
Prior to liquidation, even when private market returns are measured using an accurate methodology, they are heavily influenced by the paper gains and losses of estimated interim NAVs.
General partners have different philosophies about what is a fair NAV valuation. Some have a market valuation perspective, while others take a less sensitive position to market risk. Not all private market fund valuations are created equal.
In fact, the International Private Equity and Venture Capital Valuation Guidelines (IPEV) dictate various valuation methodologies to obtain the fair value of private funds. These range from multiple comparable transactions to discounted cash flow methodologies to quoted investment benchmarks. However, the Financial Accounting Standards Board (FAS 157 – ASC 820) emphasizes fair value, with an emphasis on exit value, or the expected proceeds from the sale of the given asset.
Although private market investments tend to be held for the long term, the settlement mechanism of your fund gives the final say to its market value. Only when the assets in the portfolio are sold does the seller discover what the market is willing to pay. If the paper valuations of these assets do not reflect their corresponding secondary market price, the buyer may seek to negotiate a discounted price and thereby increase their likelihood of a positive risk premium.
The way forward
Our research has sought to explain and maximize the value of time-weighted metrics in private market investments. Because? Because private market assets should be comparable to all other asset classes and easier to understand. This will make the asset class more usable, improve portfolio and risk management, and reduce idiosyncratic cash inefficiencies or undrawn over-allocations.
Our research has yielded many first-of-its-kind private market solutions.
Valuation transparency
Using our duration-based calculation methodology, we measure the time-weighted performance of private market investments and establish a real-time valuation link with the public markets that makes volatility explicit and eliminates delays or lack of estimates.
This rule-based probabilistic framework is based on a robust benchmarking approach. Investors can objectively project and assess the market value quality of the NAV of their investments in the private market.
Price discovery
Using real-time and time-weighted indexing techniques, the duration-adjusted return on capital (DARC) methodology constructs a forward yield curve for private market funds that links ex post performance to future expectations . Only time-weighted returns can be traded over time, and the DARC makes private funds tradable with future maturities.
With our Private Fund Forward Exchange (PRIFFE), investors can test the potential of current NAVs to deliver cash equivalents in the future, anticipate expected forward returns over the target time horizon and manage market value volatility. The premise behind our approach is that money on the table can take advantage of misplaced private market NAV expirations, hence the acronym PRIFFE, which plays on “priffe”, or money in the 19th century Roman dialect , and priffe, a traditional Swedish card game with deals and contracts.
Level the playing field for private market NAVs
A conventional rationale for private market investments is that their “old” valuation profile reduces the volatility of a typical multi-asset portfolio and provides performance stability. But this is only true for short-term declines in ratings. Private market fund reports are delayed by several months and can benefit from hindsight. Since the global financial crisis, we have yet to see a prolonged period of asset appreciation. Hopefully, we won’t see one again, although that may be wishful thinking given the current economic environment. If this price change occurs, there is no exit for private market investments.
Market conditions will always influence the exit values and returns of private investment portfolios. Even assuming stable valuations, the settlement process can take time, reducing returns. In bullish cycles like the one of the last decade, duration and market risks are often neglected, but they follow private market investments through the ups and downs. The brand in the market only makes them more visible.
In the future, we need to anticipate and manage market value adjustments to increase transparency around private fund investments. Private market funds that take a market value approach may exhibit more volatility and apparently even underperform under certain market conditions. But they offer investors three important advantages:
- Despite the usual delay in reports, investors can calculate more robust NAV estimates. The more consistent the starting point, the smaller and more random the estimation error.
- This NAV data makes investors’ balance sheets more resilient and eliminates the negative return spiral that results from the artificial denominator effect, which locks in losses.
- At any given time, any asset allocation that includes private market funds would provide a balanced view of the prospective risk premiums expected to be earned by the various asset classes.
A market valuation context creates positive countercyclical investment dynamics. This means the possibility of increasing risk at decreasing valuations and vice versa instead of crystallizing losses or adding risk to increasing valuations. This will naturally reinforce the smoothed benefits of diversification.
Not all NAVs are created equal, so not all prospective returns will be equally attractive. Some of them may be worth selling, others may be worth buying, if you can differentiate and execute them.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Massimiliano Saccone, CFA
