“It’s the very first time that actually we are going to see this system stress-tested,” said Cyril Demaria, head of private markets at consultancy Wellershoff & Partners, speaking to sister title Private funds CFO about the mark-to-market framework put in place even before the great financial crisis of 2008.
It’s a seemingly contradictory statement. But the mark-to-market, or ‘fair value’, has never been truly tested during a global downturn. The result could be the undoing of the traditional argument that private equity is a comparatively stable and uncorrelated with volatile public markets.
Implemented in the US in 2007 and in Europe in 2011 (under Financial Accounting Standard 157 and IFRS 13, respectively), mark-to-market accounting for level three securities wasn’t practically adopted by the private markets until mid- to late-2009, by some accounts, and the International Private Equity and Venture Capital Valuation Guidelines for implementation weren’t introduced until December 2012.
Demaria points to historical assets-under-management values in the private equity. There, the pre-crisis ratio of dry powder to unrealised value was 92% between 2000-2004, according to Preqin data. That was largely due to a conservative assessment of unrealised value based on the traditional ‘historical cost’ approach, where an asset is marked at the purchase price (or the latest round of third party financing in venture capital), and marked down only if an investment began to sour.
That ratio stayed relatively consistent through about 2006. In 2007, it declined to about 75%, as some firms stumbled to put fair valuation into place without a set guidance, in a kind of makeshift approach. In 2008, the ratio popped back up as dry powder increased and unrealized value slightly decreased.
Then the denominator started to soar.
Unrealised value has increased at a rate of 19% year-over-year since 2008 (according to the most recent data, which ends with 2018) – largely a result of mark-to-market implementation on the valuation of both existing and newly acquired assets. Dry powder, meanwhile, increased at a rate of 6%.
“The value of the actual assets has been increasing much faster versus dry powder,” Demaria said.
‘Good news’ people
While much attention in recent years has been paid to dry powder, it’s the unrealised value where Demaria said mark-to-market has made the most impact. “I’ve been trying for about two years to attract the attention of the wider public to the unrealised value part,” he said.
It’s that part of the equation that drove conservatively assessed net asset values pre-2008, he said, adding that “conservatism is consistent with these firms insuring against future bad luck that could make them appear as though they are NAV manipulators.”
Managers can “shoot themselves in the feet” if they’re too conservative on their NAV assessment during a fund’s divestment period (typically the past five years of a fund’s life), because it reduces their management fees, he said. But managers also raise new funds regularly, and if they overvalue NAV, they risk future income streams. “The value of the future income stream from all of the funds they raise later is much higher than the immediate sacrifice they make by being conservative on the value of their funds,” Demaria said. “You want to be perceived as the ‘good news’ person.”
Playing it cool
So, managers would often flirt with their LPs a bit, signalling to them that there may be some upside to their NAV calculations, which were in fact marked at a very conservative level – effectively reserving the upside surprise for later, with an eye to further fundraising.
That was the game, Demaria said, but it changed when regulators decided that, to avoid distortions and bring risks in private markets out into the sunlight, institutional investors should mark illiquid assets via a framework reflecting the inclusion of all available information. “Interestingly, they raised the point before 2008, so they must have had a sense that something was in the making,” noted Demaria.
A comparison of changes in public market values and leveraged buyout NAVs between the beginning of 2008 and Q3 2009 – when the industry was beginning to implement its makeshift fair value approach, at least in the US – shows how much LBO NAVs underreact to economic swings. (The exception appears to be Q4 2008 – which Demaria suggested may be because year-end PE financials are audited, and auditors favour the regulatory approach.)
In part, that underreaction is because some sectors are represented unequally between stock indices and PE portfolios. Banks, for example, are rarely acquired by PE firms. PE portfolios may contain auto parts makers, but rarely car manufacturers themselves. It also owes to the fact that managers aren’t incentivised to reflect that volatility. This is because, first, stock markets historically revert to their mean and, second, reflecting indices’ volatility would potentially attract the scrutiny of regulators, who could then force LPs to up their solvency ratios. “Movement is risk” from a regulator’s perspective, Demaria said.
And, of course, PE firms tend to inject cash into struggling portfolio companies at just the times when their public market equivalents have difficulty accessing liquidity increases. Think Blackstone’s acquisition of Hilton in 2007. Hotel-backed loans were among the leading subsectors in delinquency rates for commercial mortgage securitisations during the crisis (and some are headed toward default as we speak), as reported at the time. Indeed, Blackstone failed to sell a CMBS tied to its LBO of Hilton in in 2008, as then reported by the Wall Street Journal. But in 2013, Hilton became the biggest hotel initial public offering in history.
And the ‘smoother’ downward valuations don’t appear to have been the result of managers ‘cheating’ on valuations, said Demaria. “If they were cheating, you’d see the NAVs increase [in Q2 and Q3 2009] much more than the index.” Instead, they significantly underperformed.
In the long-term, PE assets do tend to converge with public equity, because most targets either go public via IPO or are acquired by publicly-traded companies, Emilian Belev, Head of Enterprise Risk at Northfield Information Services, a risk management analytics solutions provider, told Private Funds CFO. So, some reflection of public markets volatility is justified, he said.
In fact, the ‘denominator effect’ – where a decline in the value of public market holdings can cause investors to be overallocated to private markets – was in part caused by the ‘smoothness’ of PE NAVs during the great financial crisis, said Belev. Today’s market, in which firms reflect some, but not all, of public market volatility, may represent a mixed blessing.
“In this situation, GPs have the option to adjust valuations closer to the grim reality of the current public markets while having to explain the sharp drop from Q4 2019, or, alternatively, stick to their guns and risk not being able to raise new funds as LPs shrink their commitments in the face of the allocation dislocation,” said Belev. “The additional risk in the second alternative is that when the portfolio companies’ earnings do suffer in the near future, the write-down recognition would occur anyway.”
Private Funds CFO previously reported that CFOs appear to be coming to the consensus that their 31 December 2019 marks will be left untouched by the covid-19 epidemic, and that how to go about 30 March valuations is still up in the air, as the situation rapidly evolves, public markets are still swinging wildly and EBITDAs won’t really be clear until things settle into a new normal. But it is fairly clear that mark-to-market will increase volatility.
The problem is, while regulators don’t like the potential market distortion of the historical cost approach, they don’t like volatility, either.