When write-downs have upside

Private equity fund managers marking their investments to market may be doing their over-allocated LPs a muchneeded favour

Deal activity in private equity has ground to a near total standstill, but don't expect general partners to be booking extended holidays. For the most part, they are busy. They are helping portfolio companies prepare for a potentially long and nasty economic downturn. They are also having to think hard about revaluing their holdings. For many portfolio companies, the trading outlook for 2009 has substantially worsened in recent weeks, and for general partners responsible for these companies and committed to mark-to-market accounting rules, sharp reductions in interim valuations are now a likely prospect.

There is no knowing by how much general partner positions will be marked down in the coming months – and whether the industry will take a consistent approach. There is still no common valuation methodology in place for private equity, and existing valuation guidelines, such as the ones produced by the European Private Equity and Venture Capital Association (EVCA), leave ample roomfor interpretation and case-by-case judgment. (See following page for a discussion on how ambiguity on accounting rules continues to preoccupy the asset class.)

Suffice it to say that the idea of applying fair value accounting principles to interim valuations in private equity is far from universally popular among industry insiders. What is the point of revaluing my investment periodically when I intend to hold on to it for several reporting periods still to come, unreformed sceptics (or sound pragmatists depending on your point of view) – will ask.

But regardless of how much resistance to marking-to-market among GPs there may still be: those managers who do follow fair-value rules closely will likely have to show big downward corrections in their next valuation report. With public market comparables in sharp decline and corporate earnings expected to weaken as well, purchase price multiples are already contracting rapidly.

For GPs who bought businesses at full prices just before the credit crunch, the consequences will bematerial. Imagine a portfolio of assets purchased at an averagemultiple of 9.5 times earnings, then assume that the financial crisis has already taken out two turns; assuming further (optimistically) that earnings have remained flat, that's a 25 percent reduction in net asset value (NAV) right there.

This is back-of-the-envelope stuff and may seem crude. However, a look at recent news coming out of the listed funds segment of the asset class suggests it is entirely within the bounds of realism. Take KPE for instance, Kohlberg Kravis Roberts's troubled Euronext vehicle that started life just over two years ago with $5 billion in freshly raised capital. In November, KKR said KPE's NAV had dropped to $3.9 billion, down nearly $640 million in the third quarter as a result of fair value write-downs. Given that KPE is a co-investor in deals sponsored by KKR's private funds this gives a clear indication of the firm's current stance on valuations across the board.

And KKR is not alone in having to revalue its positions. The firm's experience can be seen as a reasonably accurate reflection of the crisis-induced pain the whole asset class is feeling at the moment. This doesn't add up to a pretty picture – except that if you are a limited partner, interim write-downs of your private equity positions might be exactly what you need right now.

Limited partners the world over are currently feeling the grip of the so-called denominator effect around their necks: when publicly traded securities in a diversified investment portfolio decline in value but the non-listed ones do not, the latter rise as a percentage of total assets, and the investor ends up violating allocation targets. Right now over-allocation to private equity as a result of the recent public market decimation is a widespread problem in the LP universe. In extreme cases, the denominator effect may trigger sales of private equity assets in the secondary market at fire-sale prices.

Unless, of course, the investor has the flexibility to wait for fair value-driven write-downs of the private equity assets that will help restore the portfolio's original balance. In other words, relief can come frommarket-driven changes to the numerator that will make the problem go away, at least to a degree.

A falling tide sinks all boats, and in the extreme circumstances facing the financial world at the moment, therein lies some good news for LPs. For many of them, the denominator problem is a real problem at the moment. But in a perverse way, GPs marking their deals to market may be part of the solution.