What's in store for private equity valuations?

Is the current valuation of private equity investment companies justified? At many of these funds, the shares currently trade on discounts to the underlying assets of 20, 30 or even 40 per cent. Those are big numbers, even in the context of the market volatility we have seen this year.

Now, private equity funds often do trade at chunky discounts when investors are in downbeat mode. There are essentially two reasons for this. First, unlike funds invested in listed equities, where you can see the value of the underlying assets each day very clearly, private equity fund holdings are more opaque, with valuations updated quarterly or even more seldom. During tough times, investors naturally worry there may be a shock around the corner.

The second reason to mark these funds down is the nature of their investments. Some invest in earlier-stage businesses that may find it harder to cope with economic shocks. Others invest in more mature companies, but with high levels of leverage. If you expect bad economic news, therefore, it is reasonable to worry about the prospects for these businesses.

Still, the discounts at which some private equity funds currently trade really do seem to be obsessing on such concerns. Do we really think, for example, that the portfolio of Pantheon International, one of the sector’s longest-established funds, is worth more than 40 per cent less than its current net asset value suggests? That is what the mid-August share price discount implies. Other funds are trading on even more lowly valuations.

One investment trust analyst that questions these discounts is Kepler. In a recent note on the sector, it posited two reasons to think that the current level of pessimism is overdone.

First, Kepler points out, the evidence that valuation shocks are imminent is pretty sparse. On the contrary, private equity funds making disposals this year have typically sold holdings at a healthy premium to the valuations marked in their portfolios. Funds are, of course, naturally inclined to sell at a time when they can realise a decent profit, so this evidence is not conclusive (maybe they’re holding on to loss-making holdings). But valuations do appear to be holding up more strongly than the market believes – partly, no doubt, because most funds value their portfolios relatively conservatively.

Kepler’s second argument is that earnings fears may be overblown too. The analyst accepts that some portfolios may be vulnerable – and that many of these investee companies have not been tested in a recessionary period – but it also points out that private equity managers have been planning ahead, focusing on more defensive investments in recent times. Fund reports published in recent months do not show any sign of sustained earnings declines from portfolio holdings.

All of which is to say that the current valuation of listed private equity investment companies may be seen by some as an opportunity. There are good reasons to build some exposure to private equity into a well-diversified long-term investment portfolio – not least, the potential for outsized returns – so this could be the moment to consider doing so.

More broadly, it’s worth pointing out that the possibility of discounts of the type we are currently seeing is the price you pay for access to a sector that is otherwise off-limits to most investors. These investment companies offer daily dealing in their shares, with no minimum investment, which provides ordinary investors with a route into an asset class that normally requires a long lock-in period and a huge lump sum upfront. The stock market listing provides liquidity in an illiquid asset class – but the downside is that sometimes, the shares get dramatically out of alignment with the value of the underlying portfolio.