It is generally understood that the performance of public markets is one of the most, if not the most, important drivers of private market returns.
At the most basic level there is a kind of ‘law of one price’, which one would expect to operate in any reasonably efficient and deregulated market. Whether public or private, similar financial claims ought to trade at the same price when all risk premia, liquidity, convenience and other factors are taken into account.
In principle, the value of an investment is determined by discounted cashflows, and indeed most private valuations will be based at least partly on a DCF model. However, even within the context of such a model, the choice of discount rate includes a risk premium, which needs to be broadly consistent with the valuation of public markets.
In most cases, valuation advisers will ‘sanity check’ any DCF model against a peer group of quoted comparators. If the value of publicly quoted investments has moved by 10 percent over a period, this should be the starting point for assessing the change in the valuation of a private investment.
However, putting together a peer valuation table is an art rather than a science. It is unusual to find a quoted company whose share price is an exact match for a given private equity asset. It is common for them to be sufficiently different from one another to make the calculation of “average” valuation multiples far from straightforward. The only way of solving this problem is to bring in a considerable amount of subjective judgement.
Some of the issues in establishing valuations are intrinsic to the process. Buyouts will, as a matter of course, have more leverage than non-buyout companies in the same industry and are more likely to be affected by restructuring costs. Venture capital investments are likely to be difficult to value in comparison with mature quoted companies, even those which are a good match in terms of industry sector and geography.
Even in ideal conditions, the flexibility of interpretation inherent to the valuation process is likely to be procyclical with respect to public markets. When the stock market is going up, adjustments tend to err on the side of generosity, and vice versa in a bear market. There can be a triple effect on secondary transaction prices: as the price of peers in the comp table rises or falls, the discounts and other ‘fudge factors’ move in the same direction, exaggerating the effect on NAV. The discount to NAV may itself overreact in both directions.
Offsetting this, there is a tendency on the part of valuation advisers to ‘smooth’ valuations. Advisers are understandably reluctant, in the absence of substantial fundamental news-flow, to say that the value of an asset has changed by a large amount since the last time they reviewed it. To do so would undermine the credibility of the valuation process and lead to accusations of ‘simply following the market’.
This means that during periods when public markets are moving quickly in either direction, private market NAVs will tend to lag, underperforming rising markets and outperforming falling markets. A clear example of this tendency was in March 2020, when stock markets fell very rapidly in the early stages of the covid-19 pandemic. For the most part, private asset NAVs did not fall anything like as quickly.
So what drives value?
In our view, there are three elements which go into a valuation: the normalised cashflow, the capitalisation multiple and the premium/discount.
Of these three elements, the first is specific to each asset. It depends on the intrinsic capacity of the asset to generate cash, plus whatever operational or financial synergies and improvements can be created.
The capitalisation factor could be an earnings multiple, or it could be the output of a DCF model, but it is likely to be heavily influenced by the valuation of public markets.
The premium/discount to NAV also has some degree of cyclicality to it. It reflects the balance of supply and demand, and the liquidity position of the vendor, but also optimism or pessimism on the part of buyers above and beyond what is reflected in the NAV.
The question of which is the most important driver of valuation gains and losses will therefore be determined by which of the three elements is likely to show most variation.
Our assessment is that secondaries prices are loosely coupled to public markets. During long periods of steady market falls or rises, there may be periods of outperformance and underperformance due to the procyclical revision of valuation multiples. But this is a consequence of the fact that the NAV adjustment process is inherently backward looking, which benefits the investor as it creates an implicit volatility hedge.
When considering an individual transaction, however, we would emphasise the importance of information asymmetry and arbitrage opportunities. Knowing the dynamics of the NAV adjustment process allows investors to focus attention on the appropriate discount or premium. The fact that the average secondary market transaction takes place at a discount to NAV suggests that in the typical deal, the vendor is either paying a price for immediacy, exploiting an information advantage, or a combination of the two.
Informed purchasers can use their knowledge of the relationship between private and public valuations to assess the extent to which they are receiving this liquidity premium and acquiring an asset for a discount to its equilibrium value.
The secondaries advisory team at Swiss inter-dealer broker Tradition is led by head of private markets Dan Nolan. This is an extract from the first in a series of whitepapers aimed at LPs that are new to the secondaries market. The full version can be found here