In a falling NAV environment, buyers are often guessing where NAV will be the following quarter and it can paralyse some market participants.
Most secondaries professionals I’ve spoken to recently are expecting third quarter net asset values – or ‘September NAVs’ in industry parlance – to drop. By how much they’ll drop is the big question.
Some are guessing September NAVs will be down somewhere between 5 and 10 percent, but no one really knows.
Stock market volatility over the past month or so is the main reason why NAVs are expected to drop, given the mark-to-market ‘fair value’ accounting rules with which many managers must comply. Since the introduction of US accounting rule FAS 157 (now ASC 820), NAVs have been increasingly dependent on public equities’ valuations.
“Because of FAS 157, people mark their books with a standard market comp model,” one advisor in New York told me. “When they see volatility, depending on how high and how long volatility lasts, they’ll have to start marking down their portfolios and eventually it will have an impact on NAVs. The change to FAS 157 has made private equity portfolios more volatile and more correlated to public markets.”
NAVs have also become more sensitive to volatility in the public market because an increasing number of funds have exposure to publicly-traded companies that they have not fully exited. This is mainly a result of the global financial crisis lengthening the time to exit. One secondaries investor noted that some tail-end funds can have as much as a 40 percent exposure to public equities.
The expectation of lower NAVs is already being felt in terms of discounts.
Secondaries buyers are still basing their offers on June NAVs, which are likely inflated compared to where NAVs must be today, so to make sure they aren’t overpaying, they are increasing the discount to NAV they are willing to pay.
“Pricing is starting to soften,” said one secondaries buyer in New York. “Volatility is very difficult for secondaries.”
He explained that the secondaries market operates well in a rising NAV environment, because buyers can easily book a gain from one quarter to the next just because NAVs went up.
“If it’s a liquid private equity market and you have rising NAVs, you can also apply leverage and produce returns without having to call capital,” he added. But in a falling NAV environment, you’re merely guessing where NAV will be the following quarter and it can paralyse some players. Just look at the market in 2009, there were hardly any transactions and the market stalled.
We’re far from being in the same situation as ‘09, but some sources are acknowledging a slowdown may start to happen.
“People are less likely to transact,” another advisory firm told me. Buyers may still want to go ahead with a deal, but at a wider discount. Sellers, in response, are likely withdraw or postpone their offering rather than sell at a greater discount.
“There are very few sellers that are liquidity-constrained,” said the advisor. “Most are tactical. As a result, they are more sensitive to pricing. They want to wait and see if the market improves.”
The aforementioned buyer told me he thinks that from a purely human and psychological standpoint, it’s difficult for sellers to dispose assets at more than a 20 percent discount, unless they’re in a distressed situation. So they might as well wait until NAVs are adjusted to reality and discounts aren’t as big.
The secondaries market will have to wait a little longer to find out where exactly 30 September NAVs will stand though, given they typically come out in October and November. Until then, watch this space and expect more pre-emptive discounts.
Do you think September NAVs will be down? By how much? Send me your thoughts at email@example.com.