If we are to believe some headlines in the financial press, private equity managers are burying their heads in the sand and refusing to write down their portfolios. I believe this opinion is based on a lack of understanding as to how high-quality private equity managers value their portfolios. Private equity valuations don’t behave like levered listed equity, as many assume.

As for our opening question, there isn’t a quick and easy answer, so let me try to explain.

Portfolio valuations underpinned by strong governance

Firstly, there’s strong governance surrounding modern, institutional-grade private equity managers. This negates the idea that managers can simply refuse to mark down their portfolios. All the private equity managers in APEO revalue their portfolios on a bottom-up basis every quarter. They do so in line with International Private Equity and Venture Capital Valuation (IPEV) guidelines, International Financial Reporting Standards, and US General Accepted Accounting Principles (GAAP) accounting standards. All the Trust’s investments are audited at least annually at the underlying level. Furthermore, APEO’s auditors annually assess the valuations of a sample of the largest positions in its book and both APEO’s Manager and Audit Committee scrutinise the valuations on a quarterly basis. What this shows is that scrutiny of these valuations is multi-layered.

It’s also worth noting that private equity funds typically charge management fees on commitments and cost, not on value. Their carried interest, the equivalent of a performance fee, is paid only on cash received from the realisation of investments. There is little incentive for a high-performing private equity manager to aggressively value their unrealised portfolio. In fact, the market has grown so accustomed to private equity managers selling companies at an uplift to unrealised valuation, that it is now expected and a market norm (more on that later).

Valuations backed by strong earnings growth

APEO is principally focused on the European mid-market buyout segment of private equity. Here, the majority of companies tend to be profitable, cash-generative businesses. Therefore, valuations are mainly based on earnings or, to be more accurate, EBITDA (earnings before interest, tax, depreciation and amortisation). EBITDA in APEO’s portfolio grew in the financial year to 30 September 2022. For example, the portfolio’s top 50 underlying companies (which equate to around 42% of the portfolio value), grew EBITDA by 24% on average during the 12 months.

Why were these businesses and portfolios still growing against this more difficult backdrop? There is undoubtedly some hangover from the global pandemic in the comparative 2021 numbers. However, I believe this strong growth is principally because private equity buyout managers changed their focus following the chastening experience of the global financial crisis.

The buyout managers we back have become more focused on market-leading, non-discretionary businesses in resilient markets. Crucially, these have pricing power. We've increased exposure to ‘mission-critical’ businesses in technology, B2B (business-to-business) services and healthcare sectors in our private equity portfolios in the last 10 years. This is at the expense of the cyclical old stomping grounds of consumer discretionary (such as traditional retailers and casual dining roll-ups) and industrials (for example, chemicals or manufacturers). As an illustration, APEO increased healthcare sector exposure from 6% in 2012 to 20% at the end of financial year 2022.

Private equity managers are also much better at buying, creating value, and supporting their portfolio companies than they were a decade ago. Today they typically have operational experts on the payroll to help identify and accelerate portfolio company organic growth, while buy-and-build strategies tend to be a bigger part of their investment plans. The modern-day buyout manager takes full advantage of the governance model of private equity. This involves majority control of the portfolio companies (or at least significant minority investment), as well as setting and implementing strategic direction. Gone are the days of passive investment and relying on financial engineering; those types of private equity managers would not survive today.

A question of multiples – comparing listed and private markets

So, earnings in general have grown. But, with the decline in public markets and higher interest and discount rates, multiples applied to earnings must have declined? In short, yes – but not to the same extent as public markets. And the reason why requires some explanation.

In their bottom-up quarterly revaluations, the APEO portfolio private equity managers typically use a basket of both publicly listed and transaction comparables to derive an overall multiple that they can apply to a portfolio company’s earnings. This has been the case for as long as I have been working in private equity, so there is a consistency in valuation approach. However, both listed and transaction comparables have advantages and flaws.

Firstly, listed comparables are marked to market at the date of valuation, which is clearly optimal. That said, these listed companies are often much larger in size, and growth can be much lower than the private company being valued. Sometimes the sub-sector isn’t a perfect match either. For example, how do you value a small, private conversational-AI technology company today using only public market comparables?

On the other hand, transaction comparables are often private transactions of similarly sized companies with similar growth trajectories, and so a more relevant way to value a private company. Nonetheless, transaction multiples are not at a uniform point in time like listed comparables and are based over a longer period. One needs to consider whether present-day market conditions are incorporated into this basket and therefore what timeframe should be used.

These advantages and imperfections mean private equity firms typically opt to use a mix, which has implications for the correlation between private equity and public equity. This is further exacerbated by the fact that private equity managers tend to apply an illiquidity discount to the basket of listed comparables. Hence, private equity and public equity are correlated but not as closely as one would immediately think. Our research suggests European private equity and the MSCI Europe are 0.57 correlated, based on data since 20001. 

Uplift upon exit

This ‘buffer’ in private equity buyout valuations is exemplified by the typical uplift in valuation once a private equity-backed company is finally sold. Our experience with APEO is that when a private equity manager exited a portfolio company in the last 10 years, it did so at an average uplift of around 25% to the unrealised valuation two quarters before. Furthermore, Bain & Co calculated that over 70% of private equity exits between 2012 and 2022 were at an uplift to the valuation a quarter prior2.

This raises the question of whether private equity valuations remain conservative and if managers can maintain the historic uplift upon exit in the current environment. Frankly, that has yet to be tested at any sort of scale, given the relatively low exit activity we’ve seen in the private equity market since the middle of 2022. That said, there are positive initial signs, with managers in APEO’s portfolio like Hg (Medifox, Transporeon), Nordic Capital (Binding Site) and CVC (April) selling portfolio companies at material uplifts to unrealised valuations following the start of war in Ukraine and interest rate rises.

It could be argued, however, that the natural and expected uplift buffer in private equity portfolio valuation (as outlined above) has been eroded, rather than the underlying valuations themselves.

Summary

In our view, most of private equity buyout managers have been conservative in valuing their portfolios over the last decade; they didn't value all the way up with public markets and so the portfolio valuations had less distance to fall. That is best evidenced by the uplift upon exit seen when managers sold a portfolio company in the last decade.

Following the declines in public markets during 2022, there is a valid question around whether private equity valuations remain as conservative today. It might be the case that the uplift upon exit in private equity could moderate somewhat in the future, although we've not seen any evidence of that so far.

Can we trust current private equity valuations? We strongly believe that we can. This creates an opportunity for investors, given the wide share-price discounts to NAV (net asset value) we currently see in listed private equity investment trusts like APEO.

1.      abrdn, Private equity as an investment portfolio diversifier

2.     Bain & Company, Global Private Equity Report 2023