Private Equity is an asset class that has garnered increased interest from institutional and accredited investors since the Financial Crisis, with Pension Funds and Family Offices demonstrating especial keenness. The driving force for the fervor is that PE investors are attracted to investment premiums for assuming PE’s poor liquidity and reduced degree of single asset transparency. Investors are also attracted to the perception of PE’s lower level of pricing volatility. In this article we explore some of the valuation shortcomings that investors are exposed to when owning Private Equity funds.
GPs Want to Value Assets as High as Possible
When a Private Equity fund is recently established it can contain a large component of portfolio assets whose valuations are unrealized. When placing a quarter-end value on such unrealized assets, the General Partner (« GPs ») typically uses valuation techniques that adhere to certain industry guidelines that offer a great degree of flexibility. This self-assessment practice opens investors up to the possibility that GPs will utilize high comparable multiples that contribute to increasing the fund’s overall valuation. The GP is motivated to do so because the higher the portfolio’s asset size, the greater will be the size of the GP’s compensation that is derived from management fees.
LPs Have Trouble Identifying Source of Performance
When acquiring an investment in a PE Fund, Limited Partners (« LPs ») must accept the lack of transparency in performance. For instance, return calculations are not provided at the investment level. As such, the LP cannot identify the sources of returns, thus rendering the manager evaluation of skill or luck to a mere a guessing exercise. LPs have no way of objectively assessing as to whether GP performance explanations yield truth or fiction. LPs must make certain to assess whether they are being properly compensated in exchange for PE Fund’s investment performance transparency being stacked in the GP’s favor.
GPs Are Often Structured With Poor Valuation Controls
GPs often perform portfolio asset valuation internally which can yield poor policies, procedures and controls. Valuation policies are often structured to allow for too much flexibility, which can lead to artificially high net asset values (NAVs) and misleading internal rates of return (IRRs). The GPs’ valuation discretion can also produce a lack of consistency in valuation among different investments. Furthermore, the absence of an independent, third-party valuation agent makes it difficult to confirm valuation accuracy. Even then, some independent evaluators lack expertise at pricing hard-to-value assets. To top it all off, it is not common practice to have a valuation committee as part of a GP’s corporate governance program.
The first step towards working in investors’ best interest of is to adopt best practices. The CFA Institute has developed standards referred to as he Global Investment Performance Standards (GIPS) that provide guidance to properly value Private Equity investments. It is very unlikely that GPs will adopt GIPS on their own. Moreover, regulators are likely to lack the necessary courage to make GIPS a requirement any time soon. Henceforth, we propose that institutional and accredited investors band together and demand adherence to GIPS. Walking away from non-GIPS PE funds will eventually get the message across. Eventually, GPs will be looking to check the GIPS box to satisfy investor needs. If GIPS is implemented across PE firms and on a broad basis, this enhanced integrity would benefit all stakeholders. That is something worth striving to achieve and there is no better time than the present to set the wheels in motion.Version PDF