Private markets myth-busting: Valuing private businesses

While private equity holdings are not valued in the same way as public companies, there are several different ways to arrive at an accurate valuation picture. James Lowe talks to Citywire Wealth Manager about the different approaches.

Institutions have so far been the main investors in private equity (PE) partly because of their greater ability to accept the long lockups and high minimum investments demanded by a limited partnership (LP). In the UK, wealth manager and retail clients have gained exposure via investment trusts. Today, new ‘semi-liquid’ fund structures mean that private investors have wider options for getting exposure to an asset class that has, over the past decade, helped to add outperformance and diversification to portfolios.

Public markets shrinking – are investors missing out?

Another important driver fuelling the PE market is the growing trend for companies to stay private, meaning that, in effect, public markets are shrinking. This year saw a net reduction of $120 billion in public equities, surpassing last year’s $40 billion shrinkage and marking the third consecutive year of decline, according to JP Morgan analysts. This is part of a long-term trend. Between 1996 and 2023, the number of companies listed on the main market of the London Stock Exchange dropped by 60%, while in the US it fell 40%. Today, fewer than 15% of US companies with revenue above $100 milliom are listed on the stock market, meaning that most savers are missing out on a broad spectrum of growth opportunities.

Understanding PE valuations

Spurred by the growing interest in private assets in the UK, the FCA is conducting a review of private market valuations. Part of the focus will be on accountability for valuation practices within firms, and governance of valuation committees. But it also addresses valuation methods. As the law firm Reed Smith said in a briefing note, a key driver of the review is likely to include the fact that ‘valuations of privately held investments are subjective because of their illiquid nature and lack of secondary market, meaning there is no single valuation technique.’ In other words: public equities are priced every day by the market, based on supply and demand. Without an open market, how can private companies be valued?

The valuation techniques used by PE providers fall into three broad categories, which are often used in combination:

  • Market approach – Utilises market prices of comparable public companies, as well as acquisitions and significant financing events of comparable private companies. Various valuation metrics can be used including valuation relative to Ebitda, Ebit, net income, revenue or book value. [Schroders Capital, Q2 2024]

  • Income approach – Utilises expected cash flows discounted to a present value using an expected rate of return that represents the time value of money and the incremental risk of the specific investment. The income approach for valuing an investment is primarily applied when an investment is expected to generate multiple cash flows.

  • Milestone approach – Valuations are based on achievement of past milestones, and probabilities of meeting future milestones. Usually used for companies that won’t generate income or cash flows any time soon – often seed, start-up or early-stage events.

The PE mindset: Learning from the institutional approach

In the absence of an open market, valuations can’t always be proven to be exact. However, PE providers argue that these methods, based on the fundamentals of a company and used in accordance with rigorous accounting standards, give an accurate picture. They also note that public equity prices are often not efficient, because they are driven by investor sentiment as well as fundamentals.

A related point is that, because PE holdings are valued at longer intervals – typically monthly or quarterly – they tend not to be subject to the short-term swings in sentiment that often affect public market prices. This means they are typically less volatile.

Investors who choose the greater liquidity of listed investment trusts to get PE exposure take on a higher degree of public market volatility, because of the daily price volatility that comes from being traded on an exchange. This is often evident in the discount to net asset value.

A ‘non-public markets’ mindset can help to maximise the efficiency of PE allocations within portfolios, according to James Lowe, sales director of private assets and investment trusts at Schroders.

‘When I speak to investors I emphasise that understanding each manager’s valuation methodology, processes, governance, and available resources is certainly very important,’ Lowe says. ‘In our PE open-ended evergreen strategies we operate in line with accounting standards such as US GAAP and IFRS 13, valuations are audited by three of the big four audit firms at varying dates, and are regularly reviewed by our own internal private assets pricing committee and group pricing committee. Schroders Capital has invested significantly in our valuation team and processes in recent years. This has been a crucial part of being able to successfully manage our semi-liquid PE strategies.’

But to focus too much on short-term valuations is to employ an implicitly public-markets mindset, Lowe believes: ‘That is not, in our view, the most effective way to use private equity in a wider portfolio.’

Lowe recommends learning from the model that institutions have used successfully for many years: implementing PE positions as part of a strategic, long-term asset allocation plan. The discipline of a strategic asset allocation gains even more importance when investing in PE vehicles that allow investors the flexibility to trade at regular intervals.

‘Investment trusts, semi-liquid funds and LPs are all useful structures with differing merits. But whichever one investors decide to use, our advice is to consider a PE allocation as one with a long-term time horizon,’ Lowe explained.

‘We believe that is the best way to benefit from PE’s return premia, which often stem from illiquidity, complex situations and the rare skills needed to operate in this area – as well as its ability to smooth overall returns by mitigating exposure to public equity market beta.’

Source: Citywire Wealth Manager