That time of the cycle again — valuations and benchmarking challenges — GPs and LPs beware of this being a fundraising make or break factor.
Tarang Kumar. 19 July 2022. On behalf of AccelNorth Partners.
Introduction. One of the wonderful things about running your own business is a heightened ability to call a spade a spade. Q2 2022 valuations and benchmarking exercises are going to make or break fundraises this cycle — these are not simply GP back office problems. Here’s why.
Valuations. The last time there was a major cyclical downturn (post-Lehmans), I was working in a Big 4 Valuations team, helping them build their PE valuations practice. When subsequent (smaller) economic cycles have ensued (the impact that the onset of the US-China cold war had on late-stage VC/early stage growth market, for example, might have gone unnoticed by those not playing in that space at the time), I was at an LP/advisor to LPs, scrutinising valuations practices of fund managers.
Here’s what happens leading up to this point in the cycle as it comes to valuations. GPs look at what comparables trading multiples are going at as well as recent precedent transactions. They are scared to mark fully to market in a strong bull market, as they don’t believe that such multiples are sustainable, and they don’t want to ‘overpromise’ their own returns to LPs, in case the market normalises and they need to take a valuation hit later on. The same LPs who want GPs to mark to market ask “so you were being over-optimistic on your valuation last quarter, were you?”. GPs don’t want that, and so build in “liquidity discounts”, ranging from 10% to 30% vs listed peers (the hotter the market gets, the larger the mark-to-market discounts tends to get). (one exception when coming close to fundraising, when many GPs can’t always resist some of their placement agents’ calls of ‘higher, higher!!’ on valuations).
What happens when the market crashes, like it has done in recent months? It no longer makes sense to take the same large liquidity discounts to listed portfolio company peers, argue GPs. The IPEVC (International Private Equity and Venture Capital) Guidelines for valuations clearly state that there needs to be a willing buyer and a willing seller, and we would not be a willing seller at a 30% discount to already discounted public market peers’ valuations, explain GPs down the phone to their academically excited auditors. Also, our company is operationally better than its listed peers, and your valuation doesn’t fairly reflect our control premium, and our ability to influence strong governance at the board level. A game of cat and mouse ensues between GP and auditor, discounts to listed peers may reduce markedly, and the auditor may ultimately agree to an acceptable, yet somewhat negotiated answer ‘within a reasonable range’.
I am not saying that GPs are trying to cheat LPs somehow by massively overvaluing companies at this point in the cycle. To the contrary, they are often trying to backsolve for what they believe is the commercially ‘correct’ answer, as they did when markets were strong by taking those larger discounts.
Some GPs are more technocratic than others, while others are more “commercial”. That’s exactly where the problem lies. The valuation (and therefore benchmarking) comparison becomes even less apples for apples at this point in the cycle, and LPs are even more at a loss on which numbers to believe. Some LPs revalue the portfolio themselves (resource intensive and hard to get spot-on with limited information), while others simply accept this reality, but there is sparse little they can do about it. They hope that if larger LPs are investing into a fund, someone somewhere will have done a revaluation exercise, and life should be fine.
It also brings about game theory — the classical prisoner’s dilemma — amongst GPs. I want to be honest in adopting a pure mark to market approach for my valuations, but hang on, what if I am the only one doing it? Relative returns can quickly drop to third or fourth quartile, and no one wants that…
Note that while I have written this article with buyout GPs in mind, the same broad logic applies to VCs, who generally tend to mark investments to the last external round’s valuation. But as the well-known case of Klarna shows, how reliable is the last round of valuation in this market anyway?
Benchmarks. Speaking of relative returns, the problem for LPs doesn’t end there. LPs look at both absolute and relative returns. We talked about the issues that LPs face when comparing the track record of the GP that they are evaluating vs the benchmark, with limited understanding of the GP’s valuation approach, let alone the valuation approach for all the individual GPs who form the benchmark. (No, the benchmark doesn’t “average out” across a large number of GPs — very few are going to take a hyper conservative approach to valuation vs their listed peer marks in Q2 2022).
The additional issue is going to be the lack of self-reporting. We ran a search on Pitchbook for the 2019 vintage on July 19th 2022, to see what % of European PE GPs were reporting Q1 2022 marks at this point vs older marks. The results are below.
It’ll be interesting to see how quickly these benchmarks update for Q2 2022 numbers, and what the relative %s in the chart shown above look like in 3 months’ time. I suspect an even smaller % will be showing Q2 numbers, but that is just a hunch.
“So what?”. Thanks for the information overload, Taz. I now need a drink. But what’s my take-away? Well, if you are a GP — have a harder think than usual for your Q2 2022 valuations. It could make or break your fundraise, if you are currently in market, or are planning to launch in the next six months. Be pragmatic and honest with your revaluations for the quarter, and be candid and transparent with your current and prospective LPs on how you are conducting your valuations and why your LPs should believe in your portfolio.
LPs, be aware of the issues described in this article. Now more than usual, make sure that your commercial and operational diligence on GPs is strong and holistic, not just focusing on short-term mark-to-market valuations and benchmarks, but make sure that you fundamentally believe in the GP’s market, that the GP’s strategy execution is truly differentiated, the GP’s team is stable and cohesive, and that the GP has shown proof of being a good investor and strong steward of capital over an acceptable period of time. Conduct your reference calls.
AccelNorth Partners is an advisor specialising in the private markets industry. Whether you’re a GP or an LP, reach out to us to discuss your strategic, operational, funding and sourcing challenges. We love to chat! Email us to find out more at info@accelnorthpartners.com. Follow us on Medium — more articles coming this summer.
