Private Assets – Opportunity or Trap?
Linchpin looks at whether Private Assets today are an opportunity or a trap
At a recent investment conference, a respected CIO answered a question on private asset valuations in four words: ‘everything is for sale.’ His implication was that current NAVs have not been cleared through the market and are therefore overstated. On the other hand, even if we disregard the Government’s push to encourage pension funds into private equity, both companies raising capital and investors are using private markets more.
Are illiquid private markets today an opportunity or a trap? We can see lots of evidence of the gap between asking prices and the prices buyers are prepared to pay: examples are the discounts which listed infrastructure and private equity investment trusts are trading at, the slow pace of real estate transactions, and the sums being raised by secondary funds hoping to exploit opportunities. Against that, the level of discounts is becoming very tempting.
Investors are sceptical about valuations
First, I look at valuations. There are three main reasons why investors are sceptical about published NAVs. The first is to do with the operating performance of the underlying companies: concern that higher rates for longer will tip the western world into recession and earnings will disappoint. At Linchpin we are significantly more positive about the outlook than the consensus. Our underlying reason is that governments and central banks will react to major problems by using their balance sheets to resume a form of QE. However, we accept there are plenty of extraneous factors which could upset our calculations, for both geo-political and just political reasons.
The second is financial: the outlook for long bond yields, used to value future cashflows, is particularly uncertain. I think there are two good reasons for expecting further rises in the short-term. Investors are beginning to realise how fiscally incontinent the United States is; and the term premium, although it has risen in the last few months, is still substantially negative.
On the other hand, governments cannot afford to let bond yields rise too far because of the increasing cost of debt service payments. They always have the levers of QE or financial repression to hand to keep yields down. In the longer-term I suspect there will therefore be a cap to bond yield rises.
The recent downgrade of U.S. credit may also have long-term consequences for valuations. Long-term Treasuries have been used as the risk-free asset by all financial theory for over 50 years. But with the U.S’s level of financial debt forecast to rise to 200% of GDP by 2048, they can hardly be considered risk-free any more. And if they are being held down deliberately, maybe financial theory will have to be re-engineered to induce a higher risk premium (or use a different asset as risk-free).
Private Equity managers are using secondary transactions to get liquidity
The third is to do with governance: in normal times private equity valuations are validated by exit prices, whether IPOs or trade sales. However, one consequence of the freezing in equity market liquidity has been a slow-down in exits.
In the absence of exits, valuations are inevitably more subjective, whether the discount rate used to value future cashflows or independent valuers’ estimates of real estate. Some listed vehicles have gone down the route of deliberately selling an asset with the aim of proving to their investors that their NAVS are robust.
Another important consequence of the lack of exits is delays in distributions to investors. General Partners do not wish to sell assets at heavy discounts (as they see it) as their funds approach the end of their lives because it reduces their returns. So they are using secondary transactions to transfer their best assets to new fund series while distributing some cash back to investors.
From the existing investors’ perspective, this gives them some cashflow, which is after all their primary motivation for investing in private equity. However, the concept of new investors paying existing ones out bears some resemblance to a Ponzi scheme. It all depends at what level the NAV is struck. I would argue that if it is not tested in the market, then it is open to manipulation. Which is why this is at heart a governance issue.
Valuations sustained but operating earnings down?
The essential metric, as ever, is the path of interest rates and bond yields. If you believe that recession lies ahead, then rates and bond yields probably come down, which will both reduce the cost of leverage and sustain discounted cash-flow models. On the other hand, exits will continue to be difficult and earnings will in aggregate disappoint. Under this scenario I would suggest that valuations are probably, subject to the governance question above, about right.
Or earnings sustained, but valuations down?
If, on the other hand, you believe like we do, that the most probable scenario is one of higher bond yields, at least in the short-term, and continuing high interest rates but no recession, then we have better fundamentals but lower valuations. There is then a political question whether governments would engage in some further form of financial repression because of the problems which high interest rates causes to their budgets.
If they do, we might in fact see bond yields start to fall at the same time as earnings estimates are sustained. In which case investors will be more relaxed about owning long duration assets such as private equity and infrastructure. However, in this case, there is reliance on the Government being willing in some way to suppress bond yields, which is not in itself a comfortable place for investors.
Good governance is the key to confidence in valuations
We don’t disagree with our respected CIO’s view that everything is for sale. The question is at what price? And here we have more confidence in today’s NAVs than he does. Our worries are more about the governance issues around GP led secondary transactions on the one hand, and on the reliance on political decision-making on the other.