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The low interest rate era is over and with it the intoxicating upward pricing cycle it supported. Regulators on both sides of the Atlantic are worried that has left valuations for private assets high, dry and hard to justify.
Financial distress could ensue. The UK’s Financial Conduct Authority is therefore planning a review of private valuation practices, following the lead of the US Securities and Exchange Commission.
There is a glaring problem with leaving dealmakers, rather than markets, in charge of asset valuations. They have good economic reasons to be biased.
Many alternative asset managers therefore rope in external valuers. These have their own cognitive quirks but are better than nothing. They are active in private credit, infrastructure and real estate investments across Europe. But many private equity managers here remain firm in their use of internal valuations, in contrast to industry practice in the US.
However, the US tech industry has nothing to learn from Europe when it comes to justifying steep numbers for corporate assets. One popular gambit is to sell relatively small lines of stock, which therefore enjoy scarcity value, to underpin a high total valuation.
ChatGPT developer OpenAI is undoubtedly the world’s hottest private stock, until the next one comes along. But it is questionable whether a secondary placing of a few hundred million dollars worth of shares would reliably underpin a $90bn total valuation as reports have suggested.
Some buyout specialists argue private assets should be valued on discounted cash flows, not mark to market. But the value of markets in price discovery is hard to gainsay.
In the first three-quarters of 2022, public markets lost 29 per cent while buyout fund valuations barely budged. However, steep discounts were apparent in secondary sales of stakes in buyout portfolio companies of 30 to 40 per cent of net asset value, noted Cameron Joyce, senior vice-president at Preqin, a data business.
Discounts have now narrowed again, to the relief of private equity groups.
The FCA and SEC can curb the numerical exuberance of deal-doers by stressing the utility of conservative independent valuations that reflect market realities. There are good prudential reasons for doing so. Debt covenants may reflect portfolio valuations as well as supposed earnings capacity. At present, there is a dangerous temptation to create hidden leverage by inflating both figures.
The Lex team is interested in hearing more from readers. Please tell us what you think of the debate over private asset values in the comments section below
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