The impact of public market dislocations on private markets

September 2022  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2022 Issue

Public markets are mostly rational due to a large collection of intelligent investors who analyse publicly available information as well as their own proprietary data and models. Occasionally, markets can become temporarily irrational due to emotions – mostly fear or greed. This seems to have been a case of the significant declines we saw in the first half of the year, and especially in the second quarter. The correction has been especially hard on unprofitable companies, including many recent initial public offerings (IPOs).

While tough for investors to digest, the selloff is rational and healthy, given the prior run-up and the rising interest rate climate. Since the fundamental performance of companies in major public indices is largely unchanged since the beginning of the year, and certainly since the end of Q1, the correction is primarily a resetting of valuation multiples. Profitable growth has replaced growth at whatever cost. If there was an irrational period, it was more likely in 2021, when public valuation multiples increased significantly.

Markets determine the fundamental value of a public company by estimating future cash flows and discounting them back at a chosen discount rate. When interest rates rise and inflation is high, the discount rate goes up, making the business worth less today, while higher discount rates are used for companies with less certain cash flows.

Even with the declines in equity indices, few public companies we have tracked for many years, if not decades, from their private company days, are trading at what we view as fire sale prices. Some are on the verge of being attractive long-term buys, creating an expectation of an increase in take-private activity by control buyout sponsors. Boards of companies whose stock prices declined precipitously may be more open to these conversations, given the looming presence of unfriendly activists and the challenge of retaining key executives who are sitting on significantly less valuable unvested stock compensation.

Finally, rising interest rates and valuation corrections are creating more debate about the risk of recession in the US and other developed economies. This fear, compounded by concern that the US Federal Reserve’s focus on inflation reduction could limit its ability to counter a slowdown, likely added fuel to the selloff fire. However, an extended economic contraction in the US is unlikely, especially given its ability to supply its own energy needs. Europe’s dependence on Russia for oil and gas puts it at higher risk of recession, possibly a prolonged one. While Europe is working quickly to reduce this reliance, long-term solutions likely involve significant capital investment as well as a delay in near-term climate goals. It remains to be seen how this will play out.

Private vs public market valuations

When public valuation multiples rapidly rise or decline, it stands to reason that private valuation multiples should move similarly. While public and private markets are correlated, private valuations have nearly always adjusted more slowly and more modestly. There are three principal reasons for this.

First, private markets focus on investment cases that typically involve above-market growth and margin expansion over multiple years, making them less reliant on the current public equity valuation environment when valuing businesses. If private companies grow faster than their market, investment cases can withstand some multiple compression from entry to exit. In addition, companies growing faster than the market should command premium multiples. As a result, private market deals are currently getting done at valuation multiples higher than public market multiples. This is common when large dislocations occur, and we expect that to continue in the near term.

Second, valuation policies of private equity and venture capital firms typically involve a combination of methods that are weighted to arrive at a fair market value.

Control buyout sponsors typically use three methods – public comps, private comparable transactions and discounted cash flow models. When public valuation multiples dislocate, control sponsors typically shift their weighting from public comps to discounted cash flows. This makes sense, given multi-year investment cases and the fact that private markets are paying higher valuations than public markets.

Venture capital firms typically use a combination of public comps, private comparable transactions, and the last private financing valuation. When public market valuations rise, venture capital firms often apply discounts, sometimes significant ones, to public comps, and when public valuations fall, those discounts are typically reduced. However, venture capital funds have more variation in their valuation methodologies than buyout firms. So, venture capital fund investors are wise to understand the chosen methodology and assess the appropriateness of valuation marks based on underlying company or fund performance. Regardless, the impact of private market valuation approaches lowers the volatility of private company valuations vs. public valuations.

Finally, the supply and demand of private capital clearly influences private market valuations. On the supply side, private equity and venture capital funds have raised significant amounts of closed-end fund capital over the past two years. In addition, private credit funds and business development companies have grown in popularity and size. This means there is a material supply of capital that has a ticking clock to be invested.

On the demand side, the volume of companies entering fundraising or sale processes typically declines when public markets are highly volatile. The combination of these two factors will likely cause a slowdown in near-term demand relative to the supply of capital, which helps put a floor on valuations that will likely be higher than public market valuations. This should be especially true in leveraged buyout transactions where purchase prices are based on cash flows rather than revenue, and purchase prices are funded in part with relatively low-cost debt.

Potential challenges

A recent area of concern has been late-stage, pre-IPO tech investing. This section of the market is usually rational, with investors conducting significant fundamental diligence, making realistic assessments of terminal value, and joining boards to help management teams to scale the business. But it has often become irrational when public tech valuations have risen rapidly. ‘Casual tourists’ with fear of missing out have appeared and taken a rapid share of the pre-IPO market, acting like undisciplined traders instead of investors. During the internet bubble, hedge funds and mutual funds stampeded into pre-revenue private internet companies at significantly inflated prices, hoping for higher valuations at IPO. The high private valuations encouraged tech CEOs to raise and spend huge sums of money. While the strategy worked briefly, it ended in disaster when public markets corrected. The casual tourists exited with terrible returns, leaving private tech CEOs to aggressively cut staff and spending.

The phenomenon returned in the past few years. As public tech valuations inflated rapidly, numerous hedge funds and corporations raised and quickly deployed tens of billions of dollars into high-growth pre-IPO tech companies. This speedy deployment may have resulted in firms often neglecting fundamental diligence, overestimating terminal value, and overlooking important governance rights and investor protections. This reached a fever pitch in 2021, with one prominent hedge fund investing in a new deal every two days – 180-plus investments a year – paying 100 to 200 times revenue vs. already historically inflated public multiples of 20-35 times. Since we had seen this before, we expected it to end poorly. The recent public market correction effectively closed the IPO window and rapidly adjusted public tech multiples to pre-coronavirus (COVID-19) long-term averages. The casual tourists are now taking massive write-downs and are exiting the market, leaving CEOs to adjust spending and private fundraising plans.

While venture portfolios may benefit from the cheap capital these tourists provide, their retrenchment is healthy, bringing discipline to valuations, fundraising, burn rates and governance.

Future investment opportunities

Market dislocations highlight the importance of experience in private market investing. Investors who have worked through numerous market cycles are less likely to be paralysed by emotion and fear when they see large declines in liquid markets. They are likely to remain calm, dust off their dislocation playbooks from 2001 and 2008, and begin proactively targeting great deal opportunities.

Fear, illiquidity and asset allocation constraints have tended to lead to terrific buying opportunities in times of dislocation. In private markets, these typically have appeared first in the secondary market as liquidity constrained and overallocated limited partners (LPs) begin to sell private equity holdings. The opportunities historically then quickly begin appearing in other sectors of the market, such as growth equity, co-investment, and private credit businesses.

Finally, a word on asset allocation: when public markets dislocate, some LPs become overallocated to private markets, since moves in the latter typically lag and are more muted. An unintended consequence is that some LPs stop making new private market commitments or sell their best assets into the secondary market. These actions often cause LPs to miss out on some of the best vintage years in the history of private markets.

During periods of volatility, many sophisticated institutional LPs temporarily increase their private market allocation target or reduce (rather than eliminate) new private markets commitments to ensure consistent vintage year exposure. History shows that this can produce better long-term returns than attempting to time the market during periods of volatility by selling private markets holdings to remain within allocation targets or by reducing commitments to current vintages before restoring them in subsequent years. This is an unintended market timing bet, which investors seeking consistent long-term investment returns should avoid.

 

Jeffrey Diehl is a managing partner and head of investments at Adams Street Partners.

© Financier Worldwide

BY

Jeffrey Diehl

Adams Street Partners

©2001-2024 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.