The Economist follows up on a theme we have featured twice in 3L&3S this year (see here and here) – how unlike public equities which have been marked down by the market this year, private assets have been stable or atleast based on one report seem to have appreciated this year.

“A huge gap between the valuations of publicly listed companies and their unlisted peers’ has opened in 2022. Lincoln International, a bank, reckons the enterprise value of firms held by private-equity funds globally rose 1.9% in the third quarter, leaving them up 3.2% for the year to date. The s&p 500, by contrast, fell 22.3% in the same period.

That is a relief to many institutional investors, such as pension funds, who cannot afford big losses. In the past decade they have splurged trillions of dollars on private assets. Soon these could also be found in greater volumes in 401k plans, America’s employer-sponsored retirement schemes. When interest rates were low, fans of buyouts and venture capital were drawn to their high reported returns. Now that market chaos reigns, their lower volatility is the bigger selling point.

The gulf in valuations cannot be justified on economic grounds. All firms face the same toxic cocktail of slowing growth, rising interest rates and stubborn inflation. If anything, private ones, often more leveraged, should be more exposed when credit tightens. Instead, the gap is mostly an illusion rooted in the peculiarities of private investing. One is well known. While public markets are constantly repriced in full view of the world’s investors, shares in private firms are traded far more rarely and opaquely. Some founders would rather sink with their ship than agree to a cut in valuation.

Less appreciated is the array of tricks private funds use to smooth out returns. Many keep their valuation-work in house: a 2015 survey by Grant Thornton, a consultancy, found that only around a quarter of them sought an independent opinion on the growth and discount rates they use in their models. That gives managers the discretion to make assumptions that flatter the prospects of the firms they own. Many have also taken to borrowing money to do deals instead of calling for investors’ capital straight away. This has the effect of artificially boosting a fund’s internal rate of return, a key performance benchmark.

…How long can the illusion last? During the bursting of the dotcom bubble in 2000, it took American venture-capital managers nearly half a year to report impairments after public markets peaked. American buy-out funds held off even longer after listed equities crashed in 2007. In fact, public markets began recovering in 2009—quickly enough that private investors never had to mark down the full extent of the slump.
It is unlikely private firms will be able to levitate long enough this time. Over a year has passed since the peak of the nasdaq Composite, a tech-heavy index. The cash holdings of some private firms are eroding, leaving little for return-smoothing financial engineers to play with. In August Masayoshi Son, the boss of Softbank Group, a Japanese investment giant, predicted private valuations would rejoin public-market ones within 12 to 18 months. Without a 2009-style recovery in public equities in sight, an unavoidable downgrade looms. No doubt many investors would prefer to continue playing along with the peekaboo charade. But soon private-fund managers will have nowhere to hide.”

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