After the Universities Superannuation Scheme (USS) reduced the value of its investment in Thames Water by almost two-thirds, IPE asked industry experts about private asset valuations and why misvaluation poses problems for pension funds.

Earlier this month, the USS wrote down the value of its 20% stake in Thames Water from £956m (€1.2bn) in 2022 to £364.4m last year after the utility company admitted that it would be unable make debt repayments. This brought the compay’s valuation from £5bn in 2022 to £1.9bn in 2023.

This was the second-biggest write-down for Thames Water after Ontario Municipal Employees Retirement System, which holds a 31% stake in the utility company, cut the value of its stake by nearly £300m, or 30%, last summer.

Such a high reduction in the investment value in the last year was unexpected, according to a report from EDHEC Infrastructure & Private Assets Research Institute, as only nine months earlier, in March 2022, some investors were still increasing the valuation of their stakes.

Private market valuations tend to lag behind public markets.

Mamdouh Medhat at Dimensional

Mamdouh Medhat at Dimensional

Mamdouh Medhat, senior researcher and vice president at Dimensional Fund Advisors, said: “Think about during the COVID-19 pandemic for instance. There was a sharp decline in all public markets followed by a sharp increase. Those sharp declines that we see in public markets, tend to only be reflected in private valuations with a lag. Typically, there are two, three or four quarters of valuations before you tend to see the same fall in private assets.”

Dimensional Fund Advisors is typically focused on public markets, but with more of its institutional investor clients interested in private markets, Medhat is currently working on a report looking at the resemblance between two asset classes. 

The Thames Water example was an “extreme downward valuation” because of the general market movements due to the future prospects of the company having been making its way slowly into that price, according to Medhat.

Frederic Blanc-Brude, director at EDHEC and chief executive officer of Scientific Infra & Private Assets, said: “Private assets are not listed on the stock market that is regularly updated.”

And “in theory”, he said private assets should be reported as fair value, but the issue is that “for a long time private assets have not been reported at what you might call the most accurate fair value”.

He added that private markets valuations are “usually reported quite late” with 18 months to two years of delay and often done by external valuers who, Blanc-Brude pointed out are unregulated.

“Often the values that are reported tend to be the same every year because no one makes an effort to find out what they are. It’s quite convenient because it shows very little variability,” he said, adding: “It looks like there’s normal activity, which is not exactly true because as you can see, in some cases, you can lose a lot of money.”

“Often the values that are reported tend to be the same every year because no one makes an effort to find out what they are”

Frederic Blanc-Brude, director at EDHEC Infrastructure & Private Assets Research Institute

So should the valuations in private markets happen more often?

Not according to Medhat. He said that the problem is that these prices are subjective and often based on the cost assumption and the latest transaction price and what similar assets are trading at in the market.

He said: “Just doing this more frequently might not necessarily imply more precision, which is what we want. We want valuations to be more precise. We want them to reflect what’s going on in a relatively timely manner.”

Medhat added that more frequent valuations could just introduce more noise.

It’s subjective

But Arif Saad, head of client advice and head of people at Van Lanschot Kempen, stressed that misvaluations are not an intentional thing.

He agreed with Medhat that valuations are subjective. But the issue is around who is making those subjective judgements and who is scrutinising those judgements.

Saad said that Van Lanschot Kempen is talking to different managers who invest in private markets, and they all have “different ways of going about [valuations]”.

He said: “That doesn’t really help with transparency and that doesn’t help with giving you comfort that what you’re getting is a fair representation.”

He pointed out that there are a number of schemes that are ready for buyout, but they need to sell private assets to “be holding liquid cash” to complete buyout.

“They might think their asset is worth £100m but the only value they are able to receive is £50m. This means they can go from being able to buyout to not being able to,” Saad noted.

Frederic Blanc-Brude

Frederic Blanc-Brude at EDHEC

Blanc-Brude agreed it poses a problem for pension schemes.

For all pension funds, it’s a risk management problem, he said, adding: “They don’t know exactly how much of a disaster may have on their balance sheet. They don’t know the real value so their allocations are wrong and they’re not managing their risk, especially in relation to liabilities.”

For DB schemes, Blanc-Brude said it creates a problem in terms of calculation of the value of people’s pensions because the value of these assets determines the benefits that are available.

For defined contribution (DC) schemes, he said it is a problem because people can decide to change the allocations to one asset class or another based on prices that are incorrect or old.

He said: “It could be to your advantage. It could be to that disadvantage. No one knows.”

He also pointed out that some people try to take advantage of this. “They know that valuations are going to change in one direction because if interest rates went up, eventually the value is going to drop and vice versa.”

He said this is something that regulators are increasingly worried about.

The Financial Conduct Authority is reportedly looking to kick off a review of private market valuations this year, and while there is no official confirmation from the regulator, it is expected that it plans to examine asset managers’ “discipline and governance” over valuations.

In the meantime, Medhat suggested that pension funds should do their due diligence before hiring a manager by familiarising themselves with their investment approach and how timely they are with reporting asset values, and after hiring a manager by challenging valuations.

Read the digital edition of IPE’s latest magazine