Interest rates have risen spectacularly since the start of 2022. While listed equities have adjusted to this new reality, private equity valuations have hardly budged. The question is whether this is realistic.
Much of the double-digit losses pension funds made on their investment portfolios in 2022 can be explained by higher interest rates. Higher interest rates mean future cash flows are discounted at a higher rate, making a company less valuable.
Growth firms, a segment that has been increasingly popular with private equity in recent years, have been hit especially hard. The share price of a firm like Amazon is down by some 40% since the start of 2022.
Private equity funds in which pension funds invest in have leeway in determining the valuations of their investee firms. They do not necessarily have to base them on public market equivalents or changes in interest rates.
In general, funds have been reluctant to adjust valuations downwards, said Ken Kencel, chief executive officer of Churchill Asset Management, a financier to private equity owned firms and an investment affiliate of Nuveen, the US pension asset manager.
“Valuations in private markets have remained higher than you would have expected. They haven’t mirrored valuations in public markets, and as a result there is a stand-off between sellers and buyers,” Kencel told IPE.
A reason for this “dichotomy” is that most deals that have been concluded this year involved “high quality companies”, Kencel noted.
He added: “Most of the recent deals involve companies that are relatively unaffected by inflation and the current market dynamics. On average, the valuations of the transactions we did last quarter were the same as a year earlier, but the quality of the companies was much better overall. Companies that do not do well are probably not being sold now.”
Apples and oranges
Private equity investors also often contend they do not need to adjust valuations as much because they invest in more resilient, defensive industrial sectors that benefit from long-term secular tailwinds. Supposedly, such companies are less affected by macro factors such as rising interest rates.
Hugh MacArthur, CEO of private equity firm Bain Capital, takes this line of argument. In a recent outlook call, he said comparing investing in public markets to investing in private markets was like “comparing apples and oranges”.
He added: “I’m investing in mission-critical software companies that bring in real cash, and we have a high weighting to healthcare companies. These investments are more resilient [than listed firms].”
Privately-owned companies tend to only adjust their valuations when they need to raise more cash.
US payment services provider Stripe is an example of this. “They raised money again this year, with the company valued at €50bn compared to €95bn at the previous funding round,” said Peter Singlehurst, who runs the investment trust Schiehallion at Baillie Gifford. This fund invests across both public and private markets.
Singlehurst expects Stripe not to be the last firm this will happen to. “We’ve proactively marked down companies in our portfolio to reflect rising interest rates,” he noted.
However, lower valuations and capital losses are not one and the same. A growing profitability can to some extent compensate for lower market valuations, said Vahit Alili of Schroders Capital, the asset manager’s private equity department.
He said: “We have fast growing companies in our portfolio with strong gross margins which have more than doubled revenues over the last 12-18 months but have a flat or slightly reduced book value, corresponding to a multiple reduction of more than 50% and reflecting also the public market reality.”
Private credit to benefit?
However, the previous golden decade for private equity investors is unlikely to be repeated any time soon. If only because rapidly rising interest rate costs will unavoidably depress returns going forward.
At the same time, however, firms like Churchill AM that lend money to private equity stand to benefit.
“A year ago a typical senior secured loan to a high quality middle market company averaged a 6-7% all-in-yield. This has now gone up to an average of 11-12%. Today’s private credit market provides very attractive investment opportunities with excellent risk-adjusted returns,” said Kencel.
Higher financing costs can be especially problematic for private equity funds with high leverage, noted Ronald Wuijster, CEO of Dutch pension asset manager APG in the firm’s annual report.
Wuijster said: “In private equity and hedge funds bank loans are frequently used to boost returns. Because borrowing money is now more difficult, returns made by these funds have the potential to disappoint.”
So are current private equity valuations realistic? To answer that question, a look under the bonnet is necessary. If pension funds were lucky enough to select managers who succeed in growing the profitability of their companies enough to compensate the lower valuations that are the result of higher interest rates, private equity returns have the potential to remain positive even in the current high-interest rate environment.
But if the managers in question own companies that struggle to pass through inflation to their customers, a drastic reduction in book value will be on the cards.