Private market valuations

Private markets investments have been pushed heavily in recent years. They are most prevalent in the institutional world, but there have been a large number of funds launched in Australia targeting high net worth investors. Most of these vehicles are funding tech and other high growth segments of the market, and the paper returns of these funds have been stellar. But with listed equity tech names tumbling over the last few months attention is now turning to how these funds’ investments will be revalued.

In recent years, venture capital funds have enjoyed a phenomenal run. The asset class recorded an IRR of 30.5% over the past three years, according to the latest figures.

Many of those gains were on paper only, a fact that will become obvious as company valuations are marked back down. Fund returns for the first quarter are starting to trickle in, and they’re ugly.

Venture firms, which pumped up valuations in line with euphoric public markets, may have some explaining to do.

“Since the dot-com reset, we haven’t seen such aggressive behavior in portfolio markups,” said PitchBook analyst Zane Carmean. “Something in the mindset shifted that gave VC firms confidence to give hyper-optimistic numbers.”

Source: How far will high-flying tech investors fall? | PitchBook

The chart below shows how far unrealised “paper” profits got ahead of actual cash returns over 2020 and 2021. We suggest that most of these gains will need to be unwound, and note that the data only includes preliminary results for the last quarter of last year, let alone the continued fall over the first five months of 2022.

You might ask why funds were so quick to write up the value of their investments. Normally this requires new investment into the underlying businesses at a new, higher, valuation. And the 30% returns that the space has seen indicate that these high priced funding rounds have been happening a lot. On the face of it, that seems like poor timing — surely it would be better for the fund manager to invest as much capital as possible into their investments at the (cheaper) earlier stage valuation? Part of the explanation might be the wall of money that has crashed into the space, but we should also note that managers have an incentive to revalue companies up quickly. By increasing the paper value of their investments they increase their management fees and can generate performance fees. If they were to only revalue their investments at maturity then they would miss out on years of higher management fees and may not get a performance fee at all.

Unlisted investment valuations tend to lag listed markets. That’s partly a function of the operations of valuation processes and the fact that unlisted valuations are generally guided by listed peers. But the incentives to keep valuations high must have an influence too.

Investors with private equity and venture capital investments may wish to consider realising some of their profits if they can before the full impact of these revaluations comes through. Unfortunately, most funds do not allow investors to redeem early and some of the more liquid funds have reduced the number of redemption windows in the last few months, so this may be hard to execute.

Important Information: This document has been prepared by Aequitas Investment Partners ABN 92 644 165 266 (“Aequitas”, “our”, “we”), a Corporate Authorised Representative (no. 1284389) of C2 Financial Services, (Australian Financial Services Licensee no. 502171), and is for distribution within Australia to wholesale clients and financial advisers only.

This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.

Please note that past performance is not a reliable indicator of future performance.

General Advice Warning: This document has been prepared without taking into account your objectives, financial situation or needs, and therefore you should consider its appropriateness, having regard to your objectives, financial situation and needs. Before making any decision about whether to acquire a financial product, you should obtain and read the relevant Product Disclosure Statement (PDS) or Investor Directed Portfolio Service Guide (IDPS Guide) and consider talking to a financial adviser.

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