The debate over private market fund valuations and volatility has come back into focus.
To quote Mohamed El-Erian: Some private equity managers imagine: “Your asset class would escape reckoning that stocks and bonds have faced this year because they were structurally immune to disruptive changes in the investment landscape.” El-Erian says this “could prove to be misplaced confidence,” while Cliff Asness describes it as “Volatility wash.”
From a capital market perspective, how can investors evaluate net asset value (NAV) valuations and efficiently transfer any risk they might have?
We have developed an actionable framework.
The best approach to make investment commentary is to walk the talk and take sides in a trade. If you think that an NAV valuation is low, it’s best to buy at that price. If you think that it’s high, it’s best to sell. There ought to be an appropriate mechanism to reward such forward-looking relative value trades. As a result, an investor could monetize the next or lower return – a positive or negative risk premium – over other allocations over a given time horizon.
The problem
Private market valuations are still opaque, making it difficult for investors to find out the worth of personal assets. Unlike listed markets, private market prices usually are not publicly available and the methods used to derive valuations are sometimes a mystery.
Nevertheless, private market investments ultimately cannot hide their true results. Their self-liquidating structures are inherently objective. Volatility can’t be washed indefinitely. At the top, the full value produced over time is converted into money.
Even when measured using an accurate methodology before liquidation, private markets returns are heavily influenced by the on-paper gains and losses of the estimated preliminary net asset values.
General partners have different philosophies about what a good NAV valuation is. Some have a mark-to-market perspective, while others take a less sensitive stance on market risk. Not all private market fund valuations are created equal.
Actually, the Guidelines for the international valuation of personal equity and enterprise capital (IPEV). There are various valuation methods for deriving the fair value of personal funds. These range from comparable transaction multiples to discounted money flow methods to quoted investment benchmarks. Nevertheless, it’s Financial Accounting Standards Board (FAS 157 – ASC 820) places emphasis on fair value, with emphasis on the exit value or expected proceeds from the sale of the relevant asset.
While private market investments are likely to be held for the long run, their fund’s liquidation mechanism gives their mark-to-market the ultimate say. Only when portfolio assets are sold does the vendor discover what the market is willing to pay. If the paper valuations of those assets don’t reflect their corresponding secondary market price, the customer may try to negotiate a reduced price, thereby increasing the likelihood of a positive risk premium.
The way forward
The aim of our research was to elucidate and maximize the worth of time-weighted metrics in private market investments. Why? Private market assets ought to be comparable to all other asset classes and easier to know. This makes the asset class more usable, improves portfolio and risk management, and reduces the idiosyncratic inefficiencies of unused money or over-allocation.
Our research has produced many unique private market solutions of its kind.
Rating transparency
Using our maturity-based calculation methodology, we measure the time-weighted performance of personal market investments and supply a real-time valuation link to public markets that highlights volatility and eliminates lags or missing estimates.
This rule-based probabilistic framework relies on a sturdy benchmarking approach. Investors can now assess and objectively assess the mark-to-market quality of the online asset value of their private market investments.
Price discovery
Using real-time time-weighted indexing techniques, the DARC (Duration Adjusted Return on Capital) methodology creates a forward return curve for personal market funds that links ex-post performance to forward-looking expectations. Only time-weighted returns will be traded over time, and the DARC makes private funds tradable over future maturities.
With our Futures exchange for personal funds (PRIFFE), investors can test the potential of current net asset values to deliver equivalent money in the long run, predict expected future returns over the targeted time horizon, and manage the volatility of market value. The premise of our approach is that the cash on the table can exploit the legacy of misguided net asset values of the private market – hence the acronym PRIFFE, which comes from “priffe” (money) within the nineteenth century Roman dialect and “priffe” (a ) composes traditional Swedish card game with bids and contracts.
Create a level playing field for the online asset value of personal markets
A standard rationale for personal market investing is that its “stale” valuation profile reduces the volatility of a typical multi-asset portfolio and provides return stability. However, this only applies to short-term valuation declines. Reporting on private market funds occurs with a lag of several months and will be helpful in hindsight. We haven’t experienced a sustained period of asset revaluation because the global financial crisis. Hopefully we cannot see anything like this again, although that could be wishful pondering given the present economic climate. If such a revaluation occurs, there isn’t any way out for personal market investments.
Market conditions will all the time influence the exit values and returns of personal investment portfolios. Even with stable valuations, the liquidation process can take time and reduce returns. In uptrend cycles like that of the last decade, duration and market risks are sometimes neglected, but they follow private market investments through the ups and downs. Mark-to-market only makes them more visible.
Going forward, we want to anticipate and manage mark-to-market adjustments to extend transparency in private fund investments. Private market funds that use a mark-to-market approach may experience higher volatility and will even appear to underperform in certain market conditions. But they provide investors three necessary benefits:
- Despite the standard delay in reporting, investors can now calculate more informed NAV estimates. The more consistent the place to begin, the smaller and more random the estimation error is.
- Such NAV data makes investors’ balance sheets more resilient and eliminates the negative performance spiral that results from the unreal denominator effect and includes losses.
- Any asset allocation that features private market funds would in any respect times provide a balanced perspective on the forward-looking risk premiums that the assorted asset classes are expected to attain.
A mark-to-market context creates positive countercyclical investment dynamics. This means the likelihood that risk increases as valuations fall and vice versa, quite than losses crystallizing or risk increasing as valuations rise. This will in fact reinforce the smoothing advantages of diversification.
Not all NAVs are created equal, so not all forward-looking returns are equally attractive. Some of those may be price selling, others may be price buying in case you can distinguish them and execute them.
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Photo credit: ©Getty Images / Gunther Kleinert / EyeEm
