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Understanding private equity valuations in tumultuous times

26 May 2020 Heleen Goussard, Head of Unlisted Investment Services at RisCura

It feels as if we woke up one morning and the world was different – but when exactly did it change, and what did we know or should have known at any point in time? Investment managers of illiquid assets need to assess when, to what extent, and how they incorporate the impact of Covid-19 into their valuations.

Like many aspects of this current crisis, there are similarities to the Global Financial Crisis (GFC), when the valuations of illiquid assets were also put under the spotlight. Quite a number of reforms post the GFC was indeed aimed at improving the reporting of the fair value of illiquid investments, and it is in the current crisis that these will be tested. In a time when factors such as climate change and the high level of interdependency of global markets are driving ever-increasing event risk, this issue is only likely to become more and more relevant.

The International Private Equity and Venture Capital Valuations Guidelines (IPEV) board released special guidance on performing valuations at 31 March 2020. The guidelines highlight how far valuation has come since the GFC, but also how the application of fair value standards is complex and subjective and how we are still struggling toward consistent application of these standards.

The guidelines remind valuers that an asset’s value on valuation date is what two market participants will pay for that asset on that date, and that this principle needs to be applied consistently. What valuers and owners of assets find difficult is that this market participant is still subject to the inefficiencies of the market. Although the market participant is independent, informed and lacks special motivation in a transaction, the price the market participant is willing to pay is still informed by market conditions. With the purpose of fair value reporting being the reflection of current market conditions, the reporting standards’ preference is always for market price rather than intrinsic value methodologies. As Warren Buffet famously pointed out, price and value are not necessarily the same thing.

A good example is the difference between market values on 29 February and 31 March 2020. Although the spread of COVID-19 over the world and the resultant economic fall-out now appears inevitable in hindsight, the listed market in South Africa was showing very little or no negative impact of the coming crisis at 29 February. However, at 31 March, the market had lost 15% in a single month, only to gain back 5% in the next. Movements that can be argued illustrate some of the market inefficiency. With the valuation standards favouring market-based techniques valuers would equally have to price in the apparent overreaction of the market at 31 March only to show a counter intuitive increase of value as the impact of the crisis slowly deepens.

Understanding volatility in private equity
Private equity is typically considered a less volatile asset class than listed equity, but in the current market reality and implementing fair value standards as intended, volatility and a big drop in valuations across the board are hard to escape. The only exception to this rule is when the quality of market information becomes poor, and in this case it does not refer to inefficient pricing, but rather to an inability to observe pricing as, for instance, liquidity in certain instruments dry up. Although fair value measurement is surely flawed in some ways and the reporting standards still a work in progress, applying the standards consistently and impartially builds credibility by not ignoring market realities. This in many ways, for us at RisCura and the industry, is what the guidance issued by most regulators in this time of volatility and crisis has been, a call to keep a cool head and hold the line by applying standards designed to be tested in these conditions.

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