The title to this article sounds like a topic for a doctoral thesis. The concept in determining private alternative investment valuations is simple but the actual calculations to determine a private valuation can be quite complex and subjective. A few definitions before we go on:
- What is an alternative investment? – At a high-level, it’s an investment that is not one considered conventional as in stocks, bonds, cash, etc. Alternative investments include private equity, hedge funds, real estate, commodities and derivatives. Alternative investments can be complex in nature and are less regulated than the public securities markets. In that regard they generally can only be owned by institutions, and accredited or qualified individual investors. The latter requires certain income and net worth levels.
- What is a public alternative investment? – Some alternative investments such as high-yield debt funds and bank loan funds are usually partnerships that own a portfolio of publicly traded debt securities of companies. The investors are the partners. In the case of the high-yield fund, the portfolio companies are not highly rated, hence they are required to pay a high interest rate on their publicly traded debt. The bank loan funds hold a portfolio of fully collateralized publicly traded company loans. They are considered less risky than high-yield and generally have lower interest rates. The securities held by these two types of funds trade daily and are marked to market (or “priced”) at the end of every trading day like conventional stocks, bonds, etc.
- What is a private alternative investment? – An alternative investment that is not publicly traded where the investment manager must calculate the value of the investment at certain intervals, typically at the end of a calendar quarter.
Given the recent public market volatility, what effect has it had on privately valued alternative investments? Assuming a quarterly valuation period, we will not know until the 3/31 reporting period, which may not be delivered to investors until May! Why is that? It doesn’t seem right. As an example, a review of the private equity valuation process will explain.
A private equity security is a stock of a company that is not listed on a public exchange and is not traded daily. There is nowhere an investor can go to determine an independent private equity value as of any given date. Private equity funds are usually partnerships that invest in a portfolio of common stocks of private companies. How does an investor know how this type of fund is performing? The investment manager of the fund (the folks getting the management fees) is calculating the valuation of each private security in the portfolio, typically on a quarterly basis. The process can be summarized as three-fold:
- Gather the prices of companies in the same industry, like the private one being valued, that are publicly traded. Calculate a market multiple (stock price divided by earnings per share for a period) for each comparable company or document the reasoning behind any subjective determination of the multiple. Then calculate the average multiple.
- Research any 3rd party transactions (like a sale) involving a similar company in the same industry. This is like using a comparable real estate sale to support the value at which you want to sell your house. Same concept. Calculate the transaction multiple. If recent, this is more reflective of value than #1 above.
- Determine the private company’s enterprise value by taking the last 12 months earnings and multiplying it by the market multiple determined in #1 or #2 above. Take that value and subtract everything that must be paid before the common stock holders get paid, e.g., all the company debt and preferred stockholders. The remaining net enterprise value is divided by the number of shares outstanding to get a per-share valuation on the private common equity.
I hope my summary of the private equity valuation process served was understandable. There is an issue with this generally accepted methodology. Investment managers calculate new valuations as soon as possible to be able complete independent audits and report to investors on time. It is accepted practice for investment managers to use the actual quarter-end comparable public prices and apply the calculated market multiple to the portfolio private company financials usually available only through the previous quarter. So 12/31/17 private prices will be determined by multiples using 12/31/17 public prices applied to private company last 12-month earnings through 9/30/17. Think of valuing privately owned retail firms and the holiday sale season.
Independent auditors opine on 12/31 financial statements so reputable private equity firms will adjust significant valuation changes in their year-end financials, when portfolio company results through 12/31 are available (maybe not until March), despite having to deliver an annual report to investors by 3/31. But independent auditors do not review interim quarterly financial statements so there is some flexibility in reporting private equity valuations during unaudited interim periods. Materiality is a subjective concept.
If you understand the private alternative investment valuation process you can see the current volatility in public securities markets have no immediate effect on private valuations. And it shouldn’t. Balance sheet valuations are as of a point-in-time (“a snapshot” going back to accounting 101). Public equity prices at 12/31 were actually close to current levels and who knows where the public markets will be at 3/31. If the market stays where it is as of this writing (down about 7.5% from its high, but a little better than flat from 12/31) private equity investors will probably be relieved to see, when they get their 3/31 report in May, volatile public prices probably had no material effect on their private equity investment. Even now, today, as your publicly traded investments are marked up or down every trading day, your private investments are at 9/30/17 valuations. Most likely they will be up in value when you get your 12/31 report sometime in March!
Alternative investment pricing policy and methodology is just one area where due diligence is necessary prior to choosing an investment manager and their fund for your investment. It is a key area in monitoring your investment as well. An investor must have qualified and experienced staff on board or outsourced to conduct the necessary diligence prior to investing in alternative products.
Comments and corrections are welcomed.
Hillhurst Wealth Management LLC