VALUATIONS: the landing is still far away

Persistent fog over valuations. The weather in private markets is likely to remain volatile over the next few months, as uncertainty remains high in many areas. For example, with regard to inflation, it is difficult to predict short- and medium-term price trends when data released from month to month contain conflicting messages, not to mention divergences between eurozone economies. Directly related to the former, monetary policy also remains complicated to read, even if interest rates seem to be stabilising after the fastest increase in many years. At the same time, geopolitical uncertainties remain high, while the impact of the covid on cash flows and corporate accounts has not yet been fully absorbed everywhere. As a result, private equity players are walking a tightrope. On the one hand, they do not want to prematurely factor these shocks into their valuations and give the impression that they have made bad deals or lacked discipline in structuring them. On the other hand, they have a duty to provide their subscribers with the most transparent and honest information possible, especially when they turn to them to source a successor fund. “The significant NAV adjustments we are seeing are currently limited to specific assets. GPs generally avoid too much volatility in their portfolios because there is no cash effect or formal exit,” says Julie Madjour, Strategy & Transaction Partner at EY. ‘We are seeing the beginning of a landing in valuations, but it is too early to draw accurate conclusions about the extent of the correction,” agrees Boutros Thiery, Director of Investment Solutions at Mercer. The few adjustments we have seen need to be put into perspective given the low level of transaction activity in the market.” Indeed, these valuation issues are primarily a matter of comparison. And the lower the volumes, the more complicated it is to produce a satisfactory and truly relevant set of comparables. “Just as we are starting to see real movement in real estate asset valuations, this update is not so obvious in private equity. There is a lag effect in this market related to the fact that valuations are based on prior quarters’ activity and use listed or transaction-based comparables. However, in the last 18 months, the volume of transactions that can be used as a basis is not very large,” points out Arnaud Garel-Galais, Global Head of Private Equity & Real Estate Solutions at Caceis. As for the net asset value of the fund’s units, which indirectly reflects the value of the holdings in the portfolio, it remains variable compared to the objective value, as secondary transactions are made at a premium or discount depending on market conditions.

VALUATIONS HOLD UP…

Given this statement, the current situation is like squaring the circle. Valuations are struggling to find a landing place because of a lack of sufficient and relevant transaction activity; at the same time, transaction activity can only return to more normal volumes if prices adjust. And while the price decline has indeed occurred in recent quarters, it has been very slow, to say the least. Between the second quarter of 2022 and the same period in 2023, the Argos index, which measures the median valuation multiple in the mid-market (enterprise value between €15 million and €150 million) in the eurozone, fell from 10 times Ebitda to 9.9 times Ebitda, with a low of 9.7 in the first three months of this year. “Multiples have not really fallen because investors have become very choosy and many assets offered for sale do not find a buyer at the seller’s reserve price and therefore are not sold. This represents a significant number of transactions to be settled in the coming months,” notes Stéphane Vanbergue, partner at Eight Advisory. Against this backdrop, the reluctance of GPs to drastically reduce the value of their portfolios is understandable. In addition to this quantitative problem, the comparison methods used can be biased: “When valuing private equity portfolios, we often compare them to the multiples applied to large listed companies. However, these companies are undoubtedly less agile and have less leverage available to create value than the smaller midcap companies that are most commonly represented in funds. So when I am asked to evaluate a portfolio, it is sometimes possible to defend some stability in the value of an investment despite a falling stock market. Unlike large publicly traded companies, GPs sometimes benefit from financial leverage (LBO financing) and work hard on their investments: Their sales and profitability can improve more, which makes it possible to compensate for any decline in the multiple,” explains Enguerran de Crémiers, Managing Director of Portfolio Valuation at Kroll.

Behind these considerations lie two issues that make valuation particularly dangerous. The first, of course, is the issue of financing, the cost of which has risen significantly due to rising interest rates. As GPs find it increasingly difficult to find outside capital at a price they find acceptable, the market is faltering. “At current interest rates, and even if all funds are willing to work around their IRR, not to mention the intensity of competition for the best assets remains high, GPs are forced to pay relatively high prices to continue investing,” says Eight Advisory’s Stephane Vanbergue. Add to this the effect of the dry powder that has accumulated in recent years as a result of ever more extensive fundraising, giving investment teams plenty of ammunition to get bids, at least for deals they are convinced about and backed by increasingly thorough due diligence.

… IN A MARKET THAT REMAINS POLARISED

In this context, not all businesses are equal, and the market is becoming increasingly polarised. The best companies, operating in the most resilient sectors of the economy, continue to attract strong interest and command high valuations during the process, possibly supported by industrial investors (see box below). Conversely, the slightest hiccup in a business plan or the slightest uncertainty about a company’s actual performance is paid for in cash: the seller is asked to put the business back on the table and wait for a new opportunity before attempting to reopen the sale, at a price that has undoubtedly been revised downward. Rationalising the company’s results, if possible to a level that will attract buyers, is a sine qua non for reviving the market. It is a matter of bringing Ebitda to as normative a level as possible, despite all the ups and downs of recent years. “The choice of the benchmark aggregate is an important point in the valuation. On this point, the fog is slowly beginning to clear, thanks in particular to the gradual weakening of the impact of inflation on accounts. Previously, it was complicated to obtain normative EBITDA figures, as some companies first suffered from cost increases that were not immediately passed on to sales prices, and then benefited from a deadweight loss associated with the increase in sales prices as cost increases levelled off,” notes Stéphane Vanbergue, partner at Eight Advisory. “We have the impression that the companies’ figures for the second half of the year can be considered ‘buyable’ and reliable by the funds. Therefore, it should be possible to release deals from mid-2024 onwards based on numbers normalised over a rolling 12-month period. “The cash flow approach has the advantage of reflecting the company’s business model and the macroeconomic context in which it operates in the short and medium term to distinguish between resilient and more vulnerable assets. This approach makes it possible to create scenarios and make specific assumptions, thus objectifying the valuation multiples by relating them only to comparables,” adds Julie Madjour of EY. In this regard, there have been some creative outbursts recently by some shareholders looking to spruce up their brides in order to maintain liquidity despite the headwinds facing the market. “Until recently, the value-added levy (CVAE) was systematically removed from the balance sheets of companies for sale, in anticipation of the government’s announced abolition of the levy. However, recent announcements indicate that this measure will be postponed. We have also observed that net debt has been reduced through the use of deconsolidation factoring, which has increased the value of shares. However, the use of these factoring instruments, which have the advantage of providing cash before an invoice is paid by the customer, carries a risk: they are guaranteed by credit insurers, but they have recently withdrawn from a number of sectors. Companies exposed to these products may therefore be forced to reconsolidate part of their debt,” warns Stéphane Vanbergue. Proforma Ebitda figures have sometimes been presented as part of buy-and-build strategies, which are a good way to increase the value of a platform by acquiring smaller companies. If the LOI was even remotely attractive, the target company’s Ebitda was incorporated into that of the acquiring platform. However, this carries a risk if the build-up does not progress.

LPS AT THE HEART OF THE ISSUES

Ultimately, many professionals feel that the performance of equity investments is quite robust. Based on this assumption, maintaining relatively high valuations seems justified in some cases and, again, may discourage shareholders from rebalancing their portfolios. “Thank you to the strong performance of many portfolio companies, exits are occurring at more reasonable levels than in the past and in smaller numbers, but they are still happening. Against this backdrop, GPs have little incentive to adjust the valuation of their portfolios downward, as the market generally agrees with them. Moreover, many of them are in the process of raising capital and are therefore reluctant to downgrade their valuations and make lump-sum provisions on their books,” explains Ludovic Douge, managing director for the secondary market at DC Advisory. This observation, shared by many players, highlights a double phenomenon. On the one hand, the valuation adjustment is unlikely to be too abrupt, even if it seems inevitable if the market is to regain momentum. “On the other hand, we are likely headed for a greater dispersion of performance between managers. In fact, it could be the greatest dispersion ever seen in private equity, as many teams have never experienced a crisis and the market has become increasingly complex over the past decade,” warns Boutros Thiery, investment director at Mercer, whose seventh-generation fund of funds (Private Investment Partners VII, successor to a €4.3 billion fund) is nearing the end of its fundraising. Historically, we have seen a difference in annual IRR between the best and worst managers of about 10-15%; we believe it could be much more in the current environment. We will probably have to wait another 12 to 18 months to see the first changes. Stéphane Barret, Head of Crédit Agricole Private Capital Services at Crédit Agricole CIB, looks at the same period to see things more clearly and to envisage a market recovery on a new basis: “If the macroeconomic situation does not deteriorate too much, valuations should remain calm; on the other hand, if there is the slightest disruption in equity sales, the flow of exits might not start. On the other hand, a recession in 2024 could lead to a decline in interest rates and revive the financing market. While this macroeconomic approach ultimately raises more questions than it answers, as the latter are more in the hands of central bankers than GP, there remains one factor that will most likely shift the lines. This is LP behaviour, which many market participants believe is the key to adjustment. “The catalyst to break out of this period of inertia and align sellers’ expectations with those of buyers will likely come from LP-induced redistribution. Indeed, managers are constrained by the exit schedule to preserve their IRR and future fundraising,” says Julie Madjour, partner at EY.

PRICE CONVERGENCE ON THE SECONDARY MARKET

“All GPs seeking to raise funds in 2024 will be required to submit DPIs to their current and future subscribers. So it is quite possible that we will see semi-forced sales in the coming months. They will not necessarily be scrapped, but they will very likely be sold at lower valuations than originally sought by the sellers,” adds Cacib’s Stéphane Barret. Boutros Thiery, investment director at Mercer, is himself an underwriter of numerous mid- and large-cap buyout, venture and growth funds, primarily in the United States and Europe, and confirms that he “questions the valuations reported to us by GPs. There is no absolute valuation rule for all assets, but we feel it is necessary to ‘stress test’ the models and see what we can do.”