Active investment commentary & analysis

Can investors trust private equity valuations?

Does private equity need more scrutiny from investors and regulators? In the UK and across Europe, the industry’s growth is being driven both by new money and soaring valuations. Businesses are staying private for longer, fuelled by readily-available capital - even to a size of £5bn or more. Regulation of the industry is light, but the sheer scale of private equity now demands responsibility. Can valuations and corporate behaviour be trusted without the discipline of a listing?

Investors hope that a wall of US money will come in for European private equity, but valuations look stretched. It is not clear that ratings from a more dynamic US economy would apply in Europe. An easy supply of capital this side of the Atlantic means strong competition for deals, pushing up pricing, but with a smaller ecosystem of support. Many European investment businesses are younger, and the teams less experienced.

Over the last decade, capital investment in European private technology businesses has more than trebled, with $1bn+ unicorns up fourfold. But signs of a possible disconnect between private valuations and public interest came in 2019 with the disappointing IPOs of Uber and messaging app, Slack. WeWork’s failure to list was followed by a significant down round, a much lower valuation. In the UK, fintech business, Zopa, recently funded at a steep discount to its 2018 value. A number of private companies have stock trading at a discount in secondary transactions – but this derating seems not to impact valuations. Flexibility in valuation appears upwardly biased, perhaps driven by the need for funds to continue raising assets to help with follow-on commitments.

Private growth businesses need financing over several years, putting valuation at risk each round; anti-dilution structures do not always fully protect. Existing investors who do not follow-on proportionately may lose out – sometimes in very subtle ways. Each round can have different rights that impact valuation. In later stages, it is common for investors coming in at higher prices to require more downside protection at the expense of existing investors. And lenders can compromise risks with high charges or hard to account for structures like Payment In Kind. Valuation tends not to be on easy measurables, such as profit, but take its cue from the most recent price paid by someone else. The rights attaching to each subscription matter a lot.

Valuations appear now less based on revenue trends and unit economics – becoming more varied and with less agreement. Governance and conflict management are typically opaque, despite the higher incentives involved with private equity funds and their investee companies.   The industry in the UK and Europe is growing rapidly – without intervention, private equity risk could become systemic.