Active investment commentary & analysis

How can unquoted investments be valued consistently?

Problems in private equity get noticed when retail investors lose. But concerns with the asset class go beyond individual rogue managers or poorly structured funds. How can unquoted investments be valued consistently? Lossmaking technology and e-commerce businesses are particularly hard to assess objectively. Many clients are unaware of the risk that conflicts pose to the concept of independent and fair valuation. Investors hope that a wall of US money will come in for European private equity, but valuations look stretched. The industry in the UK and Europe is growing rapidly – intervention is needed before the issue becomes systemic. 

Private businesses can now access significant capital without needing to list, reducing the number of IPOs. Businesses on a strong growth trajectory tend only to list when that growth slows. The scarcity of these businesses on listed markets has driven many investors to look at private equity, and vehicles accessing that, to participate in growth that is missing from the listed market. In revenue growth trends, it is estimated that the FTSE 100 and Euro Stoxx 50 currently averages 6%, versus private technology and e-commerce businesses at 30% or more. 

Over the last decade, capital investment in European private technology businesses has more than trebled, with the $1bn plus 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.

Previously, much of this investment was handled in traditional private equity partnership structures with flexible, limited-life funds. Now there is pressure from institutional investors and wealth managers to access the opportunities via vehicles with shorter term focus and easier dealing - creating a boom in closed-end funds. In theory, these should be well matched to the challenge of unquoteds, but the Woodford Patient Capital Trust experience shows that even closed-end investment companies have problems. 

There may be conflicts in how valuation is managed, flexibility in the numbers, and a desire by boards and managers to expand a fund even if technically closed-end. Boards themselves can have personal interests in portfolio companies. And individual managers may be able to cherry-pick investments in a portfolio to back personally, a bias that could distort professional duty to the whole fund. Surprisingly, managers can commit to follow-on investment without specifying exactly how this responsibility is shared across client funds. This cocktail of conflicts is a huge challenge for fair and consistent valuation. And, it is hard for many auditors to fully check a valuation that is the responsibility of boards, managers and administrators. 

Closed-end funds realise that they still need follow-on capital to protect their interests in further fundraising rounds by their investee companies.  And a bigger fund brings more management fee income. Shareholders would not approve issuing new shares at a discount, but undervaluing the prospect of imminent mark-ups or realisations, can allow the fund to expand. A share placing at what looks like asset value could really be an undervaluation, meaning existing investors could lose out if they do not follow-on their money. The broker to the fund or its investment bank, while placing the shares, may also write “research” but can be themselves incentivised through warrants or options. It means that many may gain through enlarging a fund at a time when there is a lot of flexibility over valuation. 

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 matter a lot. 

Traditional asset managers with listed portfolios are already regulated on management of conflicts. But in the new world of private equity, it is not clear that the rules are working. The area is attracting retail investors; without action, public credibility will be undermined.

A version of this article was published in EFinancial News on 23 January 2020.