Valuations in PE… Are They Too High?
2022 performance differentials caused and continues to cause investors to rethink some of what they know about different asset classes. For instance, history would suggest that stocks and bonds are not usually highly correlated…but they were in 2022. History would also suggest that assets that carry an illiquidity premium underperform in more volatile markets…but they didn’t in 2022. One logical thought could be to adjust the 60/40 Equity/Fixed income portfolio, another would be that public markets are undervalued relative to private markets. There are many other possible conclusions and we’ve been talking to institutional investors about what they think. We’ve gotten a wide variety of opinions and frankly that is quite comforting given what we are seeing for available assets. Please keep in mind, that this information is anecdotal, but what we have found is that institutional players that carry assets measured in tens of billions think that PE is very expensive. They feel that there is too much dry powder and it’s all sitting at the largest of the large PE shops. Frankly this jives well with what we have seen as we’ve looked at fundraising the last few years. Big players, investing in big assets, have been chasing valuations higher to accommodate the big pensions and endowments. Smaller managers have had a more difficult time raising money. As a result, there are still very attractive assets out there that may not be accessible to the less nimble investor. With that said, private equity shops generally calculate valuations in 3 ways: the market approach (comparing valuation to public companies), the transaction approach (comparing similar transaction valuations), and the Discounted Cash Flow method (using the company’s results and pro forma estimates). The first two have been very easy to goose higher the last several years. The rising tide of public markets took everything with it. But discounted cash flow methodology is more rigorous and uses information about the company itself and not some proxy. DCF modeling is much more difficult to fake, but it also doesn’t have the same volatility that some of the other methods might.
As we look back on 2022 and wonder if in fact valuations are too high….there’s not a perfect way to know that, particularly in the aggregate. But we would submit that there are both overvalued and reasonably valued assets out there. It’s just about doing the work to uncover the latter. We do not believe that a simple mean reversion clears this question up. Big deals may see some pricing pressure in the coming year, but that only helps our investors as we look for new assets.
