Demystifying Private Equity Valuations

Executive summary:

  • Most private equity managers rely on three common approaches to valuation: publicly traded comps, transaction comps, and discounted cash flow models.
  • During significant market-moving events, private equity managers tend to be more conservative with their valuations. This typically leads to lower levels of volatility when compared to public equities.
  • Although many institutional investors must evaluate private-equity performance versus a benchmark on a quarterly or monthly basis, we believe it's also critical to take a long-term view.

Private markets have long been viewed by institutional investors as a key component of a well-diversified portfolio. The benefits of these strategies are clear: long-term outperformance over public markets, with increasingly important diversification benefits as the universe of publicly traded stocks continues to shrink and performance becomes increasingly concentrated to a handful of mega-cap tech companies. For investors that can afford to sacrifice some liquidity, private equity funds make sense as part of a long-term strategic asset allocation.

While investors tend to assess private equity funds through the lens of alpha generation and diversification, an additional advantage that often goes unnoticed is reduced volatility. The smoothed returns of illiquid investments can easily be written off as being a function of these investments being valued on a quarterly, rather than daily, basis. However, this is not the only factor at play. The methodologies by which private equity funds are valued play a role in their observed volatility, and it’s important for investors to understand the differences in valuation policies between liquid and illiquid funds to properly assess their impact on a portfolio.