Thread by @AdamDSchwab

A recent FT piece defends private equity’s approach to valuations. As an LP in over 100+ funds, my experience completely agrees with @CliffordAsness when he calls it volatility laundering. Here's what I've been seeing in relation to the author's claims:

ft.com/content/22a81f…

One note: the quality and behavior of GP's vary considerably and some are very transparent and consistent in their approach. But this issue of #volatilitylaundering is pervasive enough that investors need to go in with skepticism.

The author states private companies are more resilient than public companies:

This is a common narrative that they invest only in quality, defensive business models. This argument falls apart when you look at the underlying fundamentals and capital structure. More leverage (a lot more!), less free cash flow (and I don’t mean EBITDA..

I mean true FCF after capex, nwc, taxes, interest, and of course, acquisitions that will need to be funded to support the assumed growth). I won’t even start with “adjusted” EBITDA.

There is a reason these companies are paying 6-9% for senior lending and 10-14% on mezzanine debt. Hint: it’s not because they are more resilient.

Obviously, there are many high-quality private companies that will do very well.

But to claim that LBO-backed companies are less sensitive to the public market is wildly off base.

The author claims GP's are prudent on the upside and downside:

In practice, GP’s are rarely equally prudent on the upside and downside. GP are quick to mark up companies when comps/markets are up, and then on the way down, switch their rationale to, “The company fundamentals haven’t changed, so therefore we’re holding our valuation as is.”

LP’s want consistency. If you mark up based on rising comps/markets, then you mark it down on falling comps/markets. You don’t get follow the markets lockstep on the way up and then claim that markets are too irrational on the way down and you’re sticking to the fundamentals.

Markets get crazy to the downside and upside. You don’t get to cherry pick when you get to reference market comps to rationalize your end goal. LP’s don’t need perfection. Just one standard, applied consistently.

The author claims this is not 2007-2009:

The reference to the financial crisis is a red herring and irrelevant. Investors want consistent valuation standards. Follow the same valuation practices during the good times and bad times.

GPs shouldn’t get to make a gut call that a current downturn won’t be as bad as a past crisis to rationalize not marking your book down.

The author claims we can rely on audit opinions that to assess true value:

There’s a lot of naivete in a typical academic belief that because there’s an audit that everything is good. LP’s who have been investing for any meaningful amount of time know the uselessness of relying on audit opinions.

Auditors are more worried about documenting their work then they are pushing back on the GP to ensure proper valuations. Auditors don't have the skill nor experience nor incentive to take a hard line on valuations.

Valuation ranges are a mile wide and can justify almost anything. The idea that because some accounting standard was implemented that valuations are now "legit" displays an incredible lack of real-world knowledge of the inherent subjectivity in valuations.

The author claims private NAVs are more reliable than wildly gyrating public markets:

As @CliffordAsness has stated, no one is claiming that public markets are always right. Or don’t swing too far to either extreme. The point is, again, that LP’s don’t want want GP’s changing the valuation standard depending on whether the market is up or down.

So if a GP claims that markets are too extreme on the downside so they are holding their values flat, then the GP better make that same claim on the upside and hold their values flat when markets are up. But they don’t.

The author advocates for better data and transparency:

This I agree with. More data and transparency (and consistency!) would a positive step in the right direction. But given the discretion GP’s will always have, it still comes down to the willing of GP’s to apply standards in a fair and consistent manner.

But while LP’s are throwing money at private assets, GP’s have little incentive to change their behavior. Like most issues in alt assets, until LP's start turning down commitments, GP behavior won't change.