2022-08-02
Private Equity and The Great Valuation Repricing
After years of seeing emerging company valuations being driven higher by low interest rates and a frenzy of funding rounds, the private equity firms that fund (and own) some of these companies now face what some have termed the ‘Great Valuation Repricing.’
In fact, today, capital markets find themselves in the middle of significant repricing, as investors adjust to the changing economic conditions that have come to characterize 2022. Taking a look back at what has transpired over the past few years can help one understand how significant shifts have evolved and what has spawned the recent surge in new valuations.
A Look Back at the Past Decade
Over the past decade, private equity has been among the biggest winners in finance as investors put hundreds of billions of dollars into the asset class in search of noteworthy returns. The influx of capital, coupled with readily available leverage, led to a booming era of deal-making while sending asset prices and company valuations to record highs.
However, as interest rates continue to rise and we enter a recession, the high prices previously paid for assets have started to eat into returns. In a rare occurrence, we’ve witnessed both equity and fixed income markets suffer significant declines over the same period in 2022.
It logically follows that, when interest rates change, other asset prices and the destiny of startups change as well. In other words, when interest rates or inflation rise or fall, assets and the value of companies must be repriced to reflect this new reality. If low interest rates and low inflation tend to support higher capital asset prices, then conversely, higher interest rates and surging inflation tend to depress the multiple investors pay for an uncertain stream of future cash flows (such as corporate earnings).
In this context, it’s important to understand why valuation repricing is occurring and how your firm can position its portfolio to weather (and potentially thrive) in the current market. While the tumult in the public markets may have not yet fully bled into private equity, in the first half of the year, PE deal volume contracted by 26% to 1,626 deals from 2,184 deals during the same period last year, according to PwC’s “Private Equity: Deals 2022 Midyear Outlook.”
The Forces Behind the Shift
The decline in deals and the market’s rather volatile first half of 2022 can be attributed to several key factors:
A decline in market liquidity. This represents a volume of money that’s working its way through the economy. In 2020 and 2021, the federal government (through major economic assistance programs in response to COVID-19) and the Federal Reserve (through interest rate cuts and bond purchases) provided stimulus to the economy, which helped generate more money to invest. The end of these programs contributed to a significant reduction in liquidity. Less liquidity by itself does not necessarily spell the demise of markets; however, it does create conditions where other external factors can more easily have a negative impact on them.
Slower economic growth. Efforts to stimulate the economy following the onset of COVID-19 helped spawn an economic growth rate (as measured by Gross Domestic Product (or GDP)) of 5.7% in 2021—the highest annual reading of GDP growth since 1984. Currently, growth is decelerating (or some may say ‘normalizing’). Real gross domestic product (GDP) decreased at an annual rate of 0.9% in the second quarter of 2022, following a decrease of 1.6% in the first quarter.
Geopolitical Instability. The war in Ukraine, repeated COVID lockdowns in Chinese manufacturing epicenters, election year politics, energy crises—the list goes on. Generally, geopolitical risks trigger increased risk aversion among investors. They tend to negatively impact market returns in all advanced economies and capital flows are affected, too, with lower flows steered to emerging markets.
Surging inflation. Inflation—the highest it has been since the 1980s—continues to be a major concern. The consumer price index (CPI), a gauge of inflation, jumped 9.1 percent in June from a year earlier—the largest gain since 1981. Eyes continue to be on the Federal Reserve’s future meetings this year, given its historic rate hikes over the past few months. The lingering question remains: can the Fed continue to raise interest rates and increase the cost of capital in order to reduce demand, boost supply, and moderate prices without plunging the economy into a deeper recession?
The Impact of the Fed’s Policy Changes
In March, the Fed initiated two policies to try to scale back the inflation threat. Both seek to limit liquidity in the markets and the monetary policy pivots outlined below have already altered investor sentiment.
First, the Fed began raising the short-term interest rate it controls—'the fed funds rate’—for the first time since 2018. Fed chairman Jerome Powell has it made clear that interest rate hikes will continue through 2022 and, perhaps, longer. However, what seemed unthinkable just six months ago—a 75-basis-point rate hike—has now happened twice in the past month.
Second, the Fed ended its program of “quantitative easing,” or monthly injections of $120 billion in bond purchases. In addition, the Fed will scale back asset holdings it accumulated through quantitative easing. The side effect of such quantitative tightening is a liquidity drain in the ongoing asset reflation regime, which is ultimately offers a less friendly environment for financial markets.
The Fed’s hawkish policy shifts are the primary reason bond markets reacted and interest rates began to rise. Its shifts further contributed to the drop in liquidity that is being felt throughout capital markets. The outcome: PE deal pipelines in many sectors have softened, especially in technology, and debt has become more expensive.
What Happens Next?
In the wake of these changing tides, the expectations of buyers and the sellers in the private market will be adjusted. This will take some time and valuation repricing should take place—it simply needs to occur.
During the Great Valuation Repricing, PE firms will look at the revenue and expenses of their portfolio companies over the last month and quarter. They will assess the companies they own to determine the information they need to accurately revalue their worth. Then, they will work on updating valuations in their portfolio (based on the latest numbers), while concurrently updating revenue forecasts and expenses.
There are several clear factors summoning the need to reprice, as recently outlined in a recent TechCrunch article earlier this month. They are:
If the company raised capital in late 2021 or early 2022 during more favorable economic conditions that have since passed.
If the company has now made significant changes to its growth and revenue forecasts due to the prolonged economic downturn.
If the company is considering raising capital in the foreseeable future.
If the company is slowing down cash burn given the funding market.
If the company is planning an exit in the next 12 months, as the road from private to public now takes a lot longer.
Of course, maintaining an inflated valuation will not do any PE firm (or startup) any good, since it’s deceitful, it can impact hiring and retention, and it may actually harm a company’s future growth.
Yet, the true scale of valuation repricing that is needed in the industry continues to leave analysts bewildered. Could hundreds of unicorns that grew fast over the past few years be impacted? If, for example, the oft-heralded Instacart—which was able to raise aggressively during the pandemic—is now worth a fraction of what investors calculated in 2021, then just how many other billion-dollar startups are now similarly situated (ahead of their next potential funding round)?
While no one has a crystal ball that can forecast the full breadth of the Great Valuation Repricing, the good news is that, as repricing gradually occurs, PE deal flow will likely improve as more companies consider going private during heightened volatility.
The Path Forward
There’s no questioning that the current environment is somewhat daunting for PE firms, as competition continues to mount. In this environment, smart firms will take a longer-term view with well thought-out repricing plans that are assisted by unified platform technologies.
And, as the Great Valuation Repricing unfolds, firms should be ready to adjust their portfolio company valuations to deal with ongoing inflation that shows little sign of abating any time soon.
Perhaps, the two core takeaways remain as follows: (1) valuation repricing must take place (but, it will not happen overnight) and (2) PE funds must proactively anticipate change and get ahead of it by leveraging advanced technologies that will give them an edge. This will be critical to weathering this turbulent period, so firms can take advantage of the eventual (cyclical) recovery that is destined to come.
Indeed, moving forward, top-tier performance will depend on demonstrable value creation and a clear understanding of how to manage effectively during a period of rising prices. The divergences in the markets outlined above will offer opportunities to those firms that successfully partake in valuation repricing and have the foresight to adopt new technology with deliberate speed.
Discover How Asset Class Can Help Your Team
Need help navigating the murky waters of valuation repricing? Asset Class platforms power over 400 private capital funds around the world. Whether you’re a PE or venture capital firm, or a commercial lender, you can discover how our platforms help make the future of finance frictionless. Schedule a demo with one of our team members today.
Sources:
https://www.bea.gov/data/gdp/gross-domestic-product
https://www.pionline.com/private-equity/private-equity-faces-crisis-value-over-inflated-prices
https://techcrunch.com/2022/07/20/what-is-409a-valuation-stripe-instacart/
https://www.pwc.com/us/en/industries/financial-services/library/private-equity-deals-outlook.html
https://techcrunch.com/2022/07/19/how-many-unicorns-are-just-ponies-now/
