12 months ago there were widespread predictions that meaningful markdowns were inevitable for private capital funds. However, speaking to LPs many report those markdowns have been far less significant than they had expected – although investors appear relatively unconcerned that valuations are overstated. 

One possible explanation is the use of public stock comparables in private fund valuation methodologies. It has been observed that technology stocks (particularly the larger ones) have underpinned private market performance during 2023, and with so many PE firms focusing on technology either directly or indirectly (B2B with a technology product or service angle accounting for a large proportion of mid-market deal volume), perhaps these comparables have flattered the portfolios a little. Some also suggest that PE's medium-term view allows for a degree of "volatility laundering" – i.e. that the fluctuations in private valuations, upwards or downwards, tend to be less dramatic than in public stocks.

Nevertheless, when speaking to GPs about the state of their portfolio, a customary response is that it is in "pretty good shape" on the one hand, whilst also an area of significant focus on the other. Investors spending more time on the portfolio is a natural response to a difficult deal-doing environment (whether that is to best create value, prepare for incoming headwinds, or simply due to a perceived lack of opportunity to buy), but explanations as to why the portfolio is in good health can be harder to unpick. Some will point towards not having an exposure in retail, consumer or leisure for example, but as an explanation in itself this feels very 2009. Most investors have either pivoted away from consumer investments or refined their investment strategies in a way that helps mitigate exposures. 

In contrast, a business services investment that provides services to commercial landlords, energy suppliers, wholesalers or logistics companies is only one step removed from the pressures on the high street. Perhaps the true state of a portfolio that is largely exposed to the broad church of business services is currently being masked by low levels of business creditor default? Shrewd investors will point to how robust their investments are – in niche markets, or growth markets, or as market leaders, with robustly contracted long term revenues. But contracted revenue is only as valuable as the creditor that stands behind it, and with it being widely accepted that 2024 looks like a difficult year it is also likely that delinquency and default by SMEs has been suppressed by state intervention and reliance by consumers on credit (the UK credit card market achieved double digit growth in 2023). 

Against that backdrop add (1) the very high multiples paid on PE backed deals in a competitive 2020-22, and (2) the fact that debt financing used for those deals will be revisited in the short to medium term in a higher interest rate environment, and it is hard not to think that all may not be as rosy as the relatively steady PE valuations suggest.

All of this makes the timing of the FCA's recently announced review of private markets to determine risks to financial stability interesting. Given this is part of a global trend (the US Securities and Exchange Commission also recently introduced new rules) we are anticipating substantial pressure towards greater independence, frequency and oversight in PE valuations. Optimistically, this might reassure LPs that the lower volatility in movements of PE valuations is rooted in strong investment decisions and portfolio management underpinning a healthier outlook – particularly where a GP can show it already undertakes a robust, ringfenced valuation exercise. However, the fear for LPs is it may also identify situations where imperfect information, time lags or a lack of independence have masked some elements of the pain – and it does seem that the FCA at least are concerned that the higher interest rate environment is not yet fully reflected in unlisted asset valuations.