Private equity: financial engineering prevents valuation check

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There is no problem that private equity will not attempt to solve, including the problem of private equity itself. Interest rates have jumped and buyout exits have slowed amid a drought in M&A and new stock listings. The cash-churning machine is sputtering. But here comes a new market.

This week, Goldman Sachs announced that it had raised $15bn for a private equity fund. The fund will not be used to buy companies. Rather, it will buy limited partner interests in other funds, a transaction known as a “secondary”.

In such deals, pensions and other institutional investors can get cashed out, often at a discount to net asset value, near the end of a particular fund’s life. The fund sponsor is not then forced to sell an underlying portfolio of companies before it believes it can get full value.

Private equity secondaries have grown from a niche strategy with $100bn of assets to one approaching $500bn. This coincides with the rise of other forms of financial engineering, including “net asset value” lending, using an underlying fund holding a series of companies. Recently, Vista Equity relied on a NAV loan to stump up the $1bn of equity it needed for a challenged software investment.

Private equity firms are also increasingly selling equity stakes in fund managers to other specialised PE firms in order to give cash to partners.

Some industry veterans claim the golden era of private equity has passed now that low interest rates are unavailable and corporate valuations are more volatile. But the dollars keep flowing into these alternative assets. McKinsey estimates that there is now $12tn of private capital AUM. The total has grown at a 20 per cent compound rate over the past five years.

This complicates true price discovery. Public markets, while not flawless, tend to be a stricter test of fair valuations. The private equity industry deserves credit for finding continuous ways to bypass the issue and keep their fee stream running.