As we begin wading into the final earnings season of 2022 we’re all bracing for the potential disclosure of weakening revenue growth, increases in operating and financing costs, translation losses from weak foreign currency and a potential lowering of expectations for future fundamentals. This fundamental reset is already partially evident in public equity declines. However, in the private markets we have not yet seen the declines in valuations typically associated with weakening fundamentals. Some of this is simply a function of delayed valuation disclosure, but some may also be a reflection of the inherent relative stability of private markets. How can we conceptualize the appropriate declines in private values?1
In 2021 global private capital buyout, exit value, capital raises and secondary deal values all reached records. This acceleration was built on financing and valuation environments that have changed dramatically over the last twelve months – so it’s very fair to expect some measure of correction in private portfolio valuations. Public growth companies have seen valuation multiples collapse by 20%-70%, and financing costs have seen their single largest annual increase in over 50 years. This rapid change of landscape will eventually have to find its way to private valuations.
But that does not mean there is a “Private Capital Bubble”. Back in 1981 Robert Shiller shed light on something that, until then, was obvious but undefined; the idea was that public equity returns reflect both changes in fundamentals and a component of excess volatility driven by structural and behavioral phenomena like risk aversion, frequent redemption/subscription activity, momentum, greed and fear. This is important to consider today as we look across the “more rational” private markets to determine what type of fundamentally driven correction to expect.
Fundamentals (earnings) are weakening, but not dramatically. Since the beginning of the year earnings expectations for the S&P 500 Index are only down 3%. Estimates for 2023 and 2024 are down similar amounts. Price/Earnings (P/E) multiples, on the other hand, are down over 20%. That’s where that excess volatility lives – along with fundamental elements like higher interest rates. Assuming a slightly higher long-term costs of capital driven by higher normalized risk-free rates, we believe the 3% decline in current earnings could translate to a roughly 10% decline in average private values. This is a generalization across the category. Individual companies will have better and worse fundamentals and the ability to fund growth covers the gamut.
This framework can also be used to think about the tactical range of outcomes related to the over/under discounting of fundamental change in public equity markets. The point being, when public equities underperform earnings, pay attention to earnings – not prices.
Important Disclosures & Definitions
1 Influenced by Rudin, A., and Farley, D. “Public and Private Equity Returns: Different or Same?” The Journal of Portfolio Management 48 (3): 117-127
Price/Earnings (P/E) Ratio: a valuation ratio of a company's current share price compared to its per-share earnings.
S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. One may not invest directly in an index.