Expensive debt and askew valuations

Date: 07 Jun 2023

Karen Jones

With interest rates rising, debt will either deliver great returns or be an increasingly expensive item particularly with investments underperforming.

So, how is the market shaping up? One private banker shared his experiences: “Everyone has seen the price of debt rise and while people swallowed it in the past, this year there is a move to pay back debt.” He adds: “There is less lending against portfolios and fewer deals but the ones we have are sizeable.”

Debt against commercial property is also seen as a problem both in Europe and the USA as the future of office space continues to be questioned by corporates. “There are a lot of commercial real estate loans coming up and a high demand to refinance.” He adds: “However, with defaults happening in the office block space caused by lack of occupancy, there is an unwinding of leverage to come.” Hotels are seen as a better bet for financing, he says, “but loans are not the same.”

Continuing, he said: “Clients are paying down investment debt (debt secured against investments to buy more investments) because of the cost of the debt to service with rising interest rates, and also uncertainty in markets.” He adds: “There is still interest in new UK prime real estate mortgages from international clients, because whilst cost of borrowing has gone up, Sterling has remained weak and is much weaker in historic terms, so overall the package still works for clients.”

Valuations

Valuations are also coming under scrutiny in the market. Philip Higson, Founding Partner at Carlyon Services in Zurich, works with family offices as well as having a long history in private banking. He recently voiced concern about private equity valuations in the market, which remain high despite significant markets shocks like Silicon Valley Bank. He says: “We should be looking at this topic more closely” as “a decade of low rates has stimulated family offices and wealthy individuals to increase exposure to private markets which is now estimated to be a third of their wealth according to a family office report from UBS in 2023.” He adds that a latest estimate from an industry survey of allocation to subsectors of private markets is as follows: Private Equity 19%, Real Estate 13%, Private debt 2%. Total Allocation 34%.

Private equity investment valuations are typically reviewed periodically, regardless of market conditions. The frequency of these reviews can vary depending on the specific private equity firm and its internal policies. However, in a bad down market, the need for more frequent valuations arises due to increased market volatility and uncertainty. However, according to an article on pitchbook.com, “reviewing the methods PE firms and auditors use to estimate the value of the companies they buy, leads to a deeply unsatisfying conclusion: they’re generally accurate only sometimes and on a case-by-case basis.”

Ultimately, the specific timing and frequency of valuation reviews in a down market will depend on the individual private equity firm’s practices and their assessment of the market conditions and risks associated with their investments.

Higson says: “The 2022 market sell-off for equity and bonds has attracted bargain hunters. But this is not the case for private markets because lack of liquidity and higher rates equals significantly lower valuations which is not yet reflected in Net asset Values (NAV’s).” He adds, “Using examples of listed PE fund company discounts to NAV, and the price point for secondary transactions, we can measure to some degree the extent to which NAV’s are not reflecting the expectations of buyers and sellers of these assets.”

Listed PE groups – discount to NAV

“Taking a sample of 9 listed closed end investment funds holding 100% private equity the discount to NAV is average of 35% to high of 50%. This discount is not for short track record funds filled with loss making companies.”

(The sample is based on funds all greater than GBP 1.0bn AUM where all but one has published NAV in March or April 2023. Given that 7 out of the 9 funds have dividend distributions the likely cashflow of underlying investments is positive. This puts ‘these private investments’ in a lower risk category than for the loss-making names that do not distribute dividends and may have liquidity issues if M&A, IPO’s drought continues, and re-financing rounds are not executed).

Secondary market prices for private market single investment vehicles

“Further evidence of a buyer’s strike, even for the most highly regarded private market fund sponsors and their flagship investment vehicles, is the case of the secondary market in these opportunities. This data takes into the account the pressure on VC ecosystem in 2022 and falling confidence for real estate, likely associated with office properties stress.”

With continuing turbulence in the global markets, the consensus on this topic was that there was a need for better experts in the sector of valuations to better reflect market conditions and pricing.