Foul Is Fair and Fair Is Fair: Is Private Equity Still Overvalued?

Key Takeaways:

Data from the Burgiss Manager Universe (BMU) combined with novel analytics allow us to estimate whether funds are overvaluing, undervaluing, or holding their assets at fair market value (FMV). Understanding the current state of valuations is critical to Limited Partners (LPs) who are dealing with the “denominator effect” and making pacing decisions to achieve future allocations to private assets.
For most of our sample period, funds hold assets at modestly conservative valuations (a practice we refer to below as “historical norms”). However, large market moves often result in private assets being temporarily over- or undervalued.
Current data suggests that:
- Venture Capital funds are now close to being fairly valued. This is in stark contrast to the recent past when Venture Capital was significantly overvalued.
- Buyout fund valuations continue to appear to be in line with historical norms.

Whether private assets are overvalued is of great interest to LPs for a number of reasons. For example, overvaluations—and undervaluations for that matter—will paint a misleading picture regarding allocations to such assets. This can be exacerbated if public markets fall rapidly, shrinking the size of the denominator and amplifying the apparent overallocation. Since private capital investments require commitments to be made several years ahead of when capital is fully deployed, valuation biases can result in overcorrections to pacing patterns, causing allocation problems down the road.

Last September, we studied these issues in our Applied Research article The Truth Will Out: Is Private Equity Overvalued? (henceforth referred to as “The Truth Will Out”), and argued that Venture Capital funds were significantly overvalued whereas Buyout funds were approximately fairly valued (or, at most, valued modestly above historical norms). In this article, we review developments since then and reveal what our model says is the current[1] state of play.

Based on the results from “The Truth Will Out”, one would have expected Buyout funds to move roughly sideways—perhaps rising or declining somewhat depending on the subsequent evolution of the equity markets—and Venture Capital funds to decline until their valuations fell in line with their fair value; given their significant amount of overvaluation, one might have expected this to take several quarters to fully play out.

First, we summarize the actual evolution of private markets since “The Truth Will Out” (see figure 1). Note that our previous article was based on BMU data up to 2022 Q1, which is shown as a dashed line in the figure.

Buyout funds had some slight negative returns in Q2 and Q3, followed by a slight positive return in Q4.
Venture Capital suffered an unprecedented string of declines, with four consecutive quarters of negative returns; the decline in 2022 Q2 (-10.95%) was almost as severe as in 2008 Q4 (-11.89%).

Based on these data, we think it is clear that private equity returns have evolved in line with what “The Truth Will Out” suggested.

*Figure 1: Cumulative returns of U.S. Venture Capital and Buyout funds*
The dotted line is at the end of 2022 Q1, which is the latest data that was used in estimating our model in “The Truth Will Out.”

Turning to the present, are valuations now[2] fair? First, we look to the public markets, and assume that private market returns are mostly a lagged—and smoothed—version of public returns, perhaps with a beta greater than unity. Buyout funds were essentially flat throughout 2022, which seems at odds with the declines in public markets. Venture Capital funds suffered steep negative returns in all four quarters of 2022, which at first blush might seem to mirror the public markets; note, however, that numerous studies (both academic as well as our own study, O’Shea and Jeet [2017]) suggest that the beta of Venture Capital to the public markets is significantly greater than one. Taking this into account would suggest that further steep declines should be expected. But all of this is based on similarities between the public and private markets. The methodology of “The Truth Will Out,” in contrast, is entirely independent of the behavior of public markets as it uses only private capital data—namely data from the BMU. As we will see, private data paints a somewhat different picture, and it is to this analysis that we turn next.

The methodology of the “Truth Will Out” can be summarized as follows. The BMU records much more than just the pooled behavior of a large number of funds; rather, it captures the behavior of every individual fund. Furthermore, there are significant differences in behavior among the individual funds: some distribute no capital in a given quarter, while others distribute a significant fraction of their net asset value (NAV). We exploit this cross-sectional variation by noting that, for example, if valuations are too high, then funds that distribute large amounts of capital will tend to have lower returns than those that do not (since the former set of funds will be forced to recognize the true value of their assets—cash flows are objective, but valuations may not be). Further details can be found in the original article, as well as in its Technical Appendix.

*Figure 2: Overvaluation for U.S. Venture Capital and Buyout funds.*
The black line indicates whether fund assets are over- or undervalued relative to their FMVs. The colored bars correspond to various regimes; the darker color indicates the quarters when the U.S. public equity markets achieved their maximum values, and the lighter color indicates the quarters when they achieved their minimum values.

Figure 2 shows the results of estimating an index[3] based on this methodology. As we remarked in our previous article, there are a number of interesting details about the past behavior of this index, including that private equity funds generally tend to hold assets at a slightly conservative valuation (i.e., the index usually takes on negative values; we refer to the degree of such undervaluation as “historical norms” throughout this article). Fitting the methodology to the current BMU suggests that Buyout funds continue to be valued slightly conservatively, and hence in line with historical norms. But the degree of overvaluation of Venture Capital has declined markedly, to the point where it is now also aligned with historical norms. In our view, this perspective—based purely on private data—paints a somewhat more positive picture than what the public markets might otherwise suggest.

Conclusion

By exploiting the cross-sectional variation in fund behavior within the BMU—and only such data (i.e., not using any public data)—we can estimate whether private equity is over- or undervalued. This approach combined with the latest data from the BMU suggest that as of 2022 Q4, both Buyout and Venture Capital funds are approximately fairly valued. For Venture Capital funds, this is a marked change from several quarters ago when they appeared to be significantly overvalued.

[1] As of the BMU updated through 2022 Q4.

[2] As of the BMU updated through 2022 Q4.

[3] See the “Comments on Data and Methodology” section at the end of this article for why we call it an “index.”

Comments on Data and Methodology

The analyses in this article were carried out using BMU data through 2022 Q4 on over 1,500 Buyout funds and 2,400 Venture Capital funds. These funds generated around 700 individual distribution cash flows per quarter during our sample period, thus providing our methodology with the required cross-sectional dispersion in distribution amounts.

The BMU provides global investors with research-quality performance and behavioral data of unrivaled breadth and depth for private capital funds and their holdings that date back to 1978. As of 2022 Q4, the growing BMU dataset includes over 12,900 private capital funds and funds of funds, representing more than $10 trillion in committed capital across the full spectrum of private capital strategies, including private equity, private debt, and real assets.

We would also like to add some words of caution regarding our methodology. The index we show in figure 2 is the output of a model. This is in contrast to the data we show in the Universe Analytics module within Burgiss’ Private i® Platform; this data summarizes the behavior of the entire private capital universe, not intermediated by any model. Like any model, ours comes with a set of limitations; for example, the model is looking for a signal that is at the edge of detectability, which is why it relies on a spline regression. The use of splines means that the edges of the index are partial extrapolations. We have tried to optically guard against overinterpretation by changing the line representing the index from solid to dotted at the far right of the graph.

In addition, we refer to the output of the methodology as an “index”, rather than literally the degree of under- or overvaluation, since its level should be taken with a pinch of salt (see O’Shea [2022a]). However, we believe that it is directionally correct—a negative index value suggests undervalued assets; a positive index value suggests overvalued assets; and an increase in the value of the index suggests that assets have become more overvalued.

Foul Is Fair and Fair Is Fair: Is Private Equity Still Overvalued?

Conclusion

Comments on Data and Methodology

Further Reading