Three takeaways on private equity valuations: what fair value adjustments reveal

Financial regulators are increasingly focused on how private equity fund managers value their portfolio companies. In October, the Securities and Exchange Commission (SEC) said that a key issue it would examine in 2025 is how advisers to private funds calculate fees based on the valuation of illiquid assets: ‘If clients invest in illiquid or difficult-to-value assets, such as commercial real estate, examinations may have a heightened focus on valuation.’

Given the opaque nature of private markets, regulators worry that GPs might be overvaluing the businesses they own, potentially impacting financial markets by inflating asset prices across the sectors in which they’re active. The risk of overvaluation is also a concern for LPs. Almost half (49%) of global institutional investors surveyed by Preqin in H2 2024 said they consider private equity to be overvalued, up three percentage points from our previous survey in November 2023. That said, the share of LPs concerned about overvaluation in private equity has fallen consistently, from 53% in June 2023 and two-thirds (66%) in June 2022.

The potential overvaluation of portfolio companies was one of the emerging risks from private markets highlighted in a 2023 study by the Madrid-based International Organization of Securities Commissions (IOSCO), whose members comprise the world’s securities regulators.

‘There’s a whole host of regulators who have either done reviews or started consultations around valuations in private markets for the managers and allocators that are under their supervisory responsibility,’ says Leon Sinclair, EVP and Head of the GP Business Unit at Preqin.

‘There are some differences in focus, but they’re all concerned about valuation practices, the quality of fair value, collateral value, the interconnectedness of risk and conflicts of interest.’

Industry experts acknowledge that given the complexity of valuing illiquid assets, not all GPs get it right. Just how concerned should regulators – and LPs – be about the potential overvaluation of privately-held assets? How significant an issue is it? As a starting point, we can look at fair value adjustment (FVA) data, which records changes in how privately owned assets are being valued over time. By evaluating FVA trends for a specific sector and region, we can start to understand when GPs tend to mark up or mark down the value of their assets, and by how much.

Assessing private capital valuations with FVA data

Let’s look at FVA data on buyout deals in a major North America sector: software. Using an anonymized dataset of 160 2018-vintage deals from 65 GPs, we can index FVA over the past six years (Fig. 1).¹ By examining the data, we can identify the first of three key takeaways.

Fig. 1: A steep upward climb in the average fair value index for North America software buyouts (March 2018 – June 2024)

_{Source: Fair Value Adjustments, Preqin Transaction Intelligence}

1. Fair value reflects broader market conditions

If portfolio monitoring teams are valuing their assets correctly, we would expect the index to move in a similar direction as the broader market over time. True, public markets are more liquid, and valuations tend to be more volatile, which means private market valuations are unlikely to move in lockstep. But given that both markets are influenced by the same macroeconomic conditions, a sufficiently large time series dataset of private market valuations should show a trendline that correlates with public markets.

Using the NASDAQ Composite Index as a proxy for public markets bears this hypothesis out (Fig. 2). Between 2018 and 2024, we see a strong upward trend across both the NASDAQ Composite and average FVA of private assets underlying North America software buyout deals.

Fig. 2: A sharp rise in the NASDAQ Composite Index over this same period (March 2018 – June 2024)

_{Source: Nasdaq.com}

What was happening in the private equity market during this time? Let’s start with the pre-pandemic period. For GPs, 2018 marked one of the strongest five years (2014–2018) in the industry’s history across fundraising, deals, and exits, buoyed by a powerhouse global economy that had been growing for close to a decade. While macroeconomic conditions began to falter in 2019, GPs kept on securing record amounts of capital, and in the months leading up to 2020, sentiment and deal activity remained robust.

What the data shows during this time is an initial jump in the index between March 2018 and December 2019, when a peak of 1.41 is reached. This is broadly in line with the 27% rise in the NASDAQ Composite, which closed at 8,972.6 on December 31, 2019.

2. Private valuations are less impacted by an economic shock compared with public valuations

The economic impact of COVID-19 lockdowns in March 2020 forced GPs to reconsider the value of their assets. The index declined from 1.41 in December 2019 to a low of 1.25 by June 2020, a drop of 11.3%.

On the public market side, the fall was steeper, though it occurred earlier. Between December 2019 and March 2020 NASDAQ Composite Index slid by 23.5%, slumping to a low of 6,860.67 on March 23, 2020, the day the UK government declared a nationwide lockdown. This came just a week after the US began implementing economic shutdowns to slow COVID-19’s spread.

3. Private valuations recover quickly in a crisis

Unlike the Global Financial Crisis of 2008–2009, COVID-19 was a public health cataclysm rather than a systemic fault at the core of global financial markets. Market participants were optimistic that economic conditions would return to normal, and as GPs sought to recalibrate, average quarterly FVA growth fluctuated.

After dropping to 4.5% in March 2020, average quarterly FVA growth soon recovered, rising to 12.48% by June 2020 (Fig. 3). Average FVA growth then dipped again, falling to 10.98% in March 2021, then sliding further to a low of -0.64% in June 2022. Since then, average FVA growth has been less volatile, following an upward trendline to reach 2.69% by June 2024, the most recent data available.

Fig. 3: Private valuations bounced back soon after the initial March 2020 lockdown shock 

_{Source: Fair Value Adjustments, Preqin Transaction Intelligence}

The volatility in the data, and the significant course correction, reflects a tendency toward optimism in the industry, experts say.

‘What we saw in 2019–2020 was a classic overvaluation scenario,’ says one industry professional. ‘As we went into the end of 2019 and the beginning of 2020 economies were doing well, companies were doing well, and valuations were up. But then the bottom fell out in March 2020 when COVID-19 shut everything down.’

‘Some managers may have ended up overvaluing their assets because they were cautiously hopeful that this was a momentary blip. But as reality hit, GPs realized they would have to lower their valuations again. It’s not malicious intent driving these changes, it’s optimism as to how things will play out. Sometimes there’s a bit of a delay before GPs recognize that their companies are not going to perform as well as they hoped.’

Private equity valuations took multiple quarters to course correct after COVID-19

Since the lockdowns of March 2020, it has taken more than three years for volatility in FVA growth to reduce. Since then, the data shows a return to a more limited range of fluctuations.

Looking ahead to 2025, market participants may be hoping for a cut in interest rates that would help to underpin valuations going forward. The International Monetary Fund’s October 2024 World Economic Outlook highlights downside risks to the global economic outlook, though it has upgraded its forecast for US growth. All eyes will be on the Federal Open Market Committee’s next meeting, expected on January 29, for further guidance.

_{1 Preqin’s FVA data is sourced from anonymized fund portfolio reports provided to LPs, and forms part of Transaction Intelligence, a $5tn repository of private capital deals.}

_{The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.}