Private equity firms are more ‘conservative’ than ‘optimistic’ in valuations, with about 75 per cent underestimating final rates of return in the first year of investment, research reveals.
Private equity firms are more ‘conservative’ than ‘optimistic’ in valuations, with about 75 per cent underestimating final rates of return in the first year of investment, research reveals.
The British Venture Capital Association (BVCA), which has analysed data from more than 150 funds, finds that contrary to claims that equity houses and venture capitalists over-estimate valuations, they are more likely to ‘understate’ them in the early years of investment.
The research paper, ‘Are UK venture capital and private equity valuations over-optimistic?’, has compared the yearly valuations reported by the funds with the realised amounts. The dates examined are between 1980 and 2009.
The report finds that 75 per cent of funds underestimate valuations in the first year of investment. However, valuations greatly improve in time. Between 60 and 75 per cent of funds underestimate investments after the second year, while between 55 and 65 per cent in the third.
Most funds estimate the correct rate of return between years four and six, the report finds.
Colin Ellis, chief economist of the BVCA and co-author of the report, comments, ‘Private equity valuations have come under scrutiny recently following concerns about other asset valuations and mark-to-market practices.’
He adds, ‘Our research finds no evidence of systematic upward bias or artificially inflated valuations. In fact, over the early years of a fund’s life performance is, if anything, likely to be understated.’
The report says the findings are ‘both understandable and expected’ because of the difficulties in assessing valuations early on. Reasons for underestimation include changes in the cost of management fees, different methods of valuation, the restructuring of portfolio companies, and, alterations to investment and divestment plans.
‘The initial underestimates of internal rates of return could to some degree reflect the uncertainty around the many differently timed transactions that the average fund undertakes, and the lack of perfect foresight around these transactions,’ the report says.
The report can be found here.
