How to mend the valuation disconnect between GPs and LPs

Following a compelling panel discussion at the ILPA MCON in Chicago, CSC’s Anne Anquillare shares what she believes are best practices to combat an age-old problem in GP-LP relations.

In private equity, valuations can be a point of contention between general and limited partners—yet they don’t have to be. This was the topic I discussed on a panel recently at the Institutional Limited Partners Association (ILPA) MCON event in Chicago.

The disconnect between general partners (GPs) and limited partners (LPs) is often brewing under the surface but tends to bubble up when the public markets are particularly volatile. No surprise then that this gap in valuation sentiment is widening—as companies face tough market conditions exacerbated by swiftly rising interest rates after an era of quantitative easing.

Regardless of market cycle, sentiments around valuations of illiquid investments in closed-end funds have historically been a challenge. Here’s why:

• Different reasons for involvement. GPs are optimists who love the asset class and their chance to build long-term value. LPs are pragmatists—they need the asset class to satisfy long-term liabilities and understand that valuing and reporting on illiquid assets is complex and often frustrating.
• A mismatch of information. LPs are not going to know the investments better than the GPs, so they need to “trust” them. This is not a comfortable position.
• Bad behavior. A few GPs have been cited for conflict of interest and other problems involving valuations priorities and the entire industry has guilt by association.
• Differences in public markets vs private markets. Less than 1% of the companies in the US are publicly traded. Many of them represent large segments of the economy in which private equity is not active (e.g. materials and utilities). And every trade in every public stock is a reported event that can move the valuation, regardless of the reason for the trade. Private companies represent a much broader population in terms of industry niches and sizes. And valuations in private companies tend to be done for specific purposes (e.g. employee options, quarterly financials) as opposed to a public trade.

So, to clear the air, the vast majority of GPs use their best efforts in valuing the fund’s investments and work towards a balanced approach in providing meaningful information to investors.

Let’s discuss how we can reduce the angst surrounding valuations in our industry—especially when the public market volatility increases.

Recognize investors’ heightened sensitivity

As this sensitivity often comes at market turns, GPs can proactively address it—especially as this is happening when they themselves have heightened sensitivity as they help their portfolio companies navigate the market turn. Private equity managers pride themselves in their ability to work their way out of any potential issues. How GPs are helping their portfolio navigate market turns is the information the investors want to know about.

That said, GPs have limited resources (it is a people business no matter what you have heard regarding AI). There is only so much GP time to go around, and investors would prefer that time is used to preserve or increase the value of the portfolio companies. GPs need to find scalable ways to communicate what is happening at the portfolio level. Quantitative information is the easier side—e.g. financial metrics like trends on debt ratio and interest coverage ratio. However, they don’t give the whole story.

GPs are digging deep into each company in their portfolio, asking key questions like why are the earnings below expectations? How is the management handling the downturn? Are they still motivated, or have they lost interest because their performance bonus for 2023/24 is zero?

GPs are confident they can pull the right levers for operational efficiencies and live to fight another day. The tactics being used to help portfolio companies navigate through the cycle can be and should be shared at a high level with investors.

Another important ability for GPs revolves around staying on top of the market potential for each company and determining when to go to market with a company. Even though the public market is volatile and valuations have decreased for a sector, a portfolio company might still be ready to go to market due to factors specific to that company.

A way to reduce angst for your investors is to discuss the rationale and timing behind near-term exits. In some cases, larger companies within a sector regard a downturn as an opportunity to shore up existing business or add new services through acquisitions. Knowledgeable GPs with great banking relationships can still use the downturns for opportunistic exits.

And private equity doesn’t necessarily have to sell. As in every cycle before this one, the market will turn. LPs are sophisticated investors and understand unexpected factors might come into play for the actual exit.

Lastly, another source of angst for investors during volatile economic times is their own ability to plan for cash flows. Private equity cash flows spike and trough along with the cycles. That means GPs must be mindful that LPs get nervous when the volume of distributions is uneven. Communicating expected timing for cash flows helps LPs plan. By communicating rationale and timing behind near-term exits as well as the impact on cash flows for the investors, GPs are providing a full picture for LPs so that they can better manage their investments in the illiquid alternative asset class.

How to leverage a trusted adviser

As a fund administrator, we can take the role of the trusted adviser for both GPs and LPs, guiding and encouraging those on both sides of the table to navigate their way through a cycle.

Our aim is also for LPs to get comfortable with a GP’s process. We coach GPs how to communicate with their LPs, which data and insights to communicate, and how often. We also assess whether their process is robust enough. Below are some examples of discussion points regarding valuation processes and communications:

• Does it work in up-and-down markets and different credit cycles?
• Will a process that works for 15 investments be fit for purpose if scaled to 50?
• Does the GP include inputs from private company databases?
• Do they use a third-party valuation firm? What is that firm’s process and source of information?
• Has the GP done their own back testing?
• Is there an opportunity to enhance the quarterly reports to investors and improve efficiencies of communication?
• Is there an opportunity to provide investors with direct access to data via a portal?

GPs love to talk about their portfolio companies. So the natural next step is to communicate to LPs—regardless of size, budget, and access to portfolio data and analysts—about how they are adding value to their companies. This should cover, for example, the banking crisis, debt refinancings, cost-cutting, sustaining environmental, social and governance (ESG) efforts, or expanding into new markets.

This will not stop LPs asking questions. However, those questions might be fewer and more insightful.

Now is the time for GPs to beef up their quarterly newsletters, to provide additional information to LPs about the great work their portfolio companies are doing, and how they are helping investors navigate through the complexities of the illiquid alternative asset class.

Why Intertrust Group?

• CSC completed its acquisition of Intertrust Group in November 2022. Together we offer a global solution for subsidiary governance, fund strategies, and capital markets transactions, with tools to help fund managers navigate the ever-changing compliance and regulatory environment that they face. With capabilities in more than 140 jurisdictions, we are able to do business wherever our clients are—and we accomplish that by employing experts in every business we serve.
• As a strategic partner, our proprietary innovative technologies are combined with global knowledge and experience to deliver added-value services catering for all asset classes, while increasing manager visibility of portfolios on behalf of a fund’s investors.
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