May 10, 2018
May Chart of the Month
Median Markups - The Premise
Investors often ask us how accurate GPs are at valuing their portfolio companies, particularly prior to an exit. In May’s Chart of the Month, we’ll analyze the accuracy of unrealized valuations shortly before an exit. Further, we pose the surprisingly provocative question: Are GPs naturally conservative?
What we find most GPs do is look to value their portfolio companies within a range. Rather than show a small markup or mark down based on general market movements, GPs might hold a company’s valuation relatively steady. Then wait for a material change to occur within the company before making any meaningful adjustments. For example, if the GP makes a follow-on acquisition that increases EBITDA or creates synergies, it would clearly affect the company’s value. Additionally, GPs are not likely to build in significant multiple arbitrage that could be achieved from selling to a strategic without certainty around that being the method of exit. Lastly, GPs don’t have an incentive to unnecessarily mark up investments in an attempt to increase carry. Since carry can only be taken once a company is realized. All of these considerations really boil down to one key point: Since markets generally rise over the long run, logic suggests the average company may be held conservatively.
But let’s not rely on logic alone. Instead, let’s use data and see if we can’t prove that theory. After all (and we know you’ve heard us say this before), data trumps anecdote.
Median Markups - Understanding the Data
So what does the data say? This chart shows the average markup of an investment during the quarters prior to a GP exit. Not surprisingly, we see that within three months of an exit, GPs know the company’s ultimate valuation with a great deal of precision . However, the farther out the company is from an exit, the larger the markup we should expect.
This makes sense. Valuations are representative of what you could get if you sold the company right now. So, if I’m holding a soon-to-be-exited investment at a 20% IRR, I might expect just under 5% growth per quarter just to keep pace with my returns. Yet, one quarter before a sale concludes, the company is still undervalued by 11%. That’s more than twice the estimated 5% quarterly increase that could be attributed to the company maintaining its existing growth rate.
Median Markups - Takeaways
This can mean different things depending on how you participate in the private markets. For a secondary buyer, for instance, it’s best to look for funds with impending exits. After all, two quarters from an exit will see an average markup of 21%! For others, the message is broader: LPs often forget about the growth potential of mature assets and instead credit (or, rather, fault) GPs for the entire markup at exit. To be fair, yes, GPs seem to be generally conservative. More importantly though, an LP should focus on whether specific GPs within their portfolio have a history of larger than normal markups that might disrupt an investor’s cash flow planning.