Beware the Practical Expedient Rule in Secondary Private Equity Funds

A recent Morningstar podcast gave me yet another reason to stay away from private equity.  Episode 357 of The Long View is an interview with Leyla Kunimoto who “is the founder and editor of Accredited Investor Insights, a newsletter that helps investors navigate private markets.”  Among other interesting insights, Kunimoto explained how the practical expedient rule allows private equity to maintain made-up valuations even after private assets are traded at lower prices.

In public markets, company valuations are set by the actual price where willing buyers and sellers trade equities.  In private markets, equity valuations are made up.  The methods owners of private equity use to value their holdings can give a wide range of answers.  It’s up to savvy buyers to determine the true value of any assets they choose to buy.  All but the most savvy buyers of private equity are at risk of overpaying.

There is now a proliferation of secondary private equity funds buying assets from primary funds.  Suppose a primary fund holds assets it says are worth $100 million, but it chooses to sell those assets to a secondary fund for only $75 million.  You’d think this sale would establish a real price for these assets, but the practical expedient rule allows the secondary fund to mark these assets back up to $100 million immediately after the trade, thus booking a $25 million gain.  While secondary funds are deploying capital this way, their returns look spectacular.

Kunimoto goes on to explain the consequences:

“On paper, those returns look beautiful. When on paper, you’re generating double-digit returns every 12 months, investors look at that growth, and they say, ‘My goodness, I’m missing out. I’m going to allocate some money to this fund.’”

“So, these funds in the early days, virtually every single one of those funds, secondaries funds, has very robust fundraising. Some of them grow to billions of dollars without borrowing a dollar.”

“So that’s playing out right now. There are a lot of secondaries funds. A lot of them are targeting retail investors.”

In the earlier example, maybe the primary fund sold at a discount because it needed cash.  But we need to ask why the primary fund couldn’t find a willing buyer at a price closer to its made-up valuation.  Maybe the assets were never worth $100 million.  Maybe the spectacular gains secondary funds show are a complete illusion.  It’s impossible to tell unless you’re a genuine expert at valuing private assets.

The best case scenario for retail investors is that the private equity made-up valuations will prove to be accurate.  In the worst case, secondary funds have been buying up overpriced assets, and retail investors will be left holding those assets when there is no dumb money left to overpay for them.  I’ll have my money in public assets when the truth gets revealed.