Chicago Booth Review Podcast Decoding the Signals in Private Equity Reports

Steve Kaplan: Private equity had this huge streak of every year if you bought the average private equity fund, talk buyout funds in particular, if you bought the average buyout fund every year, you beat the S&P 500.

Hal Weitzman: Private equity investments are typically locked up for many years, which means investors don't know at any point in time how much their stakes are worth. Should they take at face value, the valuations that PE firms provide? Welcome to the Chicago Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way. I'm Hal Weitzman and today I'm talking with Chicago Booth's Steve Kaplan, who has detected patterns in private equity valuation reports that reveal whether the company will be sold at a premium and when that exit might happen. So how can investors get a better sense of when and how big their payoffs will be?

Steve Kaplan, welcome back to the Chicago Booth Review Podcast.

Steve Kaplan: Great to be here, Hal.

Hal Weitzman: So we are here to talk about private equity, interim valuations. All right, so let's maybe start with this question. What got you interested in this? What are we trying to solve? What is the question animating this research?

Steve Kaplan: So it's actually very topical now that when you look at private equity investments, whether buyouts, venture capital, whatever, they're illiquid. And so it means there isn't a market price for them necessarily. And so when you are an endowment or a pension fund or whatever, you have these investments and there's some question about what they're worth as you said before. And today, particularly given the fact that there has been less liquidity, fewer companies have been sold. There's a real question about the valuation. So it's a very interesting topic today because people are not sure of the valuations. And it's an ongoing topic because if you're running a pension fund or an endowment or a family office and you own private equity, you want to know what it's worth. So that's number one.

Number two, if you are trying to decide should I invest in a private equity fund that has come to market, part of the way you make that decision is you look at their past performance and their past performance is the performance of their fund that they're currently investing. And so you'd like to know what that's worth. It may be marked at 100, if it's really worth 120, well that's a better fund than you think and if it's really worth 80, then you might not want to invest in it.

Hal Weitzman: Does that mean that, so if my retirement fund is invested in private equity, and by the way, is it, I mean is that typical?

Steve Kaplan: Your retirement fund? Probably not. Right now, most of the retirement plans are in liquid assets. So whether it's the S&P 500, the total market index in fixed income, those tend to be liquid assets or assets that are traded so you can get out. Now that's also something that's controversial about whether individuals can put more money into private equity. It started out as an institutional market, an endowment market. And as that market has matured, so the private equity firms have gotten pretty much as much money out of those sources as they can. They're looking for other sources of money and so they're trying to get money or the not trying, they're now approaching individuals and trying to get private equity investors more from the individual market and also, potentially the retirement market.

Hal Weitzman: But as you say, the challenge is, I don't know at any one time if I've invested, I don't know any one time what that's actually worth because it's not marked to market at any moment.

Steve Kaplan: You don't know what it's worth. And also, you don't have liquidity. So if you retire and you need your money out, how do you get it out? So that's the-

Hal Weitzman: And what's the typical timeframe, Steve?

Steve Kaplan: So when you invest in a private equity fund, contractually they have 10 years. So they basically, there's a five-year period to invest the money. So if you commit, let's say you commit a million dollars to a fund, they have five years to ask you for the million dollars and they could ask it all in the first year, they could ask it equally over five years. They could ask it toward the end. So you're basically committing to give the fund a million dollars over five years and then the fund has at least 10 years to get your money back. And usually they're given extension their automatic extensions of three years. So they have 13 years. And in practice it usually goes beyond that. I think the median fund life for data funds raised before the great financial crisis were 15 years and we'll see whether that goes longer. The funds that were raised in early 2020s, which have not had good realizations, maybe longer. But in any event, I think if you make a private equity investment into a fund, you should expect 15 years.

Hal Weitzman: It's so interesting though because there's always speculation or there has been for many years about private equity performance and whether it's peaked. But what you're saying is we won't know that for quite some years to come.

Steve Kaplan: You get a sense of it. So this is where the marks are interesting, and this is why we did this paper, is that the funds that were raised really through 2015 now are pretty highly realized. They're not completely realized, but they're largely realized. So you can look at the performance of those funds, particularly buyout funds and be pretty confident that that's the fund performance because a typical investment in a company lasts five or seven years. So the fund, you may take investments over five years, then you sell a bunch, and then the ones that last the 15 years are the ones at the end that you haven't sold. So it's sort of like the amount of the fund or the percentage of the fund that's still outstanding in the 15th year is small, but it's not zero.

Hal Weitzman: Okay. And as you say, it's not like we get no information. As an investor, you do get some.

Steve Kaplan: Correct.

Hal Weitzman: You get these interim valuation reports. How frequently are those issued?

Steve Kaplan: So the interim valuation reports you get every quarter.

Hal Weitzman: So every quarter. So just like having a public company report. And so what is in these reports, why are they important? Well, they're important I guess because you get the valuation, but what is in them?

Steve Kaplan: So what's in them is they tell you their estimates of the value of the existing investments. So every quarter will say, okay, you got these realizations and you know if you got a realization because you get a check and you get a notice that you're going to get a wire from the fund and then at the end of the quarter at a minimum they'll tell you here's what the fund is worth and here's what the individual portfolio companies, what we're marking them at. Some funds give you a lot more information, they'll tell you the revenue, they'll tell you the operating income, they'll give you some color into what's happening in the company. And you tend to see that particularly on the buyout side where they'll give you pretty interesting information about the companies and the venture side sometimes you get that, sometimes not, but you'll always get a valuation of the individual companies.

Hal Weitzman: And so in your research that we're going to talk about, you were analyzing whether these interim valuations, how they can predict the final outcomes and the exit timing. So what is the headline finding here from this research?

Steve Kaplan: So the headline is that the pattern of how individual portfolio companies are valued is informative. And what that means is if you, let's say the private equity fund invests in a company and initially let's say invests $50 million, initially it's marking that company at $50 million. Then let's say a year later it says, "Oh, things are going well. We mark it up to 55 and then the next year we mark it up to 60." When you see that pattern of markups, that tends to be good that they undermark the companies that are doing well. On the flip side, if you see them marking a company down, it was 50 and then 45 and 40, that's bad. They tend to undermark it down. And then the thing that's actually quite interesting, if the marks are flat, so it's 50, 50, 50, 50, that's also bad. You tend to see those will underperform going forward.

Hal Weitzman: Is that because they're in denial?

Steve Kaplan: It's like it's a funny thing because they're in denial on the upside, right? They're conservative-

Hal Weitzman: Being conservative.

Steve Kaplan: They're conservative on the upside, they're conservative. I would just say they're conservative and historically, when you add that all up at the fund level, they undermark. So historically that if you look at where a fund is marked at a particular point in time, that tends to undervalue the fund going forward. Now that was true in a period where things went well and so it'll be interesting to see whether that continues post-2020, the data for that was pre-2020, particularly since I think post-2020 there are more companies that have been marked flat.

Hal Weitzman: Is that the general trajectory of private equity as an industry that more stuff is getting marked down?

Steve Kaplan: Well, what is the case is if you look at both buyout and venture and particularly venture, that the marks, at least relative to how they were doing relative to public markets peaked in 2022 because there was this great run in 2020/2021 of selling things and there was also a lot of buying. So there's a lot of transactions in 2021 when private market prices were very high, particularly on the venture side. And since then, valuations on the venture side in particular have come down.

Hal Weitzman: But not so much that they're in line with public markets. You mean just that they've lost their edge?

Steve Kaplan: I don't know. I'm not sure about the actual relative to public markets where-

Hal Weitzman: Okay, but private equity is not, at least in general is not as healthy as it was a few years ago it sounds like?

Steve Kaplan: Private equity had this huge streak of every year if you bought the average private equity fund and talk buyout funds in particular, if you bought the average buyout fund every year you beat the S&P 500. So it's true almost every year from 1992 to 2019, and that's why so much money went in. The 2020 vintages are running about the same as the S&P, maybe a little lower and the 2021 vintages a little lower on the buyout side. The venture side is much more up and down they did very well 2010 to 20, I want to say 2016 vintages. And since then they're not performing as well in the 2020 and '21 vintages are underperforming the S&P by a decent margin. So you've got this time period where the vintages, all the funds raised on the venture and buyout outside in '20 and '21 are going to have a tough time beating the S&P 500.

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Steve, in the first half you talked about your research into private equity, interim valuation reports and how the pattern can often tell us something. If the general pattern is being marked up, that's a good sign. If it's being marked down or it's being marked flat, that's a bad sign typically. So instead of looking at just how the entire PE fund is performing, your study focused on the individual portfolio company investments, why did you go down to that granular level?

Steve Kaplan: Because other people have looked at the fund level and the fund level there's not a ton of pattern, particularly on the buyout side. So the buyout outside, you can look at how the previous fund is performing. And so this is an earlier paper I did. So let's say a firm is raising fund three, let's look at fund two. Is fund two performing well or medium or badly? Turns out if you look at that performance when they're raising fund three fund two's performance tells you nothing. And so that's on the buyout side, the venture side, it tells you something, the top performers persist and that's venture is unusual if not unique that way. So that's the result at the fund level. And there are a number of papers that try to look at that. No one had really looked at or is there very little looking at the actual company level and whether you could learn something there. And so that's why it was a natural thing to look at as we were able to get data to study that.

Hal Weitzman: And then so beyond just looking at the most recent reported value, in this paper you talk about two specific measures, which I think we've covered, I just want to make sure. So staleness is one and markdown frequency is another. So we talked about the trajectories, but what is staleness and what is markdown frequency?

Steve Kaplan: Staleness is just, you have the same valuation every quarter. So you make in investment-

Hal Weitzman: So staleness is bad as it sounds like. Staleness is-

Steve Kaplan: Staleness is if you invest it at 50 and you keep it at 50, that's more likely to go down than it is to go up.

Hal Weitzman: Okay, so staleness is bad, which is what we would assume. What about markdown frequency?

Steve Kaplan: Markdown? So if you go from 50 to 40 and then keep it at 40, that's not as bad as going 50, 45, 43, 40 because 50, 45, 43, 40, you got three markdowns. Three markdowns is worse than one. That's what markdown frequency is.

Hal Weitzman: Okay. All right. So both of those are bad. What about exits? So what is the significance of those of staleness and markdown frequency in terms of the timing of an exit? So for example, did staleness mean an investment was sold sooner rather than later?

Steve Kaplan: So they also, they do similar things as you might imagine that when an investment is stale but tends to be sold later when investment has been marked up, it's going to be sold more quickly and at higher valuations. If it's stale or there have been markdowns, you tend to put off selling them and when you do sell them, the outcomes are not as good. It's not just amount, it's also time.

Hal Weitzman: It's the timing. So they tend to hold onto bad investments in the hope that things will turn out better?

Steve Kaplan: I would guess that's correct.

Hal Weitzman: It's like selling a house that you, it's hard to depart from the value that you have in your mind. So you might hold onto it for longer.

Steve Kaplan: Right. And you're hoping you can make it better, you're hoping it'll improve.

Hal Weitzman: But generally the market doesn't turn around [inaudible 00:17:03] I feel like there's a general lesson though, Steve, in terms of investments.

Steve Kaplan: Well that's the interesting thing right now because as I said, the '20 and '21 vintages, there are a lot of companies that haven't been sold and my guess is many of them haven't been written down. They're stale prices. And so you'll probably see this pattern will continue going forward.

Hal Weitzman: And so staleness cannot be, it's always going to be a bad sign?

Steve Kaplan: Well historically it is and it need not be, right? You could imagine some people will just keep it the same and then we'll sell it it'll pop up and that could happen too.

Hal Weitzman: But at times of less liquid, when you have even less liquidity, do you have more staleness?

Steve Kaplan: The answer is actually, I'm not positive from the data that that's the case, but I'm pretty sure that that's the case, is that the marks now are staler than usual. They can't write them up, they haven't improved, but they're not willing to write them down. So I would guess that's the case, but that's something we or somebody else will study going forward.

Hal Weitzman: But we are in a period now that looks somewhat stale. Is that right?

Steve Kaplan: That would be my guess.

Hal Weitzman: Okay. So how useful, we talked about interim returns, staleness, markdowns, how useful all these measures for predicting the negative tail outcomes like losing money on investment, being in the bottom 25% and then positive tail outcomes like making three times the investment, being in the top 25%?

Steve Kaplan: Yeah, I mean they're statistically significant and reasonably strongly. And where you might use that is if you are an investor looking to invest in somebody's next fund, you want to know how that fund, the previous fund is really doing? Well, if there are a lot of stale investments in that fund, I'd be a little nervous and worry that that performance is actually not as good as they say. On the other hand, if there are a number of companies that have been written up a little bit, I'd be saying maybe those things are undervalued and that would affect my investing in the next fund. And then also, of course there were a lot of secondary transactions where people are the original limited partners, pension funds, endowments want to sell some of their private equity investments. Harvard was just sold and Yale I think have just sold parts of their private equity portfolio.

So if I'm buying that portfolio and buying funds in that portfolio, I actually want to see how those individual companies are doing. And again, if there are a lot of little write-ups, that's good. There are a lot of staleness and write-downs, then I'm going to want to put a bigger discount on that. So it's potentially very useful. And a funny story, one of my co-authors, Ege and I should say this is co-written with Ilya and Ege who are both at Stanford, Ege presented this and afterward one of the people in the audience was actually someone who was an investor in secondary transactions and he told Ege, "Well, my alpha just went away because you just told people how I figure out-

Hal Weitzman: This is your special sauce you're giving away.

Steve Kaplan: Exactly.

Hal Weitzman: That makes me think though, I mean the way you've described it is quite straightforward. Like all great research this...there's a pattern there that we can detect. If there's an individual investor who is, I mean am I able to access previous interim valuation reports?

Steve Kaplan: Yeah. If you're a pension fund or family office, whatever, endowment, you can ask the general partner, the private equity fund or venture fund, what's going on in your portfolio, what's happened over time? Absolutely. There's a data room usually, and all this information is available.

Hal Weitzman: And past performance does suggest that I can derive some knowledge from that about the current valuations. So if anybody's listening who actually is looking at private equity, it looks like it's fairly straightforward according to your research, to work out what the valuation, an accurate valuation is or what they're telling you is accurate and then what that means for an-

Steve Kaplan: And which way it's likely to go. Absolutely.

Hal Weitzman: Okay, Steve, this may be a, I know you're not a financial advisor, but is private equity right now a reasonable investment?

Steve Kaplan: So that's a very long answer to that. So private equity has a lot of components. You've got venture capital, you've got buyouts, you've got infrastructure, you've got real estate, you've got private credit, and I would say different things about those different asset classes.

Hal Weitzman: Let's just take the two that you've mentioned most frequently, buyouts and venture capital.

Steve Kaplan: So venture capital, early stage venture is I think still attractive and why, again, you want to be, there are a lot of caveats there because of who you can actually invest in. But as an asset class, the attractiveness is there's a huge amount of technological change. You've got AI and that's going to do all kinds of things in many, many industries and there's not a huge amount of money that's been raised lately. It's sort of a reasonable, it's not sort of a feeding frenzy like it was five years ago, four years ago. So I think early stage venture has some attractiveness. Later stage venture, not so much for a variety of reasons. And buyout, I would say the same thing for middle market. So again, for the smaller deals, I think there are many deals to be done. There's not the same huge amount of capital. Fundraising has been sort of average, it hasn't been extreme. And there are opportunities.

I think the larger funds are a little hampered by not being able to sell. Again, it's liquidity, both venture and buyout the middle market and early I think are attractive. Real estate has performed poorly for many, many years. I don't see a lot of value added there. I wouldn't put money in real estate funds and I can go on, but I'll stop there.

Hal Weitzman: Okay. No, that's terrific. Great. Great advice. All right, Steve Kaplan, thank you very much for coming on the Chicago Booth Review Podcast and giving us the ingredients for the special sauce that goes into the private equity valuations reports.

Steve Kaplan: Very good. I should add one thing, now that I've given you advice, I have a 50% chance of being right.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.