By Bill Kelly, CEO, CAIA Association
Many of us have had the experience of buying a home and often turn to the bank to provide some level of secured funding for that purchase. Banks, of course, require documentary evidence for the value of their collateral which, invariably, results in a market-based appraisal process resulting in a very impressive tome boasting pictures, statistical analysis, trends, comparative sales, and more. Almost always, the appraisal comes in at the same dollar amount of the accepted offer for the subject property, because it reflects a market-based transaction between a willing buyer and a willing seller. It appears that family considerations, motivation, and irrational exuberance or equivocation all net to zero, and there is no other liquid market to consult for meaningful price discovery anyway.
Surely the valuation methodologies in the world of alternative investments and less liquid asset classes such as private equity and real estate are very different. After all, these are very sophisticated professionals at work, especially those carrying the CAIA marks. Their investment due diligence is subject to an intensive and competitive process and there are many cases where the general partner decides not to invest simply because the growth, industry, or return profiles do not meet the hurdle rate sought. They seek and invest in portfolio companies where they feel they can maximize value creation by generating higher levels of (interim) operating cash flow and even higher exit multiples upon liquidation.
In this yield-starved portion of the current market cycle, the allure of the outsized returns of private equity (as demonstrated by more than $1 trillion of dry powder) is getting a lot of attention, as well as increased levels of capital allocations from the return-seeking limited partners. Performance is what matters and the premiums shown over most public market proxies are impressive, especially when measured through the precision of an IRR calculation. J-curves, capital calls, interim cash flows, valuations, timing, fees, and leverage are all part of this complex cocktail that gets distilled and discounted back to an IRR number. That is essentially the published investment performance for the underlying fund—one discount rate for these many moving parts.
This brings us back to the vagaries of the valuation process for the underlying PE and RE assets. As is the case with residential real estate, market-based price discovery is absent, but the pricing is a much more critical input for a return-seeking equity investor than it is for a lender using these valuations to assess collateral coverage. The former hopes to maximize value upon liquidation, and the latter just wants their capital back and hopes that they never need to be an interested party in a liquidity event. Invariably, valuation for the GP is a hugely meaningful component of their returns and interim valuation and subsequent liquidation are integral to success, but should that valuation also drive other component parts of the IRR such as ongoing cash flows from operating results of the business? If you are not sure, it is certainly time to reacquaint yourself with the many moving parts of the performance return calculations for these non-tradeable asset classes and to reconcile some of this reporting to the multi-dimensional concept of modified IRR reporting. You can start with some of CAIA Association’s views or those of other mostly independent market players.
“Location, location, location” might be the catch phrase to describe success in residential real estate, but make “disaggregation, disaggregation, disaggregation” your new favorite when evaluating complex performance calculations for all non-tradeable investment strategies.
Seek diversification, education and know your risk tolerance. Investing is for the long term.