Irrational Opportunity

Articles From: Kepler Partners LLP
Website: Kepler Partners LLP

Listed private equity valuations have fallen despite the sector’s strengths…

Last month buy-now-pay-later giant Klarna raised $800m, valuing the business at $6.7bn (or $5.9bn if you subtract the $800m of cash). Amazing you may think, but this represented a nearly 90% decline on the valuation the company achieved in its prior round of fundraising.

Such a dramatic fall is certainly indicative of the tough times we find ourselves in. Companies like Klarna had long based their high valuations on the prospect of rapid growth, itself largely predicated on easy access to cheap capital.

But a tumultuous macroeconomic environment seems like it’s probably only part of the problem. Klarna’s valuation fell so dramatically that it does make you wonder why it was so high in the first place. The company had not made a profit for several years and, even if you envisaged a scenario in which it had some earnings, the $45.6bn valuation Klarna achieved – substantially ahead of Barclays’ $33.4bn market cap – would be something of a headscratcher.

What that would suggest is the company was swept up in the mass euphoria we saw throughout the pandemic, in which highly speculative businesses saw massive valuations, with little to show for why they deserved them.

The past nine months or so has seen that reverse. In the investment trust world, growth capital funds which focus on these sorts of business have seen their valuations fall substantially. That’s not too surprising given how their underlying investments have performed.

Private equity trusts have seen a similar decline in performance. Discounts for the sector now stand at an average of just under 16%. As our most recent strategy article illustrates, this is harder to understand. Although they’re often seen as one and the same in the eyes of the public, private equity investors and growth capital managers operate very differently.

Growth capital managers tend to take small stakes in earlier stage businesses, which are often unprofitable. Private equity managers invest in mature businesses and take a controlling stake in them, typically with the goal of increasing profits with a view to ultimately selling them.

Whereas growth capital portfolios look likely to struggle in the current macroeconomic environment, private equity holdings may be much better placed to deal with it as they are typically profitable businesses, often with defensive characteristics.

Overly optimistic valuations are also not a normal feature of listed private equity. To the contrary, managers have a record of undervaluing their businesses prior to realisations. Again, this is the sort of behaviour one would expect to be less susceptible to the hacking away at valuations which we’ve seen in 2022, but private equity has fallen nonetheless.

Irrationally valuing businesses too highly doesn’t make for many good opportunities. Buying something when it’s massively overpriced isn’t likely to end well. In contrast, irrational selling can lead to buy opportunities, as investors undervalue businesses or funds. Nothing is certain but it seems plausible this dynamic has played out in the listed private equity space, which may mean there are opportunities on the table for investors.

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