Private Equity Reporting: The Role of "Smoothed Returns" in a Volatile Environment

In discussing private equity and its function in a client’s portfolio, it is helpful to understand how private equity is reported. Private equity reporting and valuation are different from reporting and valuation of traditional asset classes like stocks and bonds. This is because private equity funds invest in private assets, like small businesses, which are less liquid and do not trade on any exchange. One of the key reasons traditional asset classes like stocks and bonds can provide daily reporting is because those investments are traded daily on a stock exchange like the New York Stock Exchange or Nasdaq. If there is no exchange for private assets, then how are these assets priced?

Since private assets are not traded on an exchange, the underlying fund manager is responsible for pricing and reporting the asset’s valuation. This process is complex and bespoke for every fund manager and their investment. Below is an example that can help explain this further.

Say a private equity fund is looking to buy a family-owned business. How much should the manager pay for the company?

The process of finding the target company’s valuation requires a deep analysis of the company’s financials, like profit margins, and an understanding of the company’s competitive market to see how comparison companies are being valued. These comparative analyses of industry peers allow managers to price the portfolio company to more accurately reflect the true value of a company that otherwise does not have a publicly sourced price.

The fund managers will usually engage with third-party valuation experts to validate their private equity reporting. This added layer can also help protect investors in the private equity fund. Third-party agents that conduct independent valuations can provide a check for investors by indicating whether the manager’s private equity reporting is accurate and reasonable.

What we’ve described above is the process of one investment that a private equity manager makes. This same process is repeated for every investment in a private equity manager’s portfolio. The valuation process is lengthy as it requires a thorough review of the company’s operations and growth to achieve a value. While there is no set time frame, the valuation process can take anywhere from a couple of weeks to a couple of months or longer, depending on the company and circumstance.

Source: Phoenix American, September 2020, Fund Accounting 101: Financial Reporting For Private Equity

The time-consuming nature and thoroughness of valuing a private equity fund impact the frequency and timeliness of private equity reporting. Typically, private equity managers will value their portfolio every quarter. Upon the end of the quarter, the private equity manager will begin to value each company. However, given the weeks and sometimes months that go into diligently pricing their assets, managers typically publish their private equity valuations with a three-month lag.

By way of example, let’s say the private equity manager has reached the end of the first quarter, 3/31, and wants to conduct a quarterly review of the portfolio as of the end of the first quarter. They would need to gather the quarterly financial statements of each underlying portfolio company as of the end of 3/31. The portfolio company would likely have those quarterly financial statements a few weeks after 3/31 but may extend longer depending on the company.

Once the quarterly financial statements are received, the manager and third-party valuation agent review each portfolio company to provide a quarterly review, which takes another couple of weeks or months. By the time the first quarter’s review is done, the manager is usually nearing the end of the second quarter, around 6/30, for the private equity reporting to be completed. This is to say that the level of analysis required for the fund manager and the bespoke nature of the investments lead to a delay in reporting.

Source: Phoenix American, September 2020, Fund Accounting 101: Financial Reporting For Private Equity

The quarterly lag on which PE valuations are published can be a surprise to investors who are used to the daily pricing of their traditional stock and bond portfolio. However, in exchange for daily price monitoring, investors receive less market-to-market volatility.

The public market prices daily during open market hours, which means that the value of a publicly-traded asset, like a stock, is subject to the whims of the market and sensitive to technical market movements, which may not reflect the fundamental value of the company. The public market is rarely stable and reacts quickly to the news, and in turn, the sometimes moment-by-moment changes to bid and offer prices. If the U.S. Federal Reserve releases its meeting notes, the public market will typically price in those meeting notes within minutes, if not seconds. This market reaction results in rapid price movements and volatility for publicly traded investments relative to privately held assets.

The private market has a different story. While a decision by the Federal Reserve may impact a private equity manager’s portfolio company, that news won’t be priced in a matter of minutes or seconds. Instead, that news will be one of many factors baked into the portfolio company’s valuation at the end of the quarter.

Since private equity reporting is not as timely as the public markets, the reporting can digest the market news, which results in “smoothed returns” for investors. Smoothed returns refer to a data set removing the spikes and drawdowns to illustrate trends. Because private equity invests in assets that are not traded on an exchange, the valuations are not subject to daily volatility, as witnessed in the public markets. The resulting smoothed returns lessen the level of volatility in a client’s portfolio. In bouts of extreme volatility, like the current environment facing the Ukraine crisis and rising inflation, the smoothed returns from private equity reporting, while not a shield for volatility, may help ease client concerns by showing less volatile return streams. But of course, this is simply due to the nature of private equity reporting, and such investments are not immune to volatility concerns.

Sources:
Financial Times, September 2019, The role of smoothed funds in a volatile environment
Investopedia, May 2021, Data Smoothing Definition

Smoothing Explained

Source: LV Adviser, Smoothing explained Smoothing, done differently

While smoothed returns might shield a portfolio from public market volatility in presentation, the trade-off is that the reporting is less frequent and lagged. Private equity investors should understand the risks and rewards of private equity reporting that exist due to the complexity of private markets. These pain points have caught the attention of government agencies looking to enhance private equity reporting standards.

In January 2022, the Securities and Exchange Commission (“SEC”) voted to propose changes to Form PF, the confidential reporting form for SEC-registered investment advisers and private funds.

Considering the recent growth of the private fund business, the proposed revisions are intended to strengthen the Financial Stability Oversight Council’s (FSOC) ability to assess systemic risk, as well as the Commission's regulatory oversight of private fund advisers and investor protection activities. The FSOC is responsible for monitoring market risks and responding to emerging threats to the financial markets.

SEC Chair Gary Gensler notes:
“Since the adoption of Form PF in 2011, a lot has changed. The private fund industry has grown in size to $11 trillion and evolved in terms of business practices, the complexity of fund structures, and investment strategies and exposures. The Commission and Financial Stability Oversight Council now have almost a decade of experience analyzing the information collected on Form PF. We have identified significant information gaps and situations where we would benefit from additional information. Among other things, today’s proposal would require certain advisers to hedge funds and private equity funds to provide current reporting of events that could be relevant to financial stability and investor protection, such as extraordinary investment losses or significant margin and counterparty default events.”

Source: Twitter, January 2022

While there have been no official changes yet, the SEC Proposal would create sweeping changes and enhancements to private equity reporting and for the private fund industry at large.

Sources:
U.S. Securities and Exchange Commission, January 2022, SEC Proposes Amendments to Enhance Private Fund Reporting
U.S. Treasury Department, April 2022, About FSOC

For investors, the proposal to increase reporting standards and broaden the scope of applicable managers is designed to provide investors with more information related to their investments and added government oversight for risk assessment. While these changes can be seen as a positive to investors, the added reporting requirements will likely result in private equity managers dedicating more resources to meet these standards, and may be passed on to investors. Nevertheless, the proposed changes are meant to provide an additional layer of protection to investors by providing more information and oversight related to their investment.

For private equity reporting, it is helpful to understand the differences in the reporting and valuation practices of public and private markets. While public markets provide more transparency in daily pricing, investments traded on a public exchange are subject to the pricing swings of the markets. Public markets have become increasingly efficient in responding to new information, which can lead to greater volatility. Private equity reporting is subject to less volatility given that these investments are not traded on a public exchange and therefore subject to daily and even intraday price movement. Rather, these investments are valued every quarter by a private equity manager and/or third-party valuation agent. The trade-off of lower volatility is delayed and less transparent reporting. As proposed federal amendments look to mitigate these risks with more timely reports, investors should still be aware of the potential benefits and setbacks and other limitations of current private equity reporting practices.