Capital Decanted: Episode Rewind – Fan-Favorite #2

Release Date: August 13, 2024

Overview In this fan-favorite episode of Capital Decanted, host John Bowman and co-host Christy Hamilton delve deep into the contentious and nuanced topic of private market valuations. Joined by esteemed guests Andrea Auerbach, Global Head of Private Capital at Cambridge Associates, and Scott Cooper, Managing Partner at Andreessen Horowitz (A16Z), the conversation navigates the complexities of valuing private investments, exploring whether current valuation practices reflect true value or are influenced by factors like volatility laundering.

1. Understanding Private Market Valuations

[00:00 - 06:11]

John Bowman opens the discussion by highlighting the divisive nature of private market valuations. Christy Hamilton sets the stage by distinguishing between two primary layers of the debate:

• Layer 1: Do private investment valuations accurately reflect reality and fair value?
• Layer 2: Do private investments benefit from practices that obscure true volatility, often referred to as "volatility laundering" or "quantitative mirage"?

Notable Quote:

John Bowman [03:27]: "There's a breakdown in this lag theory argument... we have to honestly assess whether you're endorsing, at least in part, this idea of an efficient market hypothesis."

2. Valuation Methodologies

[06:03 - 20:37]

Christy Hamilton provides a comprehensive overview of the three primary valuation methodologies:

• Discounted Cash Flows (DCF): Ideal for mature companies with stable cash flows but less effective for early-stage or high-growth companies.
• Public Comparables: Involves applying public market multiples (e.g., EBITDA) to private companies, though challenges arise when suitable comparables are scarce.
• Precedent Transactions: Relies on recent transactions or funding rounds to determine valuation, commonly used in venture capital.

Notable Quote:

Christy Hamilton [06:12]: "If you have a liquid stock like a tech stock with a small float, you see bid-ask spreads and all sorts of valuation differences. So I don't think even public markets have the lock on perfect pricing."

3. Present-Day Valuation Practices and Challenges

[20:37 - 38:55]

The hosts discuss how valuation practices have evolved over the past 15-20 years, moving away from holding investments at cost towards fair value measurements. Christy emphasizes the balance between accounting conservatism and accurate financial representation, noting the role of quarterly marks in reflecting fair value.

Notable Quote:

Christy Hamilton [18:16]: "It's bad fiduciary practice to sell it at a depressed value anyway, so what difference does the mark make?"

4. Debate: Fair Value vs. Volatility Laundering

[38:55 - 64:35]

John Bowman presents contrasting viewpoints from industry experts to illustrate the heated debate:

• Chris Schelling's Perspective: Argues that private markets are inherently more stable and reflective of true value compared to public markets, which he describes as a "voting machine" driven by public sentiment.

  Notable Quote:

  Christy Hamilton [29:32]: "The top seven stocks make up 30% of the value of the S&P 500... Apple’s market cap is larger than the Russell 2000."

• Cliff Asness's Counterargument: Challenges Schelling by introducing the concept of "volatility laundering," suggesting that some General Partners (GPs) may inflate valuations to present unnaturally stable returns, potentially masking underlying volatility.

  Notable Quote:

  John Bowman [22:09]: "Cliff suggests that part of this smoothing is the result... a principal-agent problem, meaning that LPs are paying exorbitant fees to GPs to report unrealistically rosy returns."

5. Guest Insights: Andrea Auerbach and Scott Cooper

[64:35 - 84:50]

Andrea Auerbach and Scott Cooper provide balanced perspectives on the state of private market valuations:

• Andrea Auerbach: Highlights the sophistication of Limited Partners (LPs) and the importance of consistency and transparency in valuation practices. She advocates for standardized audit and valuation standards to reduce variability and enhance trust.

  Notable Quote:

  Andrea Auerbach [86:23]: "Just think the more that we can shine a light on that, improve transparency... we can all agree to disagree on whether we think those assumptions are good or not."

• Scott Cooper: Emphasizes the concept of "lift," measuring the appreciation in value as investments approach exit. He notes that while there has been some positive lift, consistency in valuation methodologies remains crucial for maintaining trust between GPs and LPs.

  Notable Quote:

  Scott Cooper [20:18]: "Consistency is what you need to be looking for... if someone's hyper-conservative and is even below the averages that I trotted out... we're really looking for that consistency."

6. Principal-Agent Dynamics and Transparency

[84:50 - 91:29]

The conversation shifts to the principal-agent relationship between LPs and GPs:

• Potential Conflicts: While GPs have incentives aligned with LPs through long-term partnerships, there can be pressures to present favorable valuations.
• Role of Auditors: Andrea and Scott discuss the importance of auditors in ensuring valuation integrity, though challenges remain in standardizing practices across different firms.

Notable Quote:

Christy Hamilton [80:58]: "Do auditors take this job seriously, or do they just wave through valuations that they're given?"

7. Final Insights and Recommendations

[91:29 - 97:36]

In their concluding remarks, both Andrea and Scott advocate for increased transparency, standardized valuation methodologies, and enhanced communication between GPs and LPs. They stress the importance of educating all stakeholders to foster trust and ensure that valuations accurately reflect long-term value creation.

Notable Quote:

John Bowman [84:50]: "Consistency and transparency and good communication was the most important thing I learned from at least the guests."

8. Key Takeaways

• Valuation Complexity: Private market valuations are inherently complex, balancing between different methodologies each with their own strengths and limitations.
• Transparency and Consistency: Essential for maintaining trust between GPs and LPs, and necessary for accurate reflection of investment value.
• Principal-Agent Alignment: Long-term partnerships and aligned incentives are crucial to mitigate conflicts and ensure honest valuation practices.
• Industry Evolution: As private markets become more accessible to a broader range of investors, standardization and transparency will become increasingly important.

Final Quote:

Christy Hamilton [95:27]: "All of it is a snapshot in time for a diversified investor. All of it... it's just more of a data point to inform your ultimate decisions and your forward-looking plan."

Conclusion

This episode of Capital Decanted provides a deep dive into the multifaceted world of private market valuations, offering listeners a balanced view of the ongoing debates and the importance of transparency and consistency in valuation practices. Through insightful discussions with industry experts, John Bowman and Christy Hamilton equip their audience with the knowledge to navigate the complexities of capital allocation with a nuanced understanding of private investments.