The private market’s dependency on the public markets

With the FTSE down around 8% last year and S&P off 17%, one constraint facing LPs is the so-called denominator effect, triggered by the decline in public asset valuations this year.

Some LPs had to cut back on investing in private fund managers or free up their capital through secondary sales of fund stakes because their holdings of private assets exceeded the allocations allowed under their mandates. We are already seeing this happen, with analysis from Coller Capital predicting that only 27% of LPs plan to increase their allocation to private equity over the next 12 months, down from 42% six months ago.

Private markets to face reality check in 2023

The problem with the private markets having such reliance on the public markets is that this has long-term impacts on the funding successful and scaling businesses receive.

No one could have predicted that at the beginning of this year, as we looked to be emerging from the challenges of the pandemic, that the global markets would be thrown into such turmoil. If there was greater transparency within the private markets, fund managers could prepare for these eventualities, and effectively stress test their portfolio and protect more of their private market investments when there is a drop in value of public assets.

LP demand for liquidity, driven by the denominator effect and a weak exit market, is expected to cause a boom in the private equity secondary market next year. Despite this, there are emerging solutions that can bring greater transparency to investor’s portfolios, which in turn can better prepare them for the impacts of the denominator effect in the future.

Transparency will open the door to something all private investors have been wanting for decades; a real liquid market. Something close to publicly traded stocks in terms of transactions, but where the underlying intrinsic value of private companies is calculated differently.

This comes at a time when regulatory changes, such as the UK Treasury’s Solvency II reform proposals, are set to unlock more than £100bn in long-term productive assets. As it stands, pension funds currently have strict rules over how much they’re allowed to invest into private capital, as a percentage of their total assets. As this new capital is unlocked, and invested into the private markets, it’s important that these institutional investors have as much access to data for those investments.

For scaling businesses themselves, current market conditions will bring their own challenges, as boards and investors look to scrutinise cash flow more closely. You only have to look at Atomico’s recent State of European tech report to understand the challenges many of them face. The ecosystem has lost $400m in value, both from public and private tech companies so far in 2022 and the majority are having to tighten their belts as a result.

For example, at Edda, we have already agreed with our board that we can’t burn through more than $100,000 per month, and if we do, we need to be adding 10% in ARR. Gone are the days where companies that raised at a valuation of 11x their ARR, which is why we are likely to see the secondary market heating up, as investors look to share their stakes in an effort to free up cash.

The risk is that as the denominator effect really begins to impact the markets next year, vital funding for successful businesses that were in a position to scale will miss out on that funding. Not because their business is failing, but because an investor did not have the correct level of oversight and transparency of their entire portfolio.

With tools such as the Bloomberg Terminal, investors have a great deal of transparency when it comes to understanding the true value of publicly listed investments.

Confusion about ESG reporting rampant in private markets

For private equity investors, the majority still rely on tools such as Excel spreadsheets to manage their portfolios. Thankfully, new tools are emerging, which will help give a clearer picture for those who invest in the private markets, which in turn will give them the data they need to carry out their due diligence ahead of making a big investment, or tracking and managing their portfolio through to an exit. Beyond this, useful data insights such as the number of jobs created by a portfolio company or the number of female founders an investor has supported in the past year, are becoming a reality.

The denominator effect will continue to impact the private markets over the coming year. With regulatory reform, which only looks to increase private market investment opportunities, beginning to happen, its time investors stepped up their data collection on private investments and moved from an opaque to a transparent overview.

Konan Kouassi is sales and business development manager at Edda

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