The Truth About Private Equity Valuations

Key Concepts

• Volatility Smoothing: The practice of artificially reducing the perceived fluctuations in an asset's value over time.
• Mark-to-Model Pricing: A valuation method used for assets without active markets, often criticized for being subjective.
• Price Discovery: The process by which the market determines the price of an asset through the interaction of buyers and sellers.
• Liquidity/Tradability: The ability to buy or sell an asset at a quoted price without significantly affecting its value.

Critique of Private Equity Valuation

The speaker presents a sharp critique of valuation practices within the private equity (PE) sector, specifically targeting the concept of "volatility smoothing." The core argument is that private equity valuations often lack the transparency and objective reality found in public markets.

1. The Nature of "Prices" vs. "Made-up Numbers"

The speaker distinguishes between true market prices and the valuations reported in private equity.

• Economic Perspective: As economists, the speaker and their colleague (Randy) argue that a legitimate price must be determined by the forces of supply and demand.
• The PE Fallacy: The speaker contends that private equity valuations are essentially "made up" and lack the objective grounding of public market prices.
• The Tradability Test: A critical argument presented is that if an asset claims to have a specific price, but a market participant cannot actually execute a trade at that price, then that figure does not constitute a "price." It is categorized as something else entirely—a theoretical or artificial construct.

2. Volatility Smoothing as Deception

The speaker characterizes "volatility smoothing" not as a sophisticated financial strategy, but as a form of dishonesty. By artificially dampening the reported fluctuations of an asset, firms create a false sense of stability. This practice obscures the true risk profile of the investment, as the reported value does not reflect the underlying volatility that would be present if the asset were subject to daily market trading.

3. Logical Connections and Implications

The argument follows a logical progression:

• Premise: Prices are defined by market liquidity and the interaction of supply and demand.
• Observation: Private equity assets are illiquid and rely on internal valuations (mark-to-model) rather than exchange-based trading.
• Conclusion: Because these assets cannot be traded at the reported value, the reported value is not a "price" in the economic sense, and the process of smoothing volatility is a mechanism to misrepresent the asset's performance and risk.

Synthesis and Conclusion

The primary takeaway is a warning regarding the reliability of private equity valuations. The speaker emphasizes that investors should be skeptical of assets that appear stable only because they are not subject to the rigors of a liquid market. The fundamental assertion is that if an asset cannot be traded at its stated value, that value is not a price. This highlights a significant disconnect between the reported performance of private equity and the actual economic reality of the underlying assets.