Adjusted private equity: Meaning, Criticisms & Real-World Uses

What Is Adjusted Private Equity?

Adjusted private equity refers to the valuation of illiquid investments held by private equity funds that incorporates specific modifications to reflect a more accurate and current assessment of their worth. Unlike publicly traded securities that have readily observable market prices, private equity holdings, which fall under the broader category of Alternative Investments, require sophisticated valuation methodologies. The "adjusted" aspect highlights the application of various techniques and professional judgment to move beyond simple cost or prior transaction values, aiming to determine a Fair Value that considers factors not immediately apparent in standard accounting practices. This process is crucial for both General Partners managing the funds and Limited Partners seeking transparent reporting of their investments. Adjusted private equity valuations provide a more realistic snapshot of a fund's performance and the underlying value of its Portfolio Companies.

History and Origin

The need for a more nuanced approach to valuing private equity investments gained prominence as the industry expanded and institutional investors sought greater transparency and comparability. Historically, private equity investments, particularly in earlier stages, were often carried at cost or at the value of the last financing round. However, with the increasing size and complexity of private markets, and the inherent Illiquidity of these assets, this approach proved inadequate for accurate financial reporting and performance assessment. The Financial Accounting Standards Board (FASB) played a pivotal role in standardizing valuation practices through the issuance of Accounting Standards Codification Topic 820 (ASC 820), "Fair Value Measurement," effective for financial statements issued for fiscal years beginning after November 15, 2007. This standard mandated that investments be measured at fair value, defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 is a key accounting standard that mandates the reporting of investments at their fair value, providing a consistent definition and framework for measurement and disclosure.¹⁰ The implementation of ASC 820 aimed to enhance consistency and transparency in fair value reporting for private equity funds, particularly for their often highly illiquid investments.⁹

Key Takeaways

Adjusted private equity aims to provide a more accurate fair value assessment of illiquid private investments.
Valuation adjustments account for factors such as market conditions, company performance, and illiquidity premiums or discounts.
Regulatory standards, such as ASC 820, drive the need for robust and verifiable adjusted valuations.
These adjustments are vital for transparent financial reporting, investor relations, and internal decision-making by fund managers.
The process often involves a combination of quantitative models and qualitative judgments.

Formula and Calculation

While there isn't a single universal "formula" for adjusted private equity, the process involves applying various valuation methodologies and then making specific adjustments. The primary objective is to arrive at a fair value. Common valuation techniques that form the basis for adjustment include:

Discounted Cash Flow (DCF) Analysis: This method projects a company's future cash flows and discounts them back to the present value using an appropriate discount rate, such as the weighted average cost of capital.
Market Multiples Approach: This involves valuing a company based on the trading multiples (e.g., Enterprise Value/EBITDA, Price/Earnings) of comparable publicly traded companies or recent merger and acquisition transactions.
Asset-Based Valuation: Used primarily for companies with significant tangible assets, this approach values a company based on the fair value of its underlying assets.

After applying these base methodologies to determine an initial enterprise value, adjustments are then made. These adjustments can include:

Illiquidity Discount: Since private equity investments are not readily tradable, an illiquidity discount may be applied to reflect the lack of Liquidity compared to public market equivalents. This acknowledges the difficulty and potential time required to sell the asset. An academic paper highlights how illiquidity costs can be around 2.49 percent of committed capital annually for private equity funds, increasing with the funds' remaining lifetimes.⁸,⁷
Control Premium/Discount: If the private equity firm holds a controlling stake, a control premium might be added. Conversely, a minority stake might warrant a discount.
Contingent Liabilities/Assets: Adjustments for potential future obligations or benefits not fully captured in initial models.
Synergies: If the valuation is in the context of a strategic acquisition, potential synergies might be considered.

The process of determining adjusted private equity values ultimately feeds into the calculation of a fund's Net Asset Value.

Interpreting Adjusted Private Equity

Interpreting adjusted private equity values requires understanding the subjective nature inherent in valuing illiquid assets. An adjusted private equity valuation represents an estimate of the price at which an investment could be exchanged between willing, knowledgeable parties in an orderly transaction, reflecting current market conditions and specific company performance.

For Private Equity funds and their investors, the adjusted value is not merely an accounting entry; it is a critical metric for assessing fund performance, calculating management fees, and informing strategic decisions. A higher adjusted value indicates strong underlying portfolio performance and effective value creation by the fund manager. Conversely, downward adjustments signal challenges within the portfolio or adverse market shifts. Investors use these adjusted figures to evaluate their overall exposure to private markets and to make informed decisions regarding future Capital Calls or redemptions. The adjustments serve to bring the reported value closer to what a true market transaction might yield, even in the absence of an active market.

Hypothetical Example

Consider "GrowthCo," a software company acquired by a Buyout Funds in 2023 for an enterprise value of $200 million. At the end of 2024, the private equity fund needs to report GrowthCo's adjusted private equity value.

Initial Valuation: The fund's internal team performs a Discounted Cash Flow analysis, projecting GrowthCo's strong revenue growth and improved profit margins. This DCF analysis yields an implied enterprise value of $250 million. They also look at market multiples for comparable public SaaS companies, which suggest a value of $260 million. The fund's initial unadjusted fair value estimate for GrowthCo is determined to be $255 million, an average of the two.
Market Conditions Adjustment: However, the broader technology sector has experienced a downturn in public markets, leading to multiple compression for comparable companies. The fund's valuation committee determines that, due to current investor sentiment and reduced appetite for high-growth, unprofitable tech firms, a 10% market condition discount is appropriate.
- Initial Value: $255 million
- Market Condition Adjustment: $255 million * 0.10 = $25.5 million
- Value after Market Adjustment: $255 million - $25.5 million = $229.5 million
Illiquidity Adjustment: As GrowthCo is a private company, it lacks the immediate Liquidity of publicly traded stocks. The fund applies a standard 15% illiquidity discount.
- Value after Market Adjustment: $229.5 million
- Illiquidity Adjustment: $229.5 million * 0.15 = $34.425 million
- Adjusted Private Equity Value for GrowthCo: $229.5 million - $34.425 million = $195.075 million.

This adjusted value of $195.075 million would be reported by the private equity fund for GrowthCo, reflecting a more conservative and market-aware assessment than the initial unadjusted valuation.

Practical Applications

Adjusted private equity valuations are fundamental across various aspects of the financial ecosystem. In regulatory compliance, new requirements introduced by the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940 mandate private fund advisers to provide detailed quarterly statements to Limited Partners, detailing fund expenses and performance. These rules, effective from November 2023, significantly amplify the role of valuation services and fairness opinions in compliance and investor decision-making.⁶ The SEC also requires independent third-party valuation or fairness opinions for adviser-led secondary or continuation fund transactions, further emphasizing the need for robust, adjusted valuations.⁵

Beyond regulation, these adjusted valuations are crucial for performance measurement, informing Investment Horizon decisions, and calculating carried interest for General Partners. They also guide strategic asset allocation for institutional investors like pension funds and endowments, who rely on accurate valuations to manage their overall portfolios. The transparency provided by adjusted private equity valuations helps investors compare performance across different funds and make informed decisions regarding future commitments and the timing of Distributions.

Limitations and Criticisms

Despite the push for greater transparency and standardization, adjusted private equity valuations face inherent limitations and criticisms, primarily due to the subjective nature of valuing illiquid assets. The lack of a liquid market for Private Equity holdings means that fair value estimates often rely on unobservable inputs and significant judgment, categorized as Level 3 inputs under ASC 820.⁴,³ This can lead to variability in valuations across different funds or valuation firms.

Critics argue that private equity valuations can be "smoothed" or less volatile than public market equivalents, potentially masking underlying risks or underperformance. The valuations are often performed quarterly, which is less frequent than public market pricing, and can lag real-time market shifts. There are ongoing concerns about potential conflicts of interest when fund managers have a role in the valuation process, even if third-party firms are involved. Regulatory scrutiny exists regarding how private fund advisers interact with and potentially influence third-party valuation experts.² Additionally, the methodologies and assumptions used for adjustments, such as the magnitude of the Illiquidity discount, can vary, leading to different reported values for similar assets. Recent market conditions, including rising public market valuations inflating private company price expectations and increased debt costs, have made it more difficult for private equity firms to negotiate deals or find appealing exit opportunities.¹ This environment further underscores the challenges in arriving at precise and universally agreed-upon adjusted private equity values.

Adjusted Private Equity vs. Unrealized Gains

The distinction between adjusted private equity and Unrealized Gains lies in their scope and purpose, though the former contributes to the latter. Unrealized Gains (or losses) refer to the theoretical profit or loss an investment has generated but has not yet been converted into cash. For private equity, this is often the difference between the current carrying value (which incorporates adjustments) of a Portfolio Companies and its initial cost, before the asset is sold or "realized."

Adjusted private equity, on the other hand, is the process and resulting valuation that aims to establish the most current and accurate fair value of an illiquid asset. It is the valuation methodology that produces the underlying value from which unrealized gains are calculated. While unrealized gains simply reflect the change in value from a historical cost or prior valuation, adjusted private equity involves a detailed and often complex recalibration of that value to reflect various market, company-specific, and liquidity factors. Therefore, adjusted private equity is a foundational concept that informs and refines the measurement of unrealized gains within a private equity fund's portfolio.

FAQs

Why is adjusted private equity important?

Adjusted private equity is important because it provides a more realistic and up-to-date assessment of the value of illiquid investments held by private equity funds. This enhanced transparency is crucial for fund managers to make informed decisions and for Limited Partners to accurately understand their investment performance and fund exposure.

How does illiquidity affect private equity valuation?

Illiquidity significantly affects private equity valuation because these assets cannot be quickly and easily converted into cash without a substantial loss in value. This characteristic often necessitates applying an illiquidity discount during the valuation process to reflect the diminished flexibility and higher risk associated with holding such investments.

Do all private equity funds use the same adjustment methods?

No, while private equity funds generally adhere to broad accounting standards like ASC 820 for Fair Value measurement, the specific adjustment methods and assumptions can vary. Differences may arise in how funds interpret market data, apply discounts, or weight various valuation models, reflecting the subjective nature of valuing private assets.

How often are private equity investments adjusted?

Private equity investments are typically revalued and adjusted at least quarterly, especially for reporting to Limited Partners and regulatory bodies. Some funds may perform more frequent internal assessments, but quarterly valuations are standard for formal financial reporting purposes.

What is the role of third-party valuation firms in adjusted private equity?

Third-party valuation firms play a crucial role by providing independent assessments of private equity holdings. Their objective analysis helps ensure the credibility and reliability of adjusted valuations, reducing potential conflicts of interest and meeting regulatory requirements for independent opinions, particularly for complex transactions.