The Wile E. Coyote Effect: Preparing for Markdowns in Private Valuations
Fans of Saturday morning cartoons may be familiar with the hapless coyote who spends his entire life in futile pursuit of the roadrunner. Those of us who recall this desert-dwelling duo undoubtedly remember the recurring scene where the coyote hurtles headlong over a cliff in pursuit of the roadrunner—only to find himself suspended in midair, and even gaining momentum, before eventually realizing the “gravity” of his situation and plunging to the ground (the foregoing, better known as the “Wile E. Coyote Effect”).
In 2022, publicly-listed stocks plunged in value, due, in part, to surging interest rates and the outbreak of war in Ukraine. However, valuations of assets in many private funds’ portfolios still do not fully reflected these new market conditions. It is reasonable to believe that such markdown may soon come, as annual audits force private equity funds and venture capital funds to cut the valuations of unlisted assets.
This article is the first in a series about how fund managers and market participants can avoid the Wile E. Coyote Effect.
Review Key Terms:
Although 2022 was generally a productive year for many dealmakers, prudent investment managers still ought to take measures to ensure their funds and portfolio investments are well-positioned to weather recession headwinds. To optimize flexibility, managers should review and consider the following provisions:
Fund Term: If valuations are marked down at the end of the year, it will be more difficult to obtain an attractive value for investments. This risk may prompt managers to extend the hold period of their assets in order to maximize investor returns. In anticipation of these valuations, investment managers should review their fund documents and understand their potential options to extend the term of their fund.
Investment Period: On the flip side, while a recession can sharply devalue a fund’s investments and make selling precarious, it can also create valuable opportunities for managers to acquire new assets at depressed prices. If utilizing this opportunity, sponsors should proceed with caution.
It is important for investment managers to determine whether there is enough time left in their funds’ investment period to take advantage of low prices. After confirming the amount of time remaining, fund managers should determine whether they have the ability to unilaterally (i.e., without obtaining investor consent) extend the investment period and, if so, for how long. If investor consent is required, fund managers should be prepared to communicate the benefits of an extension with investors.
Investment Strategy: In order to set investor expectations and avoid unpredictable adjustments by fund managers, fund documents often contain fixed limitations on the types of investments that fund managers are permitted to make on behalf of their respective funds. With that being said, economic turbulence can upend the best-laid plans or, fortuitously, create opportunity elsewhere. In response, some fund managers may wish to adjust their strategy generally and/or specific investment restrictions, and capitalize on new value propositions. Fund managers looking to deploy capital in existing funds to new investments should review the fund documents for potential constraints and required consents, if any.
As consensus grows regarding the next economic cycle, PE firms should plan for a potential market correction and the opportunities that it might afford. For further guidance on the topics covered in this article, please reach out to Paul Marino (Partner and Head of the Corporate, Private Equity and M&A Group) via telephone at 212.573.8158 or via email at pmarino@sadis.com. The next article in this series will address the ways in which funds can seek to preserve liquidity in a recession.
