The End of the Private Equity Party

Now, investors are desperately trying to dump private equity commitments on the illiquid secondary market at huge discounts from the fair market value stated by the fund in the hopes of avoiding further so-called capital calls from the fund. Private equity commitments can be drawn down through capital calls whenever the fund decides that it can use the money. Capital calls can easily total millions of dollars, forcing investors to liquidate other investments that have sustained serious losses to cover the commitment.

Investors buying secondary commitments face a fair amount of risk in purchasing the commitments due to the questionable manner in which the valuations are calculated.

Recently, a new accounting rule, FASB 157, has changed the way private equity funds value investments. While adherence to the rule is optional for closely held companies, publicly traded firms such as Blackstone, KKR and Fortress are required to follow the new guidelines.

Before the new rules, a private equity firm could value investments at any amount that the managers determined to be fair. The valuation was usually held at the price the fund paid for the investment until it would be realized, at which point the gain or loss could finally be seen by investors.

This enabled the managers to keep their worst-performing investments at cost to avoid hurting returns while at the same time raising another fund. By the time the poor investments were finally realized, the fund would have had a much longer time period to spread out the loss, improving the annualized return, and the firm would most likely be well into the subsequent fund's life cycle, shining a light on its performance rather than the previous fund's.