The CV transaction price is the outcome that matters most for all the CV participants. It is the litmus test that determines the fairness of the CV transaction. But how do we judge the fairness of the transaction price?
Incoming investors in the CV face the risk of adverse selection. Are they paying too much to buy equity in overpriced assets? (If so, that might explain why the assets cannot be sold at a price acceptable to the GP in a traditional exit.) Selling LPs, in contrast, face the risk of inadequate consideration for their interests. Are they leaving money on the table by selling the assets for less than they are worth? These questions are particularly difficult to answer because price discovery in CV transactions is neither objective nor fully independent.
The contrast with public markets is instructive. Public markets offer price discovery that is continuous, observable, and objective. Private funds, in contrast, typically hold their portfolio of assets for years before disposing of them. In the meantime, the assets are illiquid. There is no trading to offer an objective and observable market price. The market price comes into view only in an eventual traditional exit, which transfers both ownership and control to a third-party buyer (or to the investors in an IPO).
Unlike a traditional exit, however, the CV allows the GP to retain control (and some equity) even after the transaction. Furthermore, the GP plays a central role in forming the CV and establishing the transaction price. To be sure, the process typically involves a sophisticated third-party lead investor who negotiates the price and other terms with the GP. In addition, the GP may obtain a fairness or valuation opinion from an independent provider. Nonetheless, the GP directs the process: It solicits bids, selects the winning bid, and negotiates with the winning bidder (i.e., the lead investor) to settle on a price and agree to the other terms of the CV. This arrangement makes the price discovery process significantly less than fully independent.
Nor is the process objective. In the absence of an observable and independently established market price, the most theoretically sound way to establish the intrinsic price of an asset is to forecast its future sale price and discount that back to present value. That approach, however, introduces subjectivity and reliance on models to estimate future value and risk. No matter how skilled and astute the GP is and no matter how scrupulous its due diligence is, its assumptions remain subjective and its predictions remain subject to error. Intrinsic value is based on the asset’s future prospects and eventual sale price. But those projections cannot be tested or verified at the time of the CV transaction; only time will tell.
As a result of these challenges, we cannot simply rely on the transaction price to judge the fairness of a CV transaction. Instead, we must also rely on the fairness of the process. Did the GP vigorously and effectively solicit bids? Did it seek to drive a hard but fair bargain in its negotiations with the lead investor, faithfully discharging its duties of care and loyalty?
Although the price discovery process can never be completely independent or objective, the GP can strive to attain those objectives as closely as possible. We judge the fairness of the CV by the extent to which the process succeeds in approximating those goals.
A simple analogy drawn from the philosophy of procedural justice may be helpful. Imagine that 10 individuals want to divide a cake equally. The outcome will be fair if the cake is indeed divided into 10 equal pieces and distributed to each of the individuals. We have a clear and measurable standard by which to judge the fairness of the outcome.
But suppose instead that we are engaged in a different activity whose outcome cannot be measured directly. We have no independent criterion or clear standard by which to judge the outcome. We can, however, design a clear and fair process to be followed. Then, we can judge the fairness of our actions by how well we follow the process, whatever the outcome. Stated another way, procedure substitutes for output as a means to judge the fairness of the activity. While not a perfect analogy, it bears relevance to the challenge of judging the fairness of a CV transaction.
