Tackling the Valuation Challenge
Author: Jaime Hildreth
On January 18th, I participated in PEI’s annual 2017 CFO / COO conference in NYC. As a panelist on the valuation track, I had an opportunity to dive into the topic in detail and made interesting discoveries about the processes and methodologies today’s firms are using to determine value.
The experience was so validating, it sparked the idea for a peer learning experiment that I invite you to participate in. You’ll find the call to action—along with a chance to win an iWatch—at the end of this post.
And now for a recap of the key learnings from the panel discussion.
I joined Ed Balogh, COO of Ridgemont Equity Partners and Sandra Kim-Suk, CFO and CAO of L Catterton in a session moderated by Tom Angell, Partner and Practice Lead for the PE Group at Withum Smith & Brown.
Our session covered topics ranging from methodologies and governance to deal team involvement and trends in outsourcing to Limited Partner (LP) requests and auditor demands. At the end of the session, I came away with a clear perspective on the similarities and differences in the ways PE firms are attacking the valuation challenge.
Regardless of size, the majority of PE firms are following very similar valuation processes:
- All firms have valuation policies that outline the methodologies followed for a given security and an overview of their governance structure.
- Most, if not all, firms have an internal valuation committee that challenges the movement, or lack thereof, in the marks quarter to quarter.
- Most, if not all, firms follow a relatively consistent valuation template across their portfolio.
- Most, if not all, firms calibrate the transaction price to appropriate valuation methods and assumptions.
- Most, if not all firms, agree that private valuations are as much an art as a science. The firms that do it right spend a significant amount of time documenting and substantiating – both quantitatively and qualitatively – adjustments, assumptions and ultimately conclusions about the valuation to tell the story behind the numbers to internal and external stakeholders.
While there are many areas of commonality in the way PE firms are approaching valuation, there are some key differences in terms of the methodologies applied to determining fair value, the individuals involved in the valuation process, and the leveragability of the valuation information for portfolio analysis.
When it comes to valuation techniques, for example, one General Partner (GP) may use a combination of the income approach (typically the discounted cash flow) and the market approach, looking at guideline public comparables, recent M&A transactions, and guideline transactions. But another GP may disregard the income approach completely and focus solely on the market approach. And both techniques would be acceptable, as there is no black and white answer according to accounting guidance on fair value including ASC 820, IRFS 13, and the other valuation guidelines such as IPEV (International Private Equity and Venture), AICPA (American Institute of Certified Public Accountants), and PEIGG (Private Equity Industry Guideline Group).
What is clear is that fair value represents an “estimate,” an estimate of the “price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under market conditions” (Topic 820-10-35-24A). Firms have flexibility in exercising “their judgment to select the valuation technique or techniques most appropriate for a particular investment” (IPEV). It is unclear to many how the new AICPA PE/VC Valuation Guide, expected to be released to the public in working draft form this summer, will force firms to reconsider the valuation techniques they use today.
Good valuations are expensive, time consuming and involve input from multiple parties. Some firms have a dedicated team focused on the valuation process, gathering key inputs to the valuation from deal team members, while many firms still rely on deal team members to prepare the valuation.
Firms serious about independence often take a step further and engage a third-party valuation provider, like Duff & Phelps or BRG, for an external valuation opinion; either “positive assurance” or “range of values” to independently substantiate their private marks. A survey taken during the panel session showed that roughly 20% of participants use a third-party valuation provider whereas 80% do not; coincidently, these results were consistent with a recent survey conducted by Ipreo.
My gut says the percentage of firms using a third party is significantly higher if measured on the basis of AUM. Firms that don’t engage a third party, frankly, haven’t been pressured by their LPs to do so. I’m curious to see whether the pending regulation / accreditation of valuation professionals will lead firms to establish an internal valuation group with these credentials or push them to go so far as to force GPs to engage third-party valuation providers to satisfy the gaps. Or will the Trump Administration introduce de-regulation?
My understanding is that in the long run, valuations completed by professionals without this accreditation may require additional audit work, leading to higher audit fees. Regardless, there is a clear consensus that the final valuation conclusion cannot be fully outsourced to a third party because GPs ultimately have a fiduciary responsibility to maintain their NAV to comply with ASC 820/IRFS 13 Fair Value Measurements. Pending changes mentioned above may make the valuation process even more expensive and time consuming. By leveraging technology, such as iVAL, and engaging the right advisors who know how to integrate and leverage technology in the valuation process, I believe firms can mitigate potential cost, risk, and deal team / finance team strain.
Lastly, the use of valuation information for portfolio analysis varies across the board. While some GPs may not repurpose valuation results for broader portfolio analysis, other GPs have figured out how to make the direct link between the operating performance data and valuation results for their portfolio companies and their reporting and analytics. These GPs have also figured out how to simplify and streamline the flow of information between various parties, including internal constituents and external ones such as auditors, advisors, fund administrators, and LPs.
With iLEVEL, we talk about this concept as creating a “single source of truth”. Clients who do this well can do more with their valuation information than conduct portfolio reviews and report to their LPs. They can measure value creation and performance against their original investment thesis, project exit returns for their portfolio company and funds, and assess portfolio risk concentrations and relative benchmark performance.
EY’s 2017 Global Private Equity Survey illustrates GPs’ desire to allocate more time to portfolio analysis, with 38% of the participants responding that they would like to increase their time spent on portfolio analysis while only 15% and 12% of participants wanted to allocate more time to investor relations and valuations.
The value of peer learning
Today, approximately 400 clients are using our portfolio monitoring and valuation solutions, including iLEVEL, iVAL and Qval, and while the technology is the key to enhancing their capabilities in these areas, the opportunity to learn from other PE firms that are part of the Ipreo Private Capital Markets (PCM) community is equally valuable.
In my prior role at Blackstone, I frequently spoke to colleagues at other private equity firms to share best practices and learn from each other. Unlike the deal side of the business, the “middle office” is not competing for the next big deal or raising the next big fund, so the motivation in connecting with others is much more fundamental: How do I continue to evolve my internal processes and enhance my reporting and analytical capabilities?
The more GPs I talk to, the more often I find this desire to network with each other. The question is: how open will GPs be in a broader setting? Are GPs willing to share their reporting and analysis beyond a one-on-one conversation? Do they consider these analyses, agnostic of numbers and content, proprietary?
Let’s find out.
We are asking our clients and future Ipreo PCM clients to share with us examples of what they consider their “best practices” for reporting and analysis. If you are up for the challenge, please click here to complete the form, submit your example and enter for a chance to win an iWatch. Let the fun begin! We will keep you posted with our findings!