Under Pressure: Valuations
I recently participated on a panel at Markets Group 5th Annual Private Equity Americas Forum. The topic of discussion was sharing “Best Practices for Efficient Investment Due Diligence and Operational Assessments.”
As allocations to the private capital markets continue to grow, so too does the level of scrutiny investors place on their due diligence process. Significant due diligence is often performed by investors when evaluating a private equity fund opportunity. In more recent years, operational due diligence scrutiny has focused on understanding the firm’s valuation process and policies.
The valuation process includes not only the people and system capabilities but also corporate governance and the team’s independence within the organization. Valuing illiquid assets and providing transparent reporting has never been more critical in the minds of investors.
So, what are investors looking for as part of the operational due diligence process, and what are the red flags? Let’s start with my hypothesis. I believe there are five key areas to focus on as part of a firm’s standard operational due diligence practice when it comes to addressing valuations.
1. Understanding / explaining roles and responsibilities. Who is responsible for preparing the valuations? Where does the source data come from? How are the Portfolio Companies involved? Do you have a dedicated valuation team? How is the deal team involved? What is finance’s role? Do you involve a third-party advisor; if so, what is the scope and frequency of their engagement?
2. Understanding / explaining Corporate Governance. Does the firm have a valuation oversight committee in place? If so, who is the committee comprised of and how often do they convene? Who officially signs off on the private marks and what are the controls in place to ensure appropriate checks and balances exist? Does the LP Advisory Board review or approve the fund’s valuations? Have valuation issues ever arisen during an audit?
3. Understanding / explaining the Valuation Policy. Is your firm compliant with IPEV’s Valuation Guidelines and other Fair Value Measurements (e.g. IFRS 13, ASC Topic 820)? Is there an official valuation policy that explains the valuation approaches and methodologies for a given asset class? Has the policy changed significantly over the last year? How often is the policy re-assed and updated? Do you perform a “look back” to test how close your firm’s estimated valuation was in the preceding quarters leading up to an actual monetization?
4. Understanding / explaining the software or tools used in the valuation process. Do you use a software to facilitate the valuation process? If not, what is the primary tool to calculate valuations (e.g. excel)? How do you ensure the right controls are in place to check calculations and formulas that may impact the valuation? Is the valuation support documentation centralized and accessible to auditors upon request? What other quality control checks are in place to reconcile the valuation support to the portfolio company financials, the fund’s cash flow and financial statements?
5. Understanding / explaining valuation reporting to Investors. How are investors informed of changes to the valuations? Can you provide examples of the reporting provided to investors as part of the firm’s ongoing reporting cycle? Do you complete a value creation exercise and is that analysis shared with investors?
After the conclusion of the panel, I had the opportunity to speak with other conference participants. Most agreed that valuations is in fact a critical part of operational due diligence and investor confidence, but I was still left with several lingering questions: Are these the top operational due diligence questions in the minds of investors? Are there more? How can private equity firms best prepare for the increasing scrutiny placed on their internal valuation processes? From the lens of Ipreo Private Capital Markets, how can technology best solve these problems? Tell us what you think!
For more information, another great reference to help your firm prepare for operational due diligence sessions is Institutional Limited Partners Association (ILPA) Due Diligence Questionnaire Form (Version 1.0, Section 12.0 entitled “Accounting/Valuation/Reporting”).