Valuation challenges in the private equity industry
September 2015 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
Private equity valuation has always presented a number of challenges. Such challenges typically arise out of opaque levels of information available in the market, such as finding suitable guideline companies, and calibrating the relevant liquidity and marketability discounts. Further challenges have emerged over the last few years as a result of more regulatory oversight and the investor pressure for added transparency, mostly in the area of valuation. Even further scrutiny appears to be on the way as the IMF is looking at the asset management industry, including alternatives, and has expressed concern about the potential financial stability risks posed by the asset management industry. They are recommending that the oversight of the industry should be strengthened through the adoption of a ‘microprudential orientation’. Private equity is certainly within the scope of this proposal.
Increased regulation and standards
The market has seen increased oversight from regulators related to portfolio valuation in the alternative investments space. Portfolio valuation gained prominence with the demise of some of the large US investment banks. Subsequent bailouts of remaining larger banks using taxpayers’ money have created an environment where there has been more focus on the valuation process and its disclosure. We have noted an increase in reliance on observable market inputs for valuation of these alternative assets while the market itself may be illiquid or distressed. The demand for transparency for private equity funds came from both regulatory bodies and investors. The shift in global trends in fair value accounting and the increasing importance placed on fair value by international accounting bodies, as well as European regulators, necessitated traditional valuation approaches in private equity be revisited.
The development in accounting standards such as IFRS 13 and ASC 820 took many years of effort and consultation and was not aimed specifically at private equity funds; rather, it tied in to the global recognition of transparent reporting. IFRS 13 and ASC 820 established a framework on fair value measurements which affect a wide group of corporates and financial institutions that hold investments. Both IFRS and US GAAP worked jointly in developing these standards to achieve harmony in global accounting standards on fair value. The private equity community responded quickly to the changes, and the International Private Equity and Venture Capital (IPEVC) Valuation Guidelines were set out in compliance with both IFRS and US GAAP.
On the more regulatory front, the global financial crisis and its aftermath also led to the first draft of the Alternative Investment Fund Managers Directive (AIFMD) in 2009 in Europe, which aimed at creating a standardised regulatory framework for private equity and other alternative investment funds. The directive came into place in 2013 and documented requirements in the areas of, among other things, transparency and reporting in relation to valuations.
Importance of portfolio valuation to private equity firms
Besides complying with regulatory requirements, accurate portfolio valuations facilitate the process of decision making for a private equity fund’s stakeholders. Accurate, transparent and timely valuations provide relevant information to LPs to update their investment decisions. A high quality portfolio valuation and adherence to ‘best practice’ are also features to attract potential investors.
As private equity funds continue to play a more significant role in the market, a robust valuation process minimises the risk to the macro economy as well. As stated by the IMF in its Global Financial Stability Report (April 2015), the asset management industry as a whole provides financial stability to the economy by providing financing when banks are distressed. Private equity funds have also been attributed with bringing innovation and economic growth in Europe. Therefore, transparent and precise valuation reporting in private equity becomes imperative given its cascading effects on growth and stability of the macroeconomic environment, even though such effects may not be immediate.
Real challenges in private equity valuation
Valuation as a subject matter has always relied more on judgement and less on rules. More importantly, fair value, a hotly debated topic, relies more on judgement within the gamut of set principles. Since fair value is based on judgement, it generally leads to a potentially biased view of value. This in turn often leads to disagreements. Regulators and standard setters have all worked through the last decade to bring forth a set of principles within which valuation is conducted. A prudent and experienced valuation professional uses industry-wide best practices to iron out such biases. Some of the key guidance on fair valuation is provided by IFRS 13, ASC 820, IPEVC guidelines, Hedge Fund Standards, AIMA, AIFMD, etc.
IFRS categorised inputs into 3 levels in fair value measurements. Level 1 inputs are quoted market prices in active markets for identical assets. Level 2 inputs are observable data in the market other than direct prices, such as quoted prices of comparable assets or inputs derived from observable market data by correlation. Level 3 inputs are not observable in the market place. Unquoted investments are generally illiquid in nature and valued with level 3 inputs. The challenge in the valuation process comes in the need of judgement that is required to value assets with level 3 inputs.
There is evidence from research showing smoothed valuations, as well as jumps in valuations in the fourth quarter when funds are normally audited. In order to minimise biases, the valuers of the portfolio must be independent from the portfolio managers, as stated by the AIFMD.
When valuing assets with level 1 inputs, the valuation professional must use an unadjusted quote from the market. If the valuer considers that the quoted price does not represent fair value at the measurement date, due to short term volatility in the market, e.g., a significant market event has occurred, it would be reasonable to make an adjustment to the investment’s fair value. However, the fair value measurement would then qualify as a level 2 measurement instead of level 1.
The key issues in the valuation process in level 2 and level 3 measurements all relate to the application of judgement. The first step in this valuation process would be paying attention to surrounding details around valuation such as capital structures, complex terms and liquidity. In a level 2 measurement, the valuer may be relying on data from pricing service providers and financial databases, and applying adjustments if necessary. The adjustments should reflect the views and risk adjustments that market participants would make, e.g., credit and liquidity risks. Indicative quotes provide useful reference points but they should also be treated with caution. The valuation adviser must aim to maximise the use of observable inputs and minimise the use of unobservable inputs. Therefore, sometimes it requires judgement on the valuer’s side to decide whether or not to apply level 3 measurements.
Private equity firms involved in early stage or growth focused portfolio companies may find themselves relying often on level 3 inputs and conducting valuations with modelled data. Given the level of subjectivity, the valuation adviser should document a calibration of the investment cost to the fair value and also a sensitivity analysis – how changes in the unobservable inputs would affect the fair value. As described above, multiple approaches could be used as a common sense check. Finally, the private equity firm may benefit from bringing in an external adviser to audit the inputs.
Other challenges include dealing with the complex capital structures that a private equity company may have. This would include instruments with conversion features and other contingent claims. This typically entails allocating the Business Enterprise Value (BEV) across the different tiers within the capital structure, using Contingent Claims Analysis (CCA), otherwise known as option pricing techniques.
Private equity valuation methods
A significant portion of private equity assets are held in equity of private companies through buyouts, growth capital and venture capital transactions. Other asset classes such as real estate and mezzanine debt also form part of the private equity world. The IPEVC Valuation Guidelines set out recommendations on the valuation of private equity investments, and is intended to represent current best practice. The IPEVC Guidelines discuss valuation techniques on the basis of a hypothetical sale that could be broadly categorised into the market, cost and income approaches.
The market approach involves investigating the price of recent investments in the same or comparable asset, or applying multiples of earnings based metrics appropriate to the portfolio companies. These methods require comparisons to transactions and observable metrics in the market, and presume that they are valued correctly by the market. If the market conditions remain largely identical to the initial transaction, the entry multiple would also be deemed appropriate. Indicative offers may also provide useful information to the fair value, but valuation professionals should be wary of any factors skewing the offer price, such as control/minority factors, discount due to lack of marketability, etc. This is generally considered as a level 1 or level 2 input under the accounting standards.
The cost approach requires valuation by reference to net assets, which is appropriate for investments driven by underlying assets rather than earnings, such as properties and fund-of-funds.
The income approach, also known as the discounted cash flows (DCF) method, is flexible as it can accommodate detailed forecasts around the cash flows of the businesses or assets (such as a bond). Due to the high level of subjectivity in the assumptions input for a DCF model, the IPEVC does not recommend using it in isolation. This is generally considered as a level 3 input under the accounting standards.
Choosing the appropriate valuation approach requires judgement on the part of the valuation professional. This choice depends on the industry of the portfolio company, market environment and the investment structure. It is therefore useful to conduct valuations with different approaches as a sense check of values produced.
It is important to remember that the fair value should represent the transaction price of a hypothetical sale to a market participant. As such, the valuation professional must ensure that data from the market directly relate to the current market condition, and perform adjustments if necessary. For example, a distressed sale price does not represent a fair value.
We have discussed challenges facing private equity valuation and ways that a valuation professional may deal with some of these. However, nothing can replace the value that an external independent adviser with extensive accounting and valuation experience brings to the table. Many PE funds recognise this and have been working with external valuation advisers to provide investors and regulators alike with an added level of assurance. External support not only provides such assurance, but contributes to the robustness of the valuation governance process.
Dr James Dimech-DeBono is a senior managing consultant and Karthik Balisagar is a director at FTI Consulting. Mr Dimech-DeBono can be contacted on +44 (0)20 3727 1731 or by email: firstname.lastname@example.org. Mr Balisagar can be contacted on +44 (0)20 3727 1793 or by email: email@example.com.
© Financier Worldwide
Dr James Dimech-DeBono and Karthik Balisagar