Valuations - How Smart Private Equity Managers are Getting their Act Right!

Valuations - 😟 Had Always Been Worrisome! 

One of the biggest challenges in Asset Management is to arrive at the fair market price of the portfolio and the assets that are being invested in. This challenge multiplies as the portfolio becomes more illiquid with few reliable sources of valuation data. Some of the biggest fund failures over the last few years like the Third Avenue Asset Management collapse have been attributed to badly mispriced securities. 

In the aftermath of 2008 financial crisis Valuations of securities at Funds has been in focus with investors and regulators. Investor due diligence increasingly focuses on valuation policies, processes and models. Regulators across the globe have focussed on Valuation processes and increased their oversight of how assets are being valued. A big learning from the 2008 financial crisis was how lax some of the valuation processes had been with even the larger banks which created knock-on effects up and down the financial system. 

The International Monetary Fund has flagged the alternative asset managers for potential financial stability risks due to bad valuations. They are recommending strengthening oversight through the adoption of a ‘microprudential orientation’.

The shift globally in fair value accounting and its increasing importance has forced alternative asset managers to revisit the traditional valuation approaches. Private asset valuation has always been a challenge, due to the opacity of models, inadequate public companies comps, and whimsical calibration of liquidity and marketability discounts.

Globally Changing Regulatory Environment

Accounting standards like IFRS 13 and ASC 820 were the result of global recognition for transparent reporting needs. They establish a framework on fair value measurements affecting a wide group of corporate and financial institutions holding investments. IFRS and US GAAP worked jointly, developing these standards to harmonize the global accounting standards for fair value. The Private equity community responded by setting up IPEVC (International Private Equity and Venture Capital) Valuation guidelines in compliance with IFRS & US GAAP. The Alternative Investment Fund Managers Directive (AIFMD) aimed at bringing in standardized regulatory framework for private equity and other alternative investment funds came into effect in 2013 in Europe documenting the requirements in areas of, among other things, transparency and reporting in relation to valuations.

Why Portfolio Valuation Is So Important to private equity firms

All regulatory requirements apart, accurate valuation of portfolio holds great value for every private equity stake-holder by facilitating an intelligent decision making process. Timely accurate valuation and adherence to the best practices, provides relevant information to LP’s, attracting high quality investors.  

Challenges and Pain Areas in Valuation Process

For Private equity firms largely involved in investing in early stage or growth focused companies, valuation remains more a judgement call than any rules based design. The valuations are often based on level 3 inputs and accomplished with modelled data, bringing a high level of subjectivity into the process. This makes it imperative for the valuation advisor to clearly document the calibration of original investment costs to the current fair value. It helps to provide a sensitivity analysis - on how changes in unobservable inputs affect the fair value. Having an external adviser, to audit the inputs, benefits the private equity firm.

Judgement plays a critical role in choosing the valuation methodologies, for different types of assets. A substantial part of the private equity assets employ either the Income approach or DCF (Discounted Cash Flow) for valuing an asset. These models are flexible and can accommodate detailed forecasts around the cash flow of the businesses. Private investment also come with complex capital structures of the entities being valued. This could further include instruments with conversion features or other contingent claims, requiring allocation of enterprise value across the different tiers within the capital structure, often using complex option pricing techniques.

Current guidance is to combine these principal models with other valuation approaches to reach the final fair value of the asset.

When you thought it is nailed You realize, it has just begun

It becomes immensely clear that valuing Level 3 Assets in any portfolio requires accurate and comprehensive financial models. The real adventure starts once all the above factors have been accounted for. The Operational process remains messy, with few good solutions. 

There are three critical pieces to a valuation - (a) financial data, (b) financial models and (c) the modellers. The financial statements are generated and shared by the company's CFO. It is picked up typically by the portfolio analyst at the fund, the outside auditor and often a 3rd party valuation service provider. In a frenzied messy process, multiple versions of the financial models data and reports are created by each of them. Very quickly the CFO, the analyst, the adviser and the auditor are on different pages, with different version of either the data or the model. This results in numerous inaccuracies, requiring multiple reconciliations of the final number.

How the smart asset managers are getting it right - Conclusion

Operational challenges can be more easily sorted by investing in a smart digital infrastructure. Pepper provides an integrated infrastructure for managing the models and the underlying financial data for ease of collaboration.

How Pepper Helps

• Pepper keeps the different versions of a current valuation models and the data, so users are always on the same page as they update their inputs

• Pepper keeps all historical financial data. This historical data for revenues, EBITDA, cash flows or any financial number can provide great value to the modeller. 

• Users requiring more than one model for valuing every security. For example one of our clients needs 5 separate valuation methods for reaching fair market value for each security. Pepper keeps a comprehensive view of each valuation methodology and associated values.

These are just a few of the many operational challenges we solve. To learn more about Pepper and how it helps you in valuations and more, Book your Live Demo Now alternatively you may visit us at http://onpepper.com or write to us at info@onpepper.com or call us +1-732-735-1491 we are listening

Co-author : Vivek Saxena                                                                      Co-author: Pulak Sinha 
India Head                                                                                                 Founder CEO
On Pepper LLC,                                                                                        On Pepper LLC
New York, NY, USA                                                                                  New York, NY, USA