European private equity firms are increasingly relying on backtesting to demonstrate the efficacy of their valuation models, according to attendees at Private Funds CFO Network’s Europe Forum in mid-November.
LPs are asking more detailed questions about underlying assumptions to valuations. “We’ve had to become detailed in how we are reporting to LPs,” remarked one finance executive.
And backtesting portfolio data “can help make the valuation process feel more robust,” remarked the finance director of a large London-based tech-focused buyout shop, adding that “we continually enrich the data to help the valuation committee form its judgement.”
(Reporters at the event were barred from naming attendees and speakers.)
Some CFOs are using backtesting as an opportunity to give auditors an advanced preview of their valuations ahead of audits at the end of Q3. That allows auditors “to get an early view on whether they think we are being cautious or aggressive,” remarked the director of finance and investor relations at one of Europe’s leading private debt firms.
And backtesting data can be useful when GPs are required to triangulate their valuation process – perhaps with an external valuation assessor as well as auditors and investors. By taking LPs’ feedback into account and presenting a valuation that sits within a range of those calculations, fund managers can demonstrate to their investors that they are being listened to.
The debate continues among investors and regulators as to whether the nature of private markets allows GPs to artificially inflate asset values.
So constant dialog with investors is paramount, attendees said. CFOs should explain the elements of their methodologies and the assumptions used, as well as be consistent with quarterly reporting.
“We do a lot managing LP expectations. There could be potential downside to the final valuation, so ongoing communication is needed. We do that through more transparency in our quarterly reporting and how we’ve arrived at those numbers,” explained the managing director of fund services at a global sustainable infrastructure firm. They added: “We try to graphically depict the makeup of multiples, discount rates, etcetera, and take a more data-centric approach.”
CFOs attending the event said that, ultimately, the simpler the process, the easier it is for auditors – and investors – to get their heads around the valuation framework. That means fewer questions and an overall more efficient and consistent process.
Dealing with uncertainty
Rising interest rates and uncertain macroeconomic dynamics further complicate valuations. One speaker explained that, should discounted cash flows be used as the basis of a valuation, they “often ask as a valuation committee how the discount rate is being built up? How are we factoring inflation in to the model?”
And the economic uncertainty has widened bid/ask spreads, causing valuation committees to determine fair value even when there aren’t willing buyers in the market. It also greatly complicates the valuations of early-stage investments.
One finance executive spoke about the expansion of their fund portfolio from 25 to 50 portfolio companies, stressing the need for a robust, structured process that relies on receiving data from deal teams who have “a big part to play” in making the case for early-stage valuations.
“We invest in similar types of companies, which means there’s a focus on benchmarking, calibrating and ensuring there’s a consistent answer across the board, particularly in this environment where public markets are moving up and down,” they remarked.
Some software platforms are helping to address LP questions around valuations by allowing finance teams to manage data inputs going into their valuations. “We are using software called CreditVision to scrape reported data into a central database that gets overlayed with our private transaction multiples,” said one CFO.
But tech is only an enabler, not a panacea. “We can help with the mechanics but deal teams need to apply their own judgement to the final valuation,” remarked a private credit fund executive.