Winning the valuation tussle

Even in the face of stiffer guidelines and regulatory pressure, private equity valuation will remain a process with room for interpretation. And where there’s interpretation, there’s room for argument.
With the spate of accounting scandals still fresh in mind, auditors are in the mood to argue when it comes to fair value. This is not to say that auditors and their GP clients are always sitting across from each with clenched teeth. In most cases, their collaboration is a friendly one, and even when differences arise, they can be resolved with aplomb.
Where GPs are forced to justify their initial valuations, accounting experts recommend a few practices that will make the numbers more persuasive. One, GPs should acknowledge the difference between an assumption and a fact. Every valuation involves predictions, and it’s best to find common ground as to what those might be. Two, the partner should be willing to tap outside expertise and material, such as independent industry research, to support those predictions. And finally, GPs should have their own internal historical metrics of a similar company or industry to further bolster their cases. Auditors appreciate that valuation is as much art as science, but just as architecture can boast a stunning facade, it needs a firm foundation.
More often than not, GPs would rather not look beyond the facade. Frequent revaluation of a company tends to produce fluctuation.
Writing an investment up prematurely can lead to embarrassment when the value has to be written back down. As a result, GPs historically have taken an extremely conservative approach to valuations, happy to err on the side of underestimating the portfolio (unless another fundraising drive looms).
One GP at a venerable middle market firm says his auditors have consistently been arguing for higher and higher valuations. He is not the only one to make this observation. Many GPs now find themselves in the slightly odd position of having to argue forcefully that their own investments are not worth as much as a disinterested third party says they are.
One of the arguments GPs use to keep their valuations low is the illiquidity factor. Without an exit already underway, GPs can argue that no matter the strength of the numbers, the value of a portfolio investment is limited to their ability to convince a buyer as to both the company’s current and future value. The latter point offers GPs plenty of space to play devil’s advocate about an industry’s cyclicality or factors that erode value over the long term. Another GP noted the need to substantiate that “illiquidity factor” with as much tangible evidence as possible, given the extremely rigorous audit process today.
Those tangibles can take two forms: outside expertise and historical data. Citing analyst opinions on similar enterprises or the given industry itself can bolster the case for a conservative valuation. These “independent” sources help sway the auditor to understand the valuation stems from somewhere other than the partner’s imagination.
Historical data on an industry or a similar enterprise can go even further to support those outside experts. Particularly with industry cyclicality, if there’s evidence there may be a downturn in the near future according to prior cycles, that discount seems far less arbitrary.
Another form of historical data available on behalf of a partner’s numbers are the firm’s own prior valuations. Auditors value consistency, and if the valuations were arrived at using a consistent standard, that’s another argument towards maintaining the numbers. The influence of former valuations is dependent on two qualities: consistency of process (not results), and quality of analysis. If the firm’s portfolio was consistently undervalued when compared to
eventual exits, that’s not a sign of quality analysis. Prior valuations that have landed within striking distance of the exit price can demonstrate the validity of prior techniques.
One GP speaks of an instance when the auditor wanted to chip away at a valuation of a particular portfolio company, a leading sporting goods company. At the heart of the dispute was how the company’s brand was valued. The firm cited data on peer brands, defined by similar market penetration and awareness, along with industry analysis that spoke of growth points for similar enterprises.
Coupled with examples of similar valuations in prior portfolio companies that achieved exits in line with expectations, the auditors accepted the GP’s conclusion.
At the heart of any successful debate around valuations is the abilities of both parties to admit that their differences those of perspective. The firm and the auditor are simply interpreting the data in contrasting fashions. GPs can build support for their interpretations by citing outside expertise and historical data. However, auditors are better equipped to argue their points than ever before, hence the skyrocketing prices of audits, so GPs should be prepared to concede ground from time to time.