Valuations: What do LPs want to know?

It’s fair to say LPs are not always impressed with their GPs’ valuation practices. Many LPs in recent interviews with PE Manager have said that the level of transparency, or consistency in GPs’ valuation methodologies, does not meet their expectations. A percentage of private equity firms (15 percent) even said that LPs have challenged them on at least one of their portfolio company valuation estimates, according to an informal poll of delegates taken in mid-January at the 2013 PEI CFO & COO Forum in New York.

That’s obviously a problem. As of 2009, US-based LPs began filing the ASU 2009-12, which is the Financial Accounting Standards Board’s (FASB) guideline for valuing private equity and other non-quoted assets. It allows LPs to use the net asset value reported by the general partner to estimate their own fair value of an alternative investment, but the guidelines say that on top of LPs’ normal due diligence processes, procedures should be put in place to determine that the GP has used appropriate rigor in coming up with their own fair value estimates.

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That’s why in order to meet their own accounting requirements, LPs have been putting pressure on GPs to share their notes and thinking around the firm’s valuation methodologies and procedures.

The good news is that, as time goes on, LPs are generally feeling more comfortable about the issue as the industry attempts to standardize its valuation methodologies. The International Private Equity and Venture Capital Valuation (IPEV) board, for one, has for years now been writing guidelines that could be used by private equity firms worldwide.

A fund of funds in-house accountant singing IPEV’s praises said that if more GPs started following the board’s guidelines, it would make the lives of investors much easier. “We are starting to see GPs use these more and more. And the ones that aren’t using the exact template are moving towards similar content. It would be an ideal scenario if this continues,” adds Raj Mehmi, who works on reporting and portfolio analysis for fund of funds Altius Associates.

The bad news, for at least some GPs, is that even full adoption of IPEV guidelines isn’t enough to satisfy all LPs’ expectations. According to the fund of funds accountant, GPs need to be more upfront about the constituent elements of their valuation policies and figures. “How valuations are derived is not always clear, so whether the methodology is public comparables, or discounted cash flow, it is helpful when this information is reported on a regular basis.”

Rob Wright, partner at fund of funds Pantheon backs this up: “We can’t hide behind our GP saying he provided the numbers. We have to provide clear evidence to our auditors that we have looked at those valuations, that we have considered them properly, and that we’ve made adjustments if and when necessary.”

In order do this GPs need to provide LPs more details on how exactly their calculations were derived (i.e., what comparables are being used, what discounts are being taken, what multiples are being used and so on).

Altius Associates’ chief operating officer, Jenny Fenton, adds that GPs should also provide a statement of the valuation policy in the initial Limited Partnership Agreement, and that any changes to that policy be specifically highlighted in quarterly reports. Doing so, significantly enhances the group’s relationship with GPs, says Fenton.

Multiple LP sources speaking with PEM agreed that a firm’s valuation methodology is important for their initial, and ongoing, due diligence of private equity firms – a process that involves them analyzing fundamental company performance of prior funds.

This includes checking EBITDA at entry against current EBITDA or EBITDA at exit, or net debt at entry against current net debt or net debt at exit, to name a few examples, elaborated the fund of funds accountant.

With 20/20 hindsight, the accountant is able to determine whether a company’s performance supported the valuations a GP had been reporting.

Indeed, there’s an obvious consensus amongst LPs that more transparency around valuation is needed. Yet despite this agreement, it appears some GPs haven’t taken notice, at least according to some market sources. “The transparency and level of information LPs receive from GPs is quite variable,” says Greg Branch, an audit partner at big four accounting firm Deloitte.

One of those variables is the amount of analytical work GPs are completing and subsequently reporting to investors, says Branch. “It’s not particularly transparent to LPs where value movements are coming from.”

To show where those valuation movements are sourced, firms should conduct greater analysis through valuation bridging, says Branch, who explains the process involves looking at the valuation movement in between reported periods, and analyzing what has caused the movement of the valuation.

As a side-bonus for those who love to trumpet their value-add skills, breaking down valuations in this way allows GPs to show-off how operational improvements to the business helped shape the improved valuation.  

Typical attribution analysis, which digs into what aspects of the business affected the rise or fall in valuation, only looks at changes in EBITDA, valuation multiple, and leverage. But further steps can be taken to deconstruct common high level metrics to include factors like revenue growth, margin changes, changes in cost of capital, change in growth profile, and specific balance sheet and capital structure impacts.

However, showing off any operational improvements must be tempered in the quarterly reporting, according to the fund of funds accountant. “If you were to just read the intro [of valuation reports] you would think every company is stellar.” The accountant says that any GP can make the claim their portfolio company is the leading provider of ‘X’, but when digging down into the actual financial metrics, those claims could come across as gimmicky marketing jargon. “In valuation write-ups, just stick to the facts.”

GPs are also being warned not to become too conservative in their valuation estimates. “You do get occasions where GPs might be undervaluing their companies because they feel that when it comes to [the final] realization, any uplift is a bonus to LPs, says Altius’ Mehmi, who qualified this has become less of a concern since the advent of mark to market.

The fund of funds accountant echoes the sentiment: “We found that GPs are relatively conservative, and that every GP thinks that’s a good thing. But as a chief financial officer it’s not. It raises questions like are they marking up when fundraising? As an LP we truly appreciate their best mark even if in subsequent quarters you have to mark it down.”

Managing partner of fund of funds AlpInvest, Martin Vervoort, agrees, adding to the conversation that some GPs raise their valuation figures during fundraising – which may be a reflection of a truer estimate of the portfolio’s worth, but is really done for marketing purposes.

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With this increased scrutiny of GPs’ valuation reporting one could be forgiven for thinking that LPs don’t quite trust the numbers they are given, but that is not quite the case.

“LPs rarely challenge valuations in terms of demanding to see documentation or questioning comparables. They are much more likely to question consistency with the valuation policy overall, asking ‘Are you changing your method?’ ‘And if so, why?’,” says William Hupp, vice chairman of the International Private Equity and Venture Capital Valuation (IPEV) board and former chief financial officer of Adams Street Partners.

Probitas Partners’ managing director Kelly DePonte agrees that LPs tend to trust the numbers. He says that where LPs get upset is if there is a major change in valuation that should have been forecast but wasn’t.

This is why LPs argue that transparency of methodology is so important. “What is very important is that if there is sufficient disclosure, you can do two things: check if things are really out of whack and check consistency over time,” says Vervoort.

The ability to verify consistency is one of LPs’ greatest priorities, say sources, meaning a lack of disclosure can arouse suspicions, adds Annette Wilson, an investor relations specialist for Palamon Capital Partners.

To ensure that Palamon is as transparent as possible, it sends its underlying valuation calculations, which was previously available only to its advisory committee, to all of its LPs.

If LPs have a chance to look at, and really understand the methodologies, they will be much more relaxed with the valuations, adds Wilson.

But doing this is only the start for GPs. Deloitte’s Branch says that LPs will be asking questions around not only the methodology, but also the people who are doing the valuation and their degree of independence from the figures.

“We think that one example of best practices, is that on the valuation committee, you should have reasonable representation of non-investment people to ensure objectivity,” says Pantheon’s Wright.

With the vast majority of private equity houses doing their own valuations, they should expect more questions from LPs around what the review process looks like, what is the membership of the advisory committee, the firm’s valuation committee, who will be signing off on the valuations and more.

Going one step further. Hupp says that it is not unheard of for LP involvement to go as far as having an LP advisory committee essentially sign off on the valuation methodology of the portfolio.

Whether or not all GPs go this far remains to be seen; however, GPs should be ready to explain their methods both at the start of a new relationship with an LP and on an ongoing basis. It's certainly a transarency shift relative to years past, but one likely to stay for the foreseeable future.