Most GPs err on the side of brevity when reporting valuations, relying on investors to follow-up if they have questions. And while plenty of LPs are satisfied with current levels of transparency, many are just as swamped with data as their fund managers, and would prefer more informative valuation summaries that highlight any major changes to methodology, inputs or assumptions. Ideally, GPs should craft a narrative behind a given valuation so LPs better understand the most relevant elements of that valuation and know where to dig deeper in their analysis.
Today’s limited partner agreements (LPAs) might define broad valuation standards, but there remains room for interpretation in what’s reported over the life of the fund. Most quarterly and annual reports include GAAP financials and a brief one-paragraph summary of valuations that often reiterates the basic methodology at work, which investors already know. Really what they’d prefer is a brief story behind that valuation, investors tell pfm. That means highlighting any changes in calculating that valuation or any way that valuation might be unique from its predecessor. In essence, this one paragraph summary should be newsworthy, even if that includes sharing how a valuation might have been challenged during the valuation committee process. This doesn’t mean LPs don’t still examine the underlying data concerning valuations, but what they want from quarterly and annual reports are concise narratives that explain the most pertinent elements of a given calculation.
Generally, investors are content with how fund managers report valuations. In a recent survey conducted by EY in collaboration with parent publisher PEI, roughly 69 percent of LPs were satisfied with valuation methodologies, and 56 percent with the timeliness of those reports. However, only 40 percent were satisfied with how inputs and assumptions were reported, and that number drops to 30 percent when it comes to GPs reporting changes in assumptions and valuation committee approvals.
The reason that 60 to 70 percent of LPs might have lingering questions around those elements might be due to the fact that even when CFOs use current best practices in investor reporting, they may skip these issues. At the moment, many CFOs aim to adhere closely to ILPA’s overall reporting recommendations. So they will produce a one page investment summary for a given portfolio company along with the GAAP financials. The one pager includes a portfolio company’s results and initiatives, a financial summary, stats around the investment’s performance to date and an investment profile that includes acquisition data, company data, the original investment thesis as well as any ownership and security information.
Then there will be a section on that page devoted to a valuation summary, including LTM EBITDA, x multiple, enterprise value, net debt, total equity value, then percent ownership, and an equity value. Then depending on the comps being employed, it will include some mix of LTM public comps, transaction comps and discounted cash flows (DCFs) (assuming that they’re part of the valuation). Lastly, there will be a brief paragraph of commentary on that valuation.
This commentary usually talks about the multiple being used versus the public/transaction comps, but doesn’t go into that much detail. Occasionally, there may be language that compares the current multiple to the “going in” multiple and or explains how it’s conservative to public comps due to one factor or another, such as customer concentration.
However, this paragraph is where many investors want better insights into that valuation. The commentary offers a chance to address those areas left open to interpretation and highlight any changes in process or any debate surrounding choices made during the calculation.
However, today many CFOs avoid delving into that kind of minutia here. One CFO told pfm that such detail leaves room for misunderstanding, since it might give too much weight to a relatively minor facet of the process. But several LPs stress it’s key to allowing them to understand the most relevant, newsworthy elements of a valuation report.
Wants versus realities
Yet many GPs don’t find LPs demanding those specifics in the commentary section, outside of the occasional one-off request asking for more information about the valuation. One investor speaking with pfm about the findings noted that, by and large, fund managers are getting better in terms of disclosure on both overall policies and information sharing, especially in year-end reports. A fund formation lawyer suggested that with so many firms posting record returns, LPs might be willing to leave a few questions unanswered.
But that doesn’t mean LPs still aren’t hunting for that content in the financial statements, given how much latitude an LPA gives the GP in conducting valuations. “It’s important to note that LPAs typically don’t hardwire any particular methodology,” says Tom Bell of law firm Simpson, Thacher & Bartlett. “Current market practice is to give GPs the discretion to change the methodology, if need be, provided they disclose the changes to LPs or the advisory committees and be available, upon request, to discuss those changes.”
But that mandates reporting changes to overall methodologies, not smaller tweaks or refinements in the process. Many CFOs would argue any smaller change within a pre-approved methodology could be found in the underlying data. Accounting rules currently require the disclosure of assumptions and methodologies in the fund financial statements. “But most LPs find those disclosures to be of limited use because they are on an aggregate basis,” says David Larsen
of Duff & Phelps.
Accordingly, the summaries are the GPs’ chance to assure a valuation is not merely reported, but understood. “The summaries have to cut to the meat of what’s changed and address the primary drivers of that valuation,” says Mary Ann Travers
, valuation services practice leader of Crowe Horwath.
“You have to ask, ‘What tells the story?’ What happened to drive the change in value? What happened at the company? The ‘story’ is more useful than merely sharing the quantitative inputs, in isolation, that don’t explain the valuation,” suggests Rajan Chari of professional services firm Deloitte. If the summary is clear, concise and informative, it can help an LP feel confident in the valuation, without having to always wade into the underlying data.
“A minority of LPs have the systems in place where they could evaluate and track valuation assumptions and methodologies. However, the vast majority do not have the systems or personnel to allow them to track or evaluate that data,” says Larsen. As a result, many LPs ask fund managers to simply fill out their internal templates, which can be a time consuming task, manageable for large GPs, and unavoidable for smaller funds if the commitment demands it.
But for the rest of their investors, GPs should master the art of summarizing a valuation, which often boils down to explaining what, if anything, changed. And if a given input or assumption had an impact in deriving that valuation, even if it seems minor, it’s worth highlighting.
Changes worth noting can include moving from market-based comps to income-based comps based or shifting the weight of either in valuations that involve both. There might be a shift from using current or last twelve months’ financials to forecasts, as GPs feel a company’s potential earnings are more relevant. And as the GP nears the exit of an investment, they might take less discounts for lack of marketability, and that can be newsworthy.
One of the relatively minor inputs that might be worth citing is when a GP adds or removes companies that are part of comp stats. Perhaps as a portfolio company shifts strategies a particular peer might be less relevant, or if that peer goes through a substantial merger or acquisition, it’s no longer an adequate comp. Even if such moves don’t substantially increase or decrease a valuation, it’s worth explaining to further support a GP’s current conclusion.
If relevant, valuation committee processes should be shared as well. “While many managers indicate valuations are reviewed and approved by the valuation committee, it would be helpful to know what the discussions or disagreements were leading up to those final reported valuations,” says Karin Lagerlund, CFO of Harbourvest Partners.
True, CFOs may fret that undue weight is being given to a minor change in the process, but the end result may actually lead to more confidence in the overall calculation. That candor, and the effort in crafting these summaries, can give LPs confidence that the valuation falls well within the range of what’s acceptable by industry and regulatory standards.
“Our goal is to get the best ‘fair value’ at each reporting period. I call it the Goldilocks approach – not too high, not too low – just right. We review valuation policies and methods of underlying managers to ensure they are fair value in accordance with US GAAP or other valuation methods allowable under IFRS and that these fair value principles are being consistently applied,” says Lagerlund. Minor changes to inputs and assumptions can help argue that “Goldilocks” standard is being met.
The best valuation reporting remains a conversation, but the quality of that dialogue can be established by concise, informative valuation summaries. LPs appreciate not having to scramble to verify a change in valuation or an explanation why a valuation hasn’t changed if market or industry conditions are in flux. GPs shouldn’t assume that if LPs aren’t pestering them with follow-up questions they aren’t using the information that’s distributed.
“I often hear that GPs feel they are required to provide data that they think LPs will never look at but I think that’s incorrect. If you have seen the efforts of the AltExchange Association where the data is moving towards automation, you can see the LPs are becoming more determined to free up the time to spend on data analysis,” says Kathy Jeramaz-Larson of ILPA. And LPs notice when managers skimp on reporting underlying data.
“Not all general partners apply the same rigor to their quarterly valuations as they do at year-end and we would like to see more consistency on the non year-end quarterly valuations,” says Lagerlund. “This is especially important as private equity moves to more of a public market asset.”
Indeed, that may be all the more reason for GPs to take the time to tell the story of a given valuation and ensure that the calculation isn’t merely known, but understood.