The US Securities and Exchange Commission (SEC) has made no secret about where it intends to focus its efforts when inspecting private equity firms.
Ever since the Dodd-Frank bill pushed thousands of private equity managers under the SEC’s remit in the spring of 2012, the SEC has taken pains to understand the ins and outs of the industry. With that education campaign largely completed, the agency has cited fees, conflicts of interest, and crucially, valuation as three principal areas of concern.
Private equity firms have responded to the increased oversight by fundamentally reforming their valuation processes, says Tom Angell, who leads the private equity practice at audit, tax and advisory firm Rothstein Kass.
During a sit-down interview in Rothstein Kass’ mid-town Manhattan office, Angell tells PE Manager that the formalization of GPs’ valuation polices over the past year has been “astounding”.
“Before registration, some firms would give you their valuation policy as a hand-written memo. Most others offered something more, but it was all over the map.”
Now, says Angell, the standard is for GPs to present carefully written valuation policies that can run up to 25 pages long, with some clients even offering a PowerPoint presentation explaining their valuation methodologies.
“The shift occurred because, at its most fundamental level, the SEC wants to know what the GPs’ valuation polices are and whether they are applying it consistently.”
Many GPs find it unnecessary for the SEC to inspect GPs’ valuation policies. Unlike the hedge fund industry, the private equity industry argues, compensation in private equity is based on the actual final performance of the fund (realizations subject to clawback), therein by reducing the need for valuation oversight along the way.
The SEC counters that interim valuations can be manipulated to lure investors in follow-on funds. The regulator worries that a GP will artificially balloon the value of its holdings during fundraising-mode, only to write them back down before the books are audited.
Therefore, GPs that offer detailed and objective valuation reports present in a positive light the firm’s overall attitude towards compliance, says Angell.
“The more information you have to support what you’re doing, the more positive it’s looked at by both auditors and the SEC. There should be no guess work as to how you came about your inputs when measuring the value of the portfolio.”
CONSISTENCY IS KEY
What Angell stresses most is the need for consistency. A firm that has written a clear and methodical valuation policy leaves minimal opportunity for any one individual to game the numbers for fundraising or some other purpose.
“And it’s my job to check that you’ve applied that policy consistently over time. It’s not good to see that you’ve been using a comparable transaction method for the past three years, and now you’ve switched to using an income approach based upon a discounted cash flow model which might help you achieve a better number,” says Angell.
He adds the valuation policy should clearly explain what valuation approach – or weighted combination of multiple approaches as accounting guidance suggests – will be used when determining the fair value of investments in companies in different stages of operations, companies of different sizes, and companies which operate in different sectors.
“If a valuation methodology for a given investment does change over time, there needs to be a supportable, documented rationale for the change, from a market participant perspective,” says Angell.
At the same time the valuation policy shouldn’t be so detailed that it couldn’t stand the test of time. “The replacement of the CFO, or the loss of a deal partner with a sector expertise, should not result in changes to the firm’s valuation policy,” elaborates Angell.
Instead a higher level of detail can be achieved when writing specific portfolio company valuation reports. Here GPs can document what inputs they’ve plugged into their chosen valuation models, says Angell. “So for instance if using a discounted cash flow model, list what discount rate you’re using, and be prepared to answer questions about why that rate was chosen.”
A specific deal partner can further detail, for example, why certain public benchmarks, or public company comparables, were used to determine a portfolio company’s value.
GPs whose valuations turn out to have been significantly off from the actual exit price of a company can expect further conversations with their auditor about how to improve their estimates, or be asked to justify specific data points assumed in their calculations.
“Let’s say your model predicted a portfolio company producing $5 million in profit, but it turned out it was $4 million. Well, what happened?”
And if the GP believes the company will hit the $5 million profit mark next year, Angell says there will be need to be some explanation as to why next year is different from last. Optimism, he points out, isn’t necessarily based on facts.
Indeed separating the deal partner(s) responsible for monitoring an investment from the team responsible for valuating said investment should be a crucial part of any firm’s valuation policy, says Angell. “The deal partner whose reputation is tied to the investment may not be objective about its worth.”
At large firms, this separation of roles is accomplished with an independent valuation committee. Smaller firms with less manpower and resources need a bit more creativity to achieve the same outcome.
“The challenge here is to get the deal partner’s input – who knows most about the deal – while tempering that partner’s possible enthusiasm with objectivity.”
At smaller firms, a deal partner may write up a valuation memo or fact sheet to be used by the chief financial officer or other senior partners when valuing an investment.
“For example, some firms have the CFO sit down with the deal partner to discuss the investment. And whatever the valuation policy is, he’ll use that information to help determine the value.”
Here Angell pauses and produces a subtle smile. He recalls a conversation with a CFO he met at a conference, who once told him that some deal partners’ input can require additional care.
“The CFO told me he will bounce a deal partner’s numbers off one of his colleagues to ask ‘Hey what do you think of this?’, and they’ll respond, ‘Is that Mike’s deal? Yeah, he’s way too rosy with his numbers’. So the CFO will think about dialing back the valuation when working with Mike.”
No matter what process used, the valuation policy should clearly outline one consistent method used. Using the anecdote above, the policy should state that the CFO will work in consultation with colleagues when valuing a company following a discussion with the deal partner(s) responsible for the investment.
And through it all the chief compliance officer – who may or may not double as the CFO – should fact-check that the policy is being followed, says Angell. “They don’t have to run the calculations themselves, but they should verify that the valuation approaches adopted in the policy are being followed by the firm.”
A well-documented and objective valuation policy is the end result of all these efforts. That wins points with auditors, as well as SEC inspectors determined to investigate your valuation work.