Stout on transforming valuation processes with technology

This article is sponsored by Stout

How have regulatory compliance and formalized accounting standards changed the portfolio valuation landscape?

Chris Franzek: Back in 2006, the Financial Accounting Standards Board (FASB) issued Statement 157, later renamed ASC 820, which put the valuation of illiquid assets at the top of people’s radar. Then in 2019, the American Institute of Certified Public Accountants (AICPA) published its guidance on how to value private equity and private debt instruments. While the FASB statement outlined recommended actions, the AICPA provided more concrete guidance on the handling of fair value challenges with robust examples addressing pertinent issues.

Over time, those formalized accounting standards have clarified what constitutes a robust valuation process. In addition, auditors have been less opaque regarding the accounting issues they are considering.

While the Securities and Exchange Commission does not appear to have prescribed detailed requirements, it has identified common shortfalls of individual funds and issued occasional fines. Meanwhile, LPs have improved their own operational due diligence processes, requiring funds in which they invest to improve their valuation processes or risk losing assets under management.

Harris Antoniades: We have also seen a move towards increased convergence on global accounting standards. These steps toward more formalized standards have positively impacted transparency around asset valuation so that investors can make more informed decisions.

What role can technology, such as data analytics and automation, play in the portfolio valuation process?

HA: We are moving away from manual processes and Excel-based modeling to more robust valuation tools, increasing efficiency and reliability while cutting cost. We can deliver faster valuations and eliminate much of the risk associated with human error. Technology also increases transparency.

CF: As funds have gotten larger, the “ticket size of” individual investments has not necessarily grown in the same way, so managers are managing more investments. The teams responsible for these deals have generally grown along with the funds. However, the back-office functions have not expanded at the same rate, straining back-office teams. As a result, managers have a choice of hiring more professionals to scale their back-offices or leveraging technology to assist with these back-office tasks.

What tips do you have for funds transitioning from manual valuation to more automated processes?

CF: The shift from deal team-centric valuation processes to a centralized process with an internal valuation team using more standardized modeling can be challenging. The change in control of the valuation process from the deal team to the valuation team will be easier for some organizations to implement than for other organizations.

Additionally, while a standardized model increases efficiency, it may lose some nuance that a bespoke valuation by the deal team would have captured. The organization, therefore, should consider these trade-offs, balancing input from the deal team to capture their understanding of the investments with efficient valuation processes. Each fund must decide on the balance that works best for them if they want to process growing numbers of valuations in a short period of time.

HA: When you start the transition, you must assess your current processes, identifying pain points and inefficiencies in areas ripe for automation. Then, you need to understand your needs and goals, stating your objectives and communicating those to the organization. Training will be needed, so start small and gradually roll out the changes over time.

How do you think about interest rates and macroeconomic factors in valuation processes?

CF: The private space typically differs from public markets in its response to volatile markets. Sponsors tend to be in close contact with the portfolio companies, monitoring them closely to track performance. Interest rates and other market data play a critical role in the valuation process, and a company’s cost of capital is a crucial input that directly impacts an asset’s valuation.

Many have been concerned about a raft of zombie companies that would default when interest rates increased, leading to a wave of bankruptcies. However, the direct lending community appears to be more proactive and flexible than traditional banks in working with management and sponsors to address capital structures before companies face major liquidity or legal problems. Largely because of this, we haven’t seen the rush of restructuring or bankruptcies that was feared.

How are ESG factors integrated into portfolio valuations?

CF: ESG is a consideration during the initial diligence process before an investment is made. At that time, deal teams will consider the company’s current ESG program and the changes that the deal team plans to make to the company’s ESG program during their investment period. Given that, the base forecasts for a company are calibrated to incorporate a company’s current and planned ESG initiatives. As the investment thesis plays out, incremental benefits and/or costs related to ESG above and beyond those in the initial investment thesis will be considered.

How do you incorporate geopolitics into your valuations?

HA: Geopolitics is not directly added into our modeling, but in due diligence, managers may want to run certain scenarios and projections and adjust discount rates to potentially account for additional country or legal risk in certain parts of the world. The geopolitical landscape is probably more company-specific than the impact of interest rates. Factoring this into valuations is more about adding a layer of sophistication rather than a specific input.

Do you see continuation funds as a long-lasting exit alternative, and how do you consider them in valuation processes?

HA: Continuation funds give GPs and LPs more flexibility with their exit strategy and allow managers to hold on to assets longer in order to realize a better investment outcome, which tends to increase the value of those assets.

CF: Continuation funds bring in new investment and therefore reflect a third party’s valuation on the company. As such, we consider pricing indicated by a continuation fund as an input to the valuation process.

We believe continuation funds have staying power, although it is unclear whether they are effectively a counter-cyclical complement to the primary exit market or a longer-term option that can coexist alongside a healthy primary market.