“We’re dealing with unprecedented times,” states Dennis Nisbet, director of evaluations with Pinnacle Valuations in Phoenix. The greater the uncertainty, “the more valuations are penalized,” he adds.
Yet, the task must be done.
Moon Capital Management ($1.2B in AUM) in New York reveals that the foundation of its approach to valuation is looking at a firm’s discounted cashflow. “Detailed financial models are the backbone of valuation and DCF analysis,” the firm’s Form ADV brochure states. This method can be taxed during a pandemic that has shuttered businesses nationwide and scared away customers.
As our sister publication Secondaries Investor has reported, pricing could be down as much as 30% from pre-coronavirus levels by the end of the quarter.
Where to begin
Logic dictates you start with your valuation P&Ps and governance and disclosure documents, says David Skelding of Croke Fairchild Morgan in Chicago. The compliance officer’s role “is to ensure that the proper procedures are followed and that the firm is being rigorous in its analysis,” says a GC/CCO at a private equity adviser in the Mid-Atlantic.
Firms that deviate from their valuation P&Ps should “have a well-documented rationale for why they did so,” recommends the GC/CCO.
So, what can you do? For one CCO at a private equity firm in Texas it means longer and “more involved” valuation committee meetings that take deep dives into a portfolio company’s cashflow. The CCO chairs the committee in a non-voting role. A CCO should question assumptions “to see if we really are digging deep enough” and “taking a hard look at these assets,” they add.
This translates into “extremely aggressive cuts to the cashflows” that could run for several quarters, triggering “deep, deep discounts of multiples,” the CCO continues.
You can seek comparisons with public companies that compete against your portfolio entities, says Nisbet. They “can serve as a proxy” for a private company and help you to predict the future. Consider grabbing “a basket of public companies and try to glean some information from them what future demand and cashflows might look like,” he adds.
The Texas CCO isn’t enamored with this approach. In their view, public company quotes “aren’t a great comp” because “the chaos that the pandemic has caused” means their valuations aren’t connected to the company’s fundamentals either. However, they can serve as a “helpful data point” but you shouldn’t overly rely upon the public company prices, the CCO asserts.
You also could delve into innovations forced upon your portfolio companies, states the GC/CCO. Look at cashflow, for instance, for a restaurant that’s surviving on take-out service.
An advantage handed to a CCO at a San Francisco adviser comes from the firm’s owner: an investment bank. The adviser benefits from the wealth of financial data the bank holds on those firms, easing valuation. The CCO also plans to account for steps portfolio companies have taken to reduce expenses. Another option they’ll deploy is to compare how firms in Asia, which moved quicker to resume normal business activities, are doing to project future prospects for the CCO’s portfolio companies.
Both the GC/CCO and Texas CCO rely in part on third-party valuation vendors. They can assist as well. And you should raise your concerns with your fund’s auditor, recommends the GC/CCO.
Filling the GAAP
Many firms follow GAAP rules, which can be challenging when markets are “disrupted,” says the GC/CCO. “You have to take a look at those weightings and make sure that they’re still getting the appropriate weight given the circumstances,” they add.
Use guidance from the SEC’s recent valuation proposal for registered funds. The proposal would encourage funds to periodically assess “any material risks associated with the determination of the fair value of fund investments,” including “key inputs and assumptions” and to establish “criteria for determining when market quotations are no longer reliable.”
The proposal would require records that “support fair value determinations” and would mandate that the fund’s investment adviser alert the board within three business days after discovering “matters” that could question the accuracy of an adviser’s valuation, “including a significant deficiency or material weakness in the design or implementation of the adviser’s fair value determination process or material changes in the fund’s valuation risks.”
Other steps to consider
A lesson learned by some advisers after the Great Recession was to create ‘side pockets’ that funnel illiquid assets into another vehicle. Moon Capital refers to these as “special investments.”
Hedge fund advisers may wish to establish “liquidity gating mechanisms” if redemptions prove challenging, says Skelding, although he recognizes that “it’s hard to pivot in the middle of a crisis.” One would limit or suspend redemptions should they hit a certain threshold percentage of assets. “That’s a common sort of tool,” notes Skelding.
The current downturn forces some speculation on valuations, acknowledges Nisbet. The Texas CCO agrees, stating firms must take “the best estimate that you can at that particular point in time.”
Don’t forget you could be second-guessed by OCIE examiners down the road – after all, your advisory fees may be based upon your valuations. After these types of market events, OCIE examiners will look at how firms “conducted themselves when reviewing the valuation of their investments and they’re going to look at it very closely,” predicts the GC/CCO.
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