Is it getting hot in here?” jokes Kevin Vannucci, a valuation partner at assurance, tax and consulting firm McGladrey.
Vannucci has just been talking about the importance of calibration – which many see as the next best practice GPs will begin to adopt in their valuation work.
To his left is Tom Angell, head of private equity at accounting and audit services firm Rothstein Kass, who has been arguing that calibration is an effective tool for CFOs to use in making auditors feel more comfortable about their valuation marks.
But across the table are two finance professionals: Joseph Riley, who oversees the administrative and finance functions at early-stage healthcare investment firm Psilos Group Managers, and Kristine O’Connor, chief financial officer of Franklin Park, a fund of funds manager. Although they nod in agreement with Angell, they appear visibly less enthused about the extra work that calibration entails for the valuation and audit process.
“What we’re talking about here is adding another piece to the valuation puzzle,” suggests Riley.
Together, these four professionals speak to the broad spectrum of views among those who help GPs to prepare, evaluate and deliver audited valuation reports to investors and other stakeholders. Their conversation offers a range of opinions about the valuation methodologies that have emerged in the last five years, and more importantly, sheds some interesting light on where best practice is headed next.
For the uninitiated, calibration is simply the idea that a GP should look at the market inputs or assumptions originally used to price a target company. Then during subsequent valuations (typically each quarter), the GP should consider how those original inputs and assumptions may have changed in light of changing market conditions.
Or, to put it another way, it’s a “way of seeing that your thought process about an investment remains consistent”, says Angell.
It’s a concept that has only recently begun to pick up steam at an industry-wide level. About a year ago, calibration was given considerable page space in revised guidelines overseen by the International Private Equity and Venture Capital Valuation Guidelines Board, which most private equity and venture capital trade associations consider to be the industry’s valuation gold standard.
“In theory, calibration makes a lot of sense,” says O’Connor. “Everyone is performing some sort of model analysis at the time of purchase, so why shouldn’t that be the starting point?” She briefly pauses for thought before answering her own question: “It just requires time and resources; two things CFOs are in short supply of these days.”
Nonetheless, all four roundtable participants agree that calibration will become a bigger part of GPs’ valuation policies and procedures in the coming years. And arguably, the primary reason for that is the US Securities and Exchange Commission and other regulators, which have cited valuations as a priority in their now escalated supervision of private fund managers. With calibration, GPs (and their auditors) have more supporting evidence to show that a valuation mark is reasonable.
“I appreciate the point that calibration is additional work, but it’s another method out there to help CFOs reconcile their valuation estimates,” says Vannucci. “And I think that as people do it over time, it just becomes another thing built into their Excel modelling that is updated each quarter.”
So what exactly does this additional work entail? GPs often measure the value of a private company by comparing it to similar companies in the public markets, where trading data is more easily available (see boxout on following page). They’ll look at multiples, risk exposures, growth rates, margins and other publicly available benchmarks, then compare against their own portfolio companies. What calibration involves is performing that same exercise again and again during the quarterly, semi-annual or annual valuation process.
“Really what you’re doing is seeing that your private company is growing at the same general level as its public market comparables,” explains Angell. “Because as an auditor, what I sometimes see is GPs using the same market assumptions year on year to find the portfolio company’s fair value, which is wrong – the public markets are always changing.”
“That’s exactly right,” agrees Vannucci. “Calibration helps GPs identify assumptions from the market participant perspectives and how they have changed since initial recognition, and if the assumptions used to value the subject company should be changing in line with the market participants. And as part of the calibration process, color needs to be provided to the audit firm that explains why the portfolio company’s value is growing at a similar, slower or faster rate than its public market comparables.”
Here, Riley provides an example of calibration in practice: “If three years ago I invested in a company with a 40 percent weighted average cost of capital (WACC) at a 6x EBITDA multiple, and I’m now at a 15x multiple and 20 percent WACC, does that make sense? Well yes, maybe it does, because the company picked up an extra 15 clients during that time period and rolled out a new product.”
LOOKING FOR APPROVAL
Moving on from the topic of calibration, the roundtable participants discuss another valuation best practice that seems to divide opinion: having investors give their stamp of approval to the GPs’ valuation estimates.
“There are GPs in our portfolio that ask us to do this,” says O’Connor. “But we usually steer clear of it – mainly because it’s a potential liability. There are a lot of LPs who just don’t have the resources to perform that deep-dive into a portfolio company to feel comfortable enough to sign their name to a valuation.”
The more standard practice is for investors to approve the fund advisor’s valuation policy and procedures, she says.
On the other hand, some LPs like the power to approve valuations as an oversight measure, says Riley. “As per our valuation policy, our LP advisory committee approves our valuations at the end of our fiscal year. We haven’t had a situation where the board has rejected the valuations – because the way the process plays out is more of an information-gathering session where they can ask us questions, or request further clarification about a particular mark.”
A consequence of these sessions is that investors become more informed about the methodologies and assumptions used during the firm’s valuation process, says Riley.
“Before approving the valuations, we send the advisory committee an information packet summarizing each valuation. For example, it will show we performed a discounted cash flow and trade multiples analysis on this company, and the LPs after time become really quick on the terminology. So now they might ask: ‘tell me about what multiples you’re using’ or ‘what costs of capital are out there’.”
And what happens if the GP and LPs can’t agree on a mark? Riley says the compromise is to have an independent valuation firm act as the arbiter.
“Having an outside pair of eyes provide positive assurance on a valuation is actually a common solution in those scenarios,” says Angell. “During the audit process, if we don’t feel comfortable with an estimate, even after speaking with the fund manager about it, the next step is to have an outside valuation service provider take a look at it.”
Taking the opportunity to speak candidly with an auditor about valuation disagreements, O’Connor asks Angell how much he considers materiality when contesting a mark.
“Materiality does come into play. We’ll stress test the numbers. So if we think a couple of the inputs a GP used should be different, we’ll plug them in and see what valuation comes out. And if the result is not that materially different from what the GP originally came up with – well, we can live with that.”
The conversation moves onto a topic bound to crop up whenever the subject of valuation is discussed: disclosures made in the financial statement.
For the most part, private equity CFOs suspect that their LPs are feeling bombarded with information about the valuation process. That’s because private equity firms, as owners of highly illiquid (or “Level 3”) assets, must provide a number of disclosures related to their fair value measurements.
It’s also now best practice to use multiple methodologies when measuring fair value. And each additional methodology means more disclosures around the technique, inputs and assumptions used.
“There’s a risk here too,” says Vannucci. “If there’s an information overload, an investor could miss changes in the major assumptions. For instance, if a GP changed the weightings of the valuation methodologies and all of a sudden, one method that was weighted say 40 percent at the last measurement date is now weighted 70 percent, there should be some explanation or question as to why.”
What’s more, CFOs often question the relevance of certain disclosures being made.
“For example, we have a table in our financial statement that shows our cost of capital range, but it doesn’t tell you what companies it applies to – so now how does that help someone understand the sensitivity analysis inside the portfolio?” says Riley.
“So you have a schedule which has information, but is it valuable? I’d be curious to hear from a LP – are you getting a lot of value out of me telling you my comp set was between 6x and 12x EBITDA across a portfolio of 20 companies?”
Angell responds that one can lump together this type of information about the entire portfolio – unless one portfolio company significantly deviates from the rest.
“Where clients have a problem is making that judgement call about an investment that might need to be disclosed separately. And when they have to do it, the concern is you’ve released too much information about an investment.”
Providing the LP perspective, O’Connor suggests that financial statements have become too bogged down in technical language, which makes it difficult for some investors to properly understand how valuation estimates were derived.
“But at the end of the day, what gives us comfort is that an auditor signed an opinion indicating that the marks are reasonable. And if we have a question about a particular valuation, perhaps because we think a GP used a high multiple to value a company, we want the ability to call the CFO and walk through the process.”
Whether time-strapped CFOs would be able to immediately respond to that request is another matter; after all, calibration and other recent valuation best practices do represent additional work for the firm’s finance team.
However, as our roundtable participants agreed, these practices have at least come about as a way to provide investors and regulators with a greater sense of security in GPs’ valuations – and that surely has to be a good thing.