Valuation methodologies in the private equity industry could look completely different in 2019, with tax reform, public market volatility, the rise of the secondaries market and upcoming guidelines all playing a role.
Public market volatility
December’s public market volatility will have a ripple effect on valuations for some firms. Tom Angell, a partner at WithumSmith+Brown, an accounting firm that performs audits and other financial services, anticipates an effect when conducting audits for last year.
“A number of funds use a discount to the public market as a valuation method, and seeing that the public market took such a beating in December, it’ll be interesting to see how that’s handled in the valuations,” he said. “We should see some big drops in valuations based on those who use some form of the public markets.”
However, a volatile public market is no reason to change how valuations are calculated.
“Methodologies should not change due to market conditions,” one chief financial officer said. “We do, however, expect to see a decrease in US values somewhat based on public company multiples.”
At the smaller end of the mid-market, firms get less out of looking at public company multiples when performing valuations, but public companies “should be considered along with other valuations tools,” the CFO said.
Last year, US president Donald Trump’s administration introduced uncertainty on several fronts for the private equity industry. Specifically, the Tax Cuts and Jobs Act of 2017 will impact valuations.
Blinn Cirella, CFO of Saw Mill Capital, told pfm that since the new tax law limits certain deductions, it “has caused some conversation about how to deal with it in the valuation model.”
“I expect a lot more conversation about this as 2019 proceeds,” she said, adding that tax reform is one of a host of factors she is looking at. “We will now consider the impact of raising interest rates, the impact of full employment, IT (cyber) spend and the impact of the current administration’s trade policies and potential tariff wars.”
Transparency with investors on how valuations are calculated is crucial. Even for firms making no alterations to methodologies, limited partners will continue to monitor funds’ consistency with their policies. They will also want to be informed of any changes that occur.
“One thing we do specifically is we will have a one-page write-up just reminding our investors of the pieces of the investments and an update of what’s happening,” Omar Hassan, CFO of asset management firm Cloverlay, told pfm.
Third-party valuations can also offer investors extra comfort. However, the number of firms outsourcing valuations is still low. At sister publication Private Equity International’s CFOs & COOs Forum 2019, only 14 percent of delegates surveyed said they use an independent valuation specialist to value their portfolio companies.
Several sources tell pfm that cost is a main reason outsourcing valuations isn’t catching on; managers also generally feel they know how to handle their own firm’s valuations best. But investors continue to request the use of third parties, and this is set to increase this year, Angell said.
However, he doesn’t see outsourcing valuations catching on in the way outsourcing fund administration has. For many years, funds didn’t outsource their fund administration, but that changed with the Bernie Madoff scandal, Angell said. Firms saw the potential harm and capital loss that can take place if members of a firm’s team are left unchecked.
One reason outsourcing fund administration is popular is because the cost is charged to the fund rather than the manager itself, and allows GPs to reduce their back-office headcount, he added.
“That’s not the same for the outsourced valuations because it’s not reducing back office staff; instead it’s just eliminating some extra work that the deal teams in the funds would have to perform. It’s not an enormous time saver.”
The rise of secondaries
The secondaries market has been growing drastically and is expected to continue growing in 2019. Final data from Evercore and Setter Capital and preliminary data from Campbell Lutyens and Greenhill show there was $70 billion to $79.7 billion in transaction volume in 2018. Campbell Lutyens’ estimate of $70 billion last year is significantly higher than its 2017 estimate of $48 billion. An increase in use of the secondaries market makes accurate valuations even more important for LPs.
“Funds traded in the secondaries are getting closer to par,” said Dan DiDomenico, a senior managing director at Murray Devine Valuation Advisors. “The LPs are really pushing to make sure that the sponsors are providing them timely fair values of NAVs of their investments.”
Since secondaries are illiquid assets and negotiations begin by looking at the latest valuation, “the more secondaries there are, the more scrutiny there’s going to be on people’s models and negotiating between the different assumptions,” Hassan said.
Lastly, firms should always ensure their valuations methodology is in line with how the Securities and Exchange Commission expects it to be done. The agency will be looking to make sure a firm’s valuations are consistent with their policies.
“[The SEC] will expect a signed valuation committee memo affirming each portfolio company’s valuation,” Cirella said. “They will also expect valuation models and support for all the input. They will look for consistency from portfolio company to portfolio company. They may also ask to see prior year models to look for any changes (like the multiple) and will expect any change to be documented.”
Guiding valuations in a new direction
The American Institute of Certified Public Accountants’ valuations guideline is set to be released in May. A working draft of the guide was released last May, and the organization has asked for comments on the draft to be submitted by August 15.
The guide will inform general partners on the best ways to come up with a fair value. It will also help regulators, auditors and preparers be more thorough in their valuations, which in turn helps limited partners, David Larsen, a managing director at global advisory firm Duff & Phelps and a member of the AICPA task force that wrote the valuation draft, told pfm in November.
Based on the draft, LPs are beginning to ask questions on whether firms are taking the guidelines into consideration, DiDomenico said.
“I think the biggest thing [LPs] look at is, what are your processes and procedures, do you have them in place, are they documented, are you following them on a consistent basis,” he said.
Firms should also be paying attention to the new revenue recognition rules released by the Financial Accounting Standards Board and the International Accounting Standards Board when valuing and operating a company, as that could affect valuation models. The rule, which private companies have been required to follow starting January 2019, changes the timing of when revenue is recognized. Now, revenue is recognized when the control of the goods or services transfers to the customer, as opposed to when the risks and rewards transfer to the customer.
“The analysis around it has to be more thought through if the underlying company that is being evaluated has adopted the new recognition rule,” Hassan told pfm.