A wild ride
Estimating fair value has never been more important or challenging. How did the shock of the pandemic and the subsequent market volatility impact valuation practices?
The old argument that the only value of importance is the difference between cash invested and the total received back no longer carries any weight. Today, the valuation of unrealized investments is a material piece of information.
However, the subjective nature of private company valuations makes them fiendishly tricky to calculate. And it is because of this that initiatives such as The International Private Equity and Venture Capital Valuation (IPEV) Guidelines exist; to support private capital finance and accounting professionals in this arduous task.
It’s important to note that IPEV never intended to provide a precise set of rules for establishing fair value. Rather, the guidelines are designed to allow a valuer to establish their own views of fair value in accordance with accounting guidelines and LPA requirements.
The problem with subjective and increasingly forward-looking valuations is that as digitisation advances, assets become increasingly intangible. Says Tuomas Saarinen, co-founder and chair of Apollonian, “In a modern economy investors typically have tech heavy portfolios where it’s so easy to manipulate the numbers on the balance sheet; it’s not an even playing field. In one way, the traditional rule of thumb in PE holds true; when the information is unevenly distributed someone has the edge.”
So what happens when a storm of uncertainty is unleashed onto an indefinite and tenuous foundation? While there were many obvious and immediate risks and concerns keeping GPs and LPs up at night when the pandemic first hit, the impact on valuations was one of the big ones.
In the early days of the pandemic, IPEV quickly published revised guidelines. “But they weren’t changed,” clarifies Paul Cunningham, CFO of Helios Partners and IPEV board chair. “It was more a clarification on how the guidelines should be applied in the situation we were in last year. We started from the premise that fair value as defined under the guidelines remained the correct approach - the guidance was to help practitioners get there.”
With no new information to offer GPs, why did IPEV feel it was necessary to communicate at all? Because panic levels were high, and as the gift of hindsight shows us, a natural reaction can be to pretend something isn’t happening or that it will go away quickly.
But IPEV needed to stress the importance of fair value, especially in the turbulent weeks of March and April 2020. And to reach fair value in those most uncertain times, more judgement was needed; GPs needed to look at assets on a case by case basis, to introduce a range of valuation methods to enable triangulation, and to consider discounted cash flows given the volatility of the public markets, in some cases causing dislocations and therefore weakening the use of comparables.
“We had seen significant reductions in the listed market valuations, and if PE valuations didn’t reflect what was going on, that would mean a lot of LPs were suddenly overweight in PE,” explains Cunningham. “Depending on the constitution of those LPs, they would either be prohibited from making more PE commitments, or in the worst case, would be forced to reduce existing commitments.”
The requirement to assess private capital performance alongside listed entities enables a clear and understandable macro picture to develop. Says Ryan McNelley, managing director, portfolio valuation at Duff & Phelps, A Kroll Business; “We all want to be able to compare values before, during and after the pandemic on a like for like basis. For a listed company, you can compare the stock price. For private companies, it is a bit more difficult, but one should always make comparisons on a like for like basis. In 2020, when the world changed, you would expect the values to move with that.”
Ups and downs
But the use of public market comparables in ascertaining private company valuations caused a major snag. Towards the end of Q2 2020 things got really sticky. Valuers needed to be sure that if portfolio company metrics had been adjusted to reflect a dip in performance, that the comparable metrics were also based on adjusted figures. And at the start of Q3 2020, many listed businesses had not issued revised forward guidance.
“That period around 31 March 2020 was probably when the markets were at their most volatile. There were wild swings in the listed markets; it wouldn’t be unusual to see a 20% movement in one day, with a swing back the following. So if you were just using the comparable multiples, it would depend on the moment you did the cut off. And with most comparable multiples you didn’t know whether they were based on pre-Covid forecasts, or if they had issued any updated guidance,” recalls Cunningham.
More questions than answers
With volatility piled on uncertainty, the immediate impact of the pandemic on valuations appears to have been more questions than answers. In Private Equity Demystified, Fourth Edition, John Gilligan of the Oxford Saïd Business School, with help from Hamilton Lane chair and EMEA managing director Jim Strang, put together an addendum on Covid-19 in mid-April 2020. On valuations, they wrote: “... valuations are uniquely challenging at this time. What is the most appropriate period to consider as regards profitability? Historic, LTM, something else? Also, how should the large and ever growing number of adjustments to profitability be accounted for from a valuation perspective? Then what multiple to use? What is the relevant peer set? There is no one correct answer.”
However, they pointed to the way in which ‘best in class GPs’ respond to uncertainty; through transparency and consistency of approach. “GPs thus must be thoughtful in how they derive valuations in times of such extreme uncertainty, and LPs must understand that valuations are as much art as science.”
Time for introspection
That natural urge to know what the top performers were doing would lead many to assume this was an opportunity to reassess and rethink valuation processes. “In one way this was a great opportunity for everyone to understand why it is important to focus on risk rather than fair value,” says Saarinen (Apollonian’s platform assesses a wide range of factors in order to value a company, including intellectual property, innovation, growth drivers and ESG).
But assessing more factors means more work. “And this is what it boils down to, despite all of the automation and data gathering tools, 90% of portfolio management work is manual. You can’t change these things overnight, but now we need to free up some time so that we can actually work with portfolio companies in times of distress,” adds Saarinen.
And it would seem many GPs did seek out solutions to improve efficiency. Valutico is a technology-driven business valuation tool. Says founder and CEO Paul Resch, “Because of Covid people had time to rethink their
processes and efficiencies became top of mind for GPs. We accelerated our client numbers because there was more readiness to improve.” Valutico aims to provide better benchmarking data. “People found that very useful, even if they were suffering too,” he adds.
The desire to be more efficient highlights more work was being put into valuations - by some GPs at least. “The pandemic showed us that you actually needed to spend more time and give more consideration to the specific position of each and every portfolio company; you couldn’t continue by looking at the comps and applying it to earnings. In normal circumstances that may be ok but this time it wasn’t going to work; it needed more thought, more consideration, more review to make sure you were taking into account the impact,” says Cunningham.
The reality, however, was a more nuanced affair. Some GPs knuckled down, others sought software or external solutions, and some continued on with bad habits. “We got a lot of calls from LPs observing some light practices and corners that were being cut that would previously have gone unnoticed but were more exposed in the pandemic,” recalls McNelley.
One of the most redeeming features of a major crisis is that it sorts the wheat from the chaff. As Warren Buffet famously said: “Only when the tide goes out do you discover who’s been swimming naked.” And for a moment, the tide went out and some GPs were without a bathing suit. “There were a number of examples of GPs caught off guard who wanted to kick the can down the road and left valuations unchanged at March 31, which raised concerns amongst savvy LPs - there’s no way most values could have been the same at 31 March 2020 as at 31 December 2019,” says McNelley.
The most obvious impact of ‘suspending’ valuations - as some GPs called it - was on the fundraising market; for anyone raising capital, not having a robust view of recent valuations would have caused a major problem.
But the wider impact, which according to some was ‘easily overlooked’ was the risk on secondaries. In times of crisis or uncertainty, LPs need to quickly assess their exposure. “LPs are our customers; they were as keen on seeing how their private capital portfolios were performing as they were their listed. So to ignore valuations was a cop out,” says one GP anonymously.
Control the narrative
Given the scale of the shock caused by the pandemic, by May and June 2020, many GPs were producing Covid 19 assessments. “A lot of GPs published more insights on Q1 and Q2 last year than normally. There were lots of management assessments with a lot of detail around the impacts, remedial plans, preserving value, how are we operating as a manager. Part of that was also some scenario analysis,” says McNelley.
While more information can only be a good thing - and the sheer volume of interaction between GPs and LPs over the past 12 months has been a remarkable feature of this crisis compared to the GFC - in the end you can only put out one number in your NAV. Furthermore, when it comes to information sharing, less is definitely more. With this in mind, the cynical view of the increased communications would be that GPs were trying to control the narrative.
A lot of the communication from GPs to their LPs involved statements such as ‘we believe value has been preserved’ and ‘we’re taking a long term view’, as opposed to what value the asset would achieve if it were sold today. “We didn’t hear much of that,” concurs McNelley, “But that is what the NAV should be telling you, so putting out one of those Covid updates was a way of controlling the narrative.”
While the crisis opened up a window of opportunity to improve, the rapid return of public company valuations quickly slammed it shut. “It went past so quickly and GPs got rid of the issue in one way,” says Saarinen. “It wasn’t really a test.”
Indeed, following the GFC it took almost seven years for the S&P 500 to return to its pre-crisis high. It took just 150 days this time, and ended 2020 16% higher than where it started. The swift rebound of both global credit and public equity markets pulled private asset prices up along with them.
“Covid has been one of those events that caused GPs to up their game and do things better, but it wasn’t quite the watershed moment for improved governance that it could have been. This is largely because it was surprisingly short lived,” says McNelley. “For those GPs who were behind their peer group by kicking the can down the road, by Q3 you had caught back up with the can. If this had been a deeper, longer market dislocation you wouldn’t have been able to keep kicking the can down the road. It caused some people to up their game, but not fully.”
Returning to the Buffet quote; in 2020, the tide didn’t go out all the way, and it came back in too quickly.
It’s not over yet
Despite the public markets’ rebound, we’re by no means out of the woods yet. The markets are being propped up by unfathomable amounts of government support, in the shape of quantitative easing, stimulus packages as well as company and individual level grants and funding. On top of that, private capital markets as well as valuation methodologies are still developing.
“I’ve been part of this industry since the beginning of fair value - prior to the Fair Value accounting standards (ASC820/IFRS13) when PE firms reported on a cost basis. We created this practice in the mid-2000s to support fair value; that was 15 years ago,” says McNelley. “And we’re about 15 years into a 30 year process of institutionalisation; not just of PE in general, but the valuation of private assets. Every year, a PE CFO will look at their peer group and want to keep up thereby elevating their standards. And every so often, news breaks about a GP doing something funny and it causes others to elevate their game even further.”
As well as keeping up with the Joneses, regulators play a major role in the industry’s advancement. And as it happens, the revised ISA 540 accounting standards will undoubtedly bring about a new level of focus and rigour when it comes to valuation practices. “PE firms are only now seeing this challenge from auditors, and they will continue to see more of this,” says Karen Allan, director at Haysmacintyre. “The expectation is that managers become more informed, and make more informed decisions, which they can justify to auditors and LPs.”
Allan points out it is simply happenstance that these things have come at the same time. “The combined regulatory and Covid impact has doubled the focus on valuations,” she says. “In the first year of these new rules there will be much more work; ground work on understanding the assumptions and where GPs can source data on key assumptions. And going through the process of valuations will bring up questions for audit firms and valuation advisors. Perhaps there will be more opportunities for external support as more expertise will be needed.”
The nature of value
One of the most obvious impacts of Covid across the investment landscape has been the intensification of ESG practices. And this focus has also spread to valuations. Valutico, the valuation software company, has recently set about investigating ESG valuations via its newly-launched platform ValutECO. Says Resch, “The ultimate goal is that in the future, when people think about the value of the company it’s not just the financial value, we want to introduce societal value.”
Value by nature will always be subjective; it is what someone is willing to pay, it is what that thing means to them. It is personal, it is emotional.
And that means approaches and attitudes towards valuation will always change. While the pandemic hasn’t brought about the levels of rigour and discipline some would have liked to have seen when it comes to valuation methodologies, it’s not over yet. Change is happening, but the shifts are so tectonic, so massive, they can’t be seen through even the widest of lenses. Change is coming on all fronts; societal, environmental, digital, and undoubtedly, economic. Covid is but one domino in an ever cascading chain of events.