The Evolving Private Assets Valuation Landscape
The Importance of Investors
Investors have been a fundamental force in the evolution of industry practices related to fair value and fair value reporting. Fair value reporting has allowed investors to make like-for-like comparisons with the liquid portion of their portfolio, to make allocation investments decisions and remuneration decisions amongst other elements. And in this context, there are three key areas to consider: firstly, the level of rigour that goes into a valuation analysis in the context of private and illiquid investments has evolved substantially over the years; second, there has been a continued and increasing focus on ensuring an appropriate level of independence in the valuation process; and lastly, the timing and frequency of valuations have shifted and, in some cases, the shift has been dramatic.
It wasn’t long ago that it was considered standard practice for managers to be biased toward a ‘cost’ as a ‘default’ valuation, and the valuations used were largely simplistic usually relying on a single methodology to value their investments or portfolio companies. For example, considering a multiple of EBITDA or in the context of valuing private credit instruments, there was a time when it was common to simply hold investments at par so long as the instrument was covered from an enterprise value or asset value perspective. But over time, it is evident that valuations and the underlying methodologies and support around them have become increasingly more robust. As a result, it is now considered best practice to weigh and apply multiple methodologies and look to reconcile those methodologies to triangulate to an ultimate conclusion of fair value. In short, the methodologies implemented should be appropriate for the asset being valued and should be calibrated, wherever possible, from recent trades/transactions involving the asset.
On timing and frequency, the evolution of the private asset landscape is evident. Broadly, there are three timing and frequency considerations for fund managers for their private and illiquid investment portfolios, i.e., timing and frequency of 1) financial and investor reporting, 2) internal valuations and 3) external / independent valuations. There was a time when it was typical for private and illiquid portfolios to be revalued, maybe once annually or semi-annually, unless the fund manager had a public filing requirement. Today, that standard has primarily shifted to a quarterly cadence. However, in preparing the NAV reports, there is no flexibility; at each period, the fund managers are obliged to present the fair value of their portfolios, irrespective of their timing and frequency choices. As such, we have also seen a shift forward to a point where many quarterly assignments are submitted well in advance of the quarter-end deadline. This shift has led to more timely reporting to the investor base on the backend, who have their own reporting requirements they need to fulfil for their beneficiaries. Each of these trends has undoubtedly helped to improve the overall quality and maybe the usefulness of the reporting that investors typically receive both during that initial due diligence phase and thereafter during ongoing portfolio monitoring.
When it comes to independence in the valuation process, we have witnessed a significant uptick in client interest due to pressure from Limited Partners (LP) for independent valuations. The frequency and timing of independent valuations is very much a commercial decision agreed upon between the fund managers and LPs.
Changes and Challenges in the Private Asset Valuation Landscape
As Valuation Advisers, we are now called upon to go into a tremendous amount of detail as people increasingly want to know how we are looking at investments and exactly how we reached the valuation we are putting forward. This is partly due to the IPEV and AIMA Guidelines, which have positively contributed to industry standards by outlining just how much data-driven examination is required for valuation analysis.
This is not to say that limited partners (LPs) have not always had an expectation of rigour, they have; rather, it’s that the expectation has increased over time.
A second area that continues to present challenges and is something we are observing throughout the COVID-19 pandemic, is the asymmetry in investor/financial reporting between underlying portfolio companies. We see this in particular in geographically diverse portfolios where the underlying portfolio companies may appear to have different reporting requirements across the varying jurisdictions. In some cases, there may be a more significant lag in terms of when financials are actually delivered which are then compared against the measurement date. However, even beyond the trailing financials, the lack of forward-looking financial information can present another challenge. This is another trend we are observing during the COVID-19 pandemic. In fact, going back to Q1 of last year as we were facing the onset of COVID-19 in Europe, this issue was thrown into high relief as there were numerous portfolio companies where the financial forecasts quite simply were just no longer valid or reliable. This was often in sectors that were facing some of the greatest levels of impact from COVID-19, given the magnitude of impact on these businesses as a result of restrictions brought about by the pandemic.
These are real challenges, but despite differences in the level of information available for a given portfolio company, at the end of the day, the requirement is the same. We need to estimate the fair value, based on the information provided at the measurement date. And often, this is where there is an inherent level of subjectivity and professional judgment that is required to update the valuation. In some instances, the only option for the valuers is to do their best with the limited information sets available. Additional criteria could consist of analysing the performance of the selected guideline public companies to infer the general market movements, and further qualitative assessments of the subject company’s performance relative to expectations to adjust valuations. Again however, professional judgment is required.
Another emerging challenge commanding more and more attention is the question of how to leverage technology to design and execute a more efficient, more effective valuation process. This includes understanding whether that is from the way that data is exchanged, to workflow management, to looking to automate certain aspects of the valuation itself. These are all intricate feats to accomplish just given the nature of private investments. Despite the challenges, technology certainly will be a key focus area going forward in our industry. While technology advancements will continue to pave the way for efficient and economically effective valuation processes, the fund board will have to continue making the ultimate and final judgment on the value conclusion, as they cannot delegate their fiduciary responsibilities for valuation to an external party or quantitative models.
Finally, as the Alternative Investment Fund Managers or ‘ManCo’ model continues to gain momentum locally in Ireland, it is perhaps still too soon to tell how the Central Bank of Ireland will approach the subject of valuation governance for Irish funds. But the importance of valuing assets correctly should not be underestimated. If an AIFM cannot demonstrate to all stakeholders that they have undertaken appropriate steps to value an asset, they could potentially be exposed to significant liability. Irrespective of the regulators’ approaches towards ManCo’s, AIFMs must ensure that they undertake thorough initial and on-going operational due diligence on external valuers as the reputational and financial risk of getting this wrong could be severe.
Niall Cribben, Valuation Advisory Services at Duff & Phelps, A Kroll Business