April 3, 2016
Interviewed by: David Snow
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The Use of ‘Calibration’ in Valuations

Kevin Vannucci of RSM US LLP and Max Wolff of Manhattan Venture Partners explain the concept of “calibration” and its growing importance in PE and VC valuations.

Kevin Vannucci of RSM US LLP and Max Wolff of Manhattan Venture Partners explain the concept of “calibration” and its growing importance in PE and VC valuations.

The Use of “Calibration” in Valuations
Valuation Trends in Private Equity

David Snow, Privcap: Today, we’re joined by Kevin Vannucci of RSM, Richard Brekka of Second Alpha Partners and Max Wolff of Manhattan Venture Partners. Gentlemen, welcome to Privcap. Thanks for being here.

Respondents: Thank you.
Snow: Today, we’re talking about a really hot topic: valuations in private equity in venture capital. More and more, there’s a buzzword that’s creeping into this conversation, which is calibration. Kevin, what is calibration and what do managers need to understand about the term?

Kevin Vannucci, RSM US LLP: Calibration, for instance, if you’re using a general public company method—that’s the easiest method to talk about around calibration, but you would also do it under a discounted cash-flow method. For instance, if you bought a company at eight times EBITDA at acquisition and, at that time, you should identify the comparable public companies—say there’s five or six—you look at their unadjusted multiple—say it’s 10 times. Therefore, you have an eight to 10 ratio or 80% calibration ratio. At that time, you should also look at the gross size of risk of those public companies versus your company.

All things being equal, at the next measurement date, you would do the same exact thing.

When you look at that, it takes a lot of things out of the picture, [such as]… whether you are going to use just an unadjusted multiple or… a 20% haircut, which we see a lot of firms do off an adjusted multiple. It actually benchmarks it at date of measurement, date of acquisition. Then, at each subsequent date, you should be doing the same thing.

That’s going to help your audit firm and your investors get a lot more comfortable that you’re actually looking at the true fair value and at the specific market participants because, unless it was a bargain purchase at date of acquisition, that’s what the market priced it at. That also takes away the whole concept of discounts for lack of marketability, if you hold a minority interest versus a controlled position.

If you bought a minority interest at an eight times multiple, that imbedded minority interest discount—if there is such a thing for private equity—is in that multiple. So, it takes away another level of subjectivity and that’s why calibration is so important.

Richard Brekka, Second Alpha Partners: What do you do if you have a premium? Instead of buying at eight times, you bought it at 12?

Vannucci: That can be a case and, again, you could have a premium. So, you would obviously document that and your… valuation policy should address it, but if you bought a company that the expected growth is going to be much greater than the comps sets you’re comparing it to—

Obviously, if the expected growth is so much greater, one would think the risk is greater as well, but you would just track the same thing.

Richard: In a way, it’s in replacement of liquidity discounts, which have been somewhat subjective. You’re trying to create a more objective approach.

Vannucci: Yeah, it’s definitely a way to replace discounts—liquidity discounts or whatever you want to call them. It’s really hard. I mean, how do you support it? Do you use studies out there to support it? Is there even such a thing as discounts within the private equity world? Because, honestly, if you look at the unit of a comp and when you buy a position, normally everyone is going to hold that position until the entire company is sold.

Snow: Max, as someone who spends a lot of time with early-stage companies, what are the challenges of trying to apply that consistent calibration to early-stage companies that have a constantly evolving story for each of them?

Max Wolff, Manhattan Venture Partners: The big one is obviously a pivot. It’s not infrequent to see a pivot, which is a really fundamental shift in business focus in an earlier-stage or even a mid-stage venture capital firm. And that inherently changes the entire comps set. So, if you started out as a social media company and you’re now an ad-tech company, there’s no recalibration I can do. I’ve got to cut down the old forest and find a new grove to compare you to. That is a unique challenge.

The other unique challenge we might get, to some extent, is the valuation comps move around quite a bit because, generally, if there are public comps where there’s much more price discovery, they’re recent public comps and they may trade in a wildly enormous range.

Snow: Kevin, do you predict that, for those people engaged in coming up with valuation for private equity and venture-capital portfolio companies, the term “calibration” will become more and more known? What regulatory trends or pressures are making that term become more well-known?

Vannucci: Yeah, I would definitely say, without a doubt, David—it is out there and very well-known. I know the [AECG] is putting out a guide for PE that I wrote the valuation section for and it talks about calibration, so that’s out there. It’s already imbedded in ASCA 20 and it’s there. People just haven’t been focused on it. And when the taskforce [inaudible] pay issues their taskforce around mark to market and PE marks in late-2017, calibration will be discussed there. It is more and more out there and it should be thought of.

Wolff: I would definitely agree with that and I think part of the reason is there’s been a bit of a power shift that seems to be ongoing. So, there was a bit more of a hubris and carte blanche from managers at different points historically. Managers are under a lot of pressure and managers need to court the desires of LPs—particularly large institutional LPs—and they heavily tend to support a documented, discoverable series of processes and benchmarks so they can benchmark you against other managers in their constellation of wealth-management schemes.

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