March 20, 2016
Interviewed by: David Snow
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How Detailed Should Your Valuation Policy Be?

SEC registration for private equity firms in the U.Shas meant a greater focus on valuation policies. But how much detail is enough? Three valuations experts share their various approaches to forming and following valuation policies, and discuss the trends that are making the topic of valuations more urgent and challenging than ever.

SEC registration for private equity firms in the U.Shas meant a greater focus on valuation policies. But how much detail is enough? Three valuations experts share their various approaches to forming and following valuation policies, and discuss the trends that are making the topic of valuations more urgent and challenging than ever.

How Detailed Should Your Valuation Policy Be?
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.

Unison: Thank you. Thanks for having us.

Snow: We’re talking about a hot topic, about which all of you are experts. It is valuations in private equity and venture capital. Let’s start with a bit of background from you, Kevin: talk about what’s changed…in recent years in the market that has led to a need for a need for much more robust valuation policies at private equity firms.

Kevin Vannucci, RSM: If you have over $150 million in assets under management, you have to register, which then you’re subject to scrutiny by the SEC. And one of the first things the SEC will do when they come in is…look at and ask for your valuation policy and go through that process to make sure you’re adhering to your own policy.

There’s not a lot out there about the valuation policy and what is the ideal valuation policy. Is it to keep it very slim in nature so there’s not a lot of description or should it be very robust?

Snow: Rich, as someone who invests and interacts with many other investors, have you seen a range of different ways that people present their valuation policies from not very robust to extremely intricate?

Richard Brekka, Second Alpha Partners: We formed Second Alpha Partners three years ago to do secondary direct purchases. We bought a whole portfolio in the first year. When we did our first annual audit and valuation, we had to come up and basically create our valuation policy, which we took the approach that we’re going to be very diligent in that we do effectively what a 409A valuation would do.

We looked at the three different models of value from an income approach, which is a discounted cash flow, market comparables, based on both the publicly traded comparable companies as well as any M&A events that might occur. Then, we also looked at financing events with the portfolio companies to be able to identify them.

Then, it’s a judgment call as to how to weigh them as to which is the most effective way to value it. We’ve always tried to take the approach of having our values being a lagging indicator of the ultimate value of the business so that the valuations are always a little bit on the conservative side.

Vannucci: Rich, do you have in your valuation policy, is it documented and detailed that it talks about all three methods? Is what you do for each of the methods or does it refer to the methods in general and not get to that level or detail?

Brekka: We do very detailed. Each portfolio company has a full report on it. It’s probably a 20-page report, looking at all the different methodologies, describing why we chose which methodology we’re using for that particular company and coming up with a full valuation with that. So, when we get done, we have 15 portfolio companies. There will be reports on each one in tremendous detail.

Vannucci: Max, the same question I asked Rich—in your valuation policy, does it describe how your analysts should go about selecting the comps? Does it go to that level of detail or not?

Max Wolff, Manhattan Venture Partners: It’s more of an arc estimate than a point estimate, so we will pick at least three public and at least three private comps whenever possible.

Vannucci: And it says that in your valuation?

Wolff: Yes, but it won’t say which ones.

Vannucci: Right. It won’t say which ones, but it will say a minimum, if possible—select three comps, three publicly traded, as part of the process.

Wolff: Right. Or more. Then, if we can’t get pure plays, we’ll try to increase it back into it.

Brekka: Do most of these companies have 409A valuations done for the stock options?

Wolff: Yes. I mean, unless they’re very early stage, we’d have that.

Brekka: There’s a great basis for doing your valuation because the 409A valuation will include comparable analysis. Regardless of whether you think it’s right or accurate, it gives you a basis for which to come up with one data point and then it’s a question of how much you weight it.

Wolff: Absolutely, so you get whatever solid you can grab onto. The other issue we have a bit lately, which I think may not be an all-the-time issue, but it certainly a big issue now is that I think some of these 409As are going to have to reset with down rounds and that’s going to make this really messy for the next 18 months.

Vannucci: Obviously, as an audit firm, we like it to be the more robust, the better and the more transparent, the better. I think we’re also seeing limited partners want that valuation policy. If they’re going to invest in your company, they’re going to ask to see that valuation policy because limited partners are out in the forefront of trying to understand how you’re marking to market because, obviously, they have their money to allocate and they look at asset allocations. That’s why fair value is so important to limited partners because of that asset allocation.

Brekka: We actually took the approach of being very robust. It does a couple of things: it saves us a lot of time later on when we’re doing the audit and it saves us money at the end of the day because the less time we have to spend with our auditors, the less they get to charge. So, it works very well there.

Wolff: I think part of what’s happened in the valuation space is that there are a lot of outside forces pushing on a valuation that historically weren’t there. There are a lot of newspaper articles and there’s a lot of active trading in the secondary market and that puts a lot of pressure. It floods you with data points, many of which are bad. So, you end up having to sift through a lot more data.

The good news is more data, but you sift through a lot of what are misdirects. So, we need to have a pretty robust strategy because we need to defend why we’re not necessarily pushing toward the latest news story or the most recent quoted or not publicly quoted prices in the secondary trade. That’s really changed our space—the venture space—a lot in the last few years.

Vannucci: Max, as you talked about that, does your actual valuation policy get to address that? Obviously, you’re going to look at the way those news articles, what’s going on at measurement date because that is about fair value. Does the valuation policy go into that depth or is it just, in general, that’s what your team does because that’s what we do in valuations?

Wolff: Yes, we try to avoid valuing based on recent press coverage for a lot of reasons, or rumors about the secondary market, as a general rule. We do mention that.

Vannucci: In the policy, you mention that?

Wolff: In the policy, you mention that. Our issue is a bit different, right? The truth is, in the last 18 months particularly, a game has emerged in venture, which is the guy writing the absurdly large check gets to pick their own structure and the person getting the big check gets to make up their own valuation. This means that a lot of the formal registered filed information is somewhere between not completely accurate and actively meaningless. So, it’s become quite difficult.

That’s part of the reason we’ve been really worried about that arc, because we have the arc, but backed off from the pinpoint stuff because the pinpoint stuff is very hard to generalize in this space, particularly because venture is hopelessly broad anyway. You have wearable devices and medical technologies and financial technologies and social-media strategies and there’s an awful lot in there, sharing the same umbrella.

Snow: For a GP from either a VC firm or a private equity firm watching this who thinks, “Maybe I need to spend the investment of time and energy to improve or to create a valuation policy,” how hard is it? How much thought needs to go into it? Can’t you just take an off-the-shelf standardized policy from another firm and it’s good enough?

Vannucci: First of all, there’s not a lot out there. If you do a little valuation policy, you’re not going to get a lot of hits. That’s why I think this is a great topic because there’s not a lot out there. I don’t think there is a standard off the shelf, here’s your starting point policy out there. I think you could potentially talk to your audit firm, potentially engage with a third-party evaluation firm, to help you with the valuation policy.

Snow: Kevin, a follow-up question for you. If you’ve got two clients and they’re both middle-market buyout firms, why wouldn’t their valuation policies be roughly similar?

Vannucci: David, I think it goes back to the point about what they want in there. Do they want that very detailed? It depends on the individual that’s leading that drive on the valuation committee or the audit committee. Some people are very detail-focused that they want every single point in the valuation policy, which could bring exposure to them. And some people want it more generic so they, in theory, don’t have that exposure.

But if it’s so generic, they’re going to be exposed to it as well because potentially, if it’s so generic, you could be marking one investment a certain way and another investment in the same fund a completely different way.

Snow: So, the culture of the firm very much influences these valuation policies.

Vannucci: I think without a doubt. I mean, Rich and Max—if you would develop your valuation policy and compare it to Richard’s, it is probably different based on how each person thinks.

Brekka: We did our valuation policy in conjunction with our auditors, so we actually worked with them to develop what the valuation policy should be.

Wolff: For us, we’re really trying to figure out an approach more than just a policy. Obviously, we need a policy, but more important to us, it’s an approach and, for us, there’s no real clear line between the approach to valuation and the investment thesis. They have to shake hands otherwise you’re just doing something to check a box, which is otherwise existentially important for us.

Vannucci: I think Max hit on a very good point there. The valuation policy has to be based upon the type of investments you hold, right? It can’t be a cookie-cutter approach. It has to be based upon the type of positions the fund holds and it can’t be static. It has to change over time, as the fund changes over time. The worst thing you can do is put a valuation policy in place and not revisit it. I guess the bigger evil would be to have a valuation policy in place and not follow it. But both of those are two evils that you want to stay away from.

Expert Q&A

Vannucci: RSM serves 1,300 private equity and VC relationships across the country. So the private equity space is what we do very well, whether it’s assurance, tax or consulting. We have over 100 people nationally doing valuations on a full-time basis.

Chris LaDue, RSM: In Boston, we have a team of eight people who essentially, being in the Boston market, specialize in what I call “under the technology umbrella.” We spend about one-third of our time valuing technology-related companies: software, hardware, electronics, to some extent. Then, another third is roughly life-sciences companies: biotech, traditional pharma and medical devices.

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