November 4, 2013
Interviewed by: David Snow
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Your Valuation Methodology: Time to Upgrade?

Private equity valuations: when do you know it’s time to upgrade your methodology? Here’s one red flag: your exit valuations are consistently higher than the last valuation. Three experts share insights into a challenging but critical function.


Private equity valuations: when do you know it’s time to upgrade your methodology? Here’s one red flag: your exit valuations are consistently higher than the last valuation. Three experts share insights into a challenging but critical function.


Your Valuation Methodology: Time to Upgrade
Best Practices in PE Valuations

David Snow, Privcap:
We’re joined by Colin Sanderson of RSM, John Lambrech of W Capital Partners and Darren Friedman of StepStone Group. Gentlemen welcome to Privcap. Thanks for being here.

  All of you are valuation experts. Valuation is a surprising hot topic in private equity, well, it’s hot in general, b in private equity a lot of attention is paid to it. People need to value their portfolio companies every quarter. And their methods and approaches are sometimes not in, in lockstep from firm to firm as all of you know better than anyone else. So, fascinating topic. I’m interested in getting your take on one particular subtopic, which is how do you know when or what are some signs that might occur to a private equity firm that they need to improve or refine their valuation methodology? For example, and maybe we can throw the first question to John from W. Capital, is it ever the case that a private equity firm will sort of consistently have exit events at which at, you know, one valuation is locked in where the prior valuation of that company was nowhere near what the exit valuation was? And isn’t that a sign that perhaps they’re not robust enough process in place for marking to market?

John Lambrech, W Capital:
Sure, and I think as you just described that would be a good indication that maybe the firm needs to look at their valuation process. Speaking from my experience at W. Capital, now that the firm has been around for more than twelve years we’ve reached a point where we really have a critical mass if you will of exits -­‐ a number of companies. So over the past year we took a look at all the exits over time, what the value of the exit was, and we compared that not only to the mark one quarter prior to the exit but two quarters as well. And the reason we went back two quarters is you would hopefully think that one quarter before you, you should have some visibility. Cause these transactions don’t just creep up and happen, you know, you normally have some lead-­‐time where you can assess what the value is going to be. So we felt like going back a little bit further was maybe a better indication. And what we found not surprisingly was that there was

some variation, but one of the considerations I think you would need to use is first of all directionally. You don’t want to be predicting an upside exit and then have the company come down and disappoint or really vice versa. Because I think the end user wants to at least have a sense of what direction these valuations are going. I don’t think anybody expects folks to have a crystal ball or be perfect at reading the tea leaves, but direction is very important.

I think if you’re, you’re more than 25% is just a gut feel that I have. I’d be curious to hear what the other panel members think. If you’re consistently off by more than that, I think you may want to think about looking at some new methods, maybe sharpening the pencil a little bit, and maybe avail yourself of some help out there. But we fell within a range that we felt was comfortable. Are we perfect at it? No of course not, but I think on balance we feel pretty good about where we shook out.

Colin Sanderson, RSM:
I would say that each event is really unique, each exit event, however, as an auditor retrospective reviews of that exit value and as you would say the last two quarters when did information become available or more visibility about potential exits? And going back and, and trying to assess whether our models do reflect or, or the client’s model reflects real world scenarios -­‐ does it really consider or simulate market participants view? And generally you would expect there to be a doubter, I would agree that you know, if I had a, a situation where consistently we’re 30% under or 30% over you know, that would be of some concern. And certainly a red flag to do, to do more work over you know, is the models, the models are they really reflective of real world scenarios?

Snow: Darren from your vantage point at StepStone what have you see with regard to this?

Darren Friedman, StepStone:
Well the way I think about it is, level three asset valuations it’s really much more of an art than a science. If it was a science you wouldn’t, you wouldn’t have people competing in M&A auctions and paying different prices. I do agree that if we would consistently see among our own portfolio or among GPs that we invest with portfolios where they consistently had exits 30+% above or below their marks that’s a red flag. But I want to really reemphasize it needs to be consistent because on a one off basis, things happen and, and you may be higher valuations. I also want to highlight the point: private equity as an asset class is one where GPs try to exit at the most opportune time, that is what we pay

them to do and we try to do ourselves. You’re trying to exit whether it’s the right strategic or time in the market to maximize your valuation. Where from an accounting perspective and evaluation perspective most of the time you’re valuing it at essentially some type of average valuation, whether you’re using public comparable, average multiples, precedent transactions, a DCF, which it’s all what your discount rate is. But you’re really discounting at essentially an average rate for that industry, and private equity’s job is to try and sell above that average rate. So if you’re valuing at an average and you’re selling above average I would anticipate if you’re doing a good job on timing your exits, you will exit most often above that value. And then the debate is really around how much above does that signal: you should have done a better job on utilizing that valuation?

Snow: So why, why is it a problem if in fact a private equity firm is a little bit under ambitious in finding the most appropriate mark and the exits are consistently, perhaps, a bit of a surprise and above that acceptable delta? Why, why would that be a red flag or a concern?

Friedman: If it’s dramatically above, I think it’s just a red flag because as an investor you’re relying on the GP to get a general sense on where valuation is. I would anticipate always to be a little bit above based on my prior comment. There is no such word as conservative in the accounting profession. But there are many GPs that we have meetings with, particularly when they’re fundraising and talking about their marks and where they think they’re going to exit them. And then they’ll go back and show us their portfolio over five, ten years or longer, and every exit that they’ve had -­‐ what the exit valuation was and where it was marked the prior quarter, and they pride themselves that it’s higher.

Lambrech: I think that’s just part of you know, there are certain aspects there that transcend private equity and it just moves towards this notion of it’s always better to under promise and over deliver right? But I think Darren’s point is well taken that you want to have a sense of what the GP really thinks the company is worth. You have the models, which take real metrics and can spit out a number, but there is also the qualitative aspects that come from the GP that talks about the story about the company. Because those are very important, I was glad to hear Colin mention that you want to have the model somehow connected to reality. Because the models just in and of themselves you can take them with a grain of salt, but I think you need to have that story with it too. And GPs by and large of course they’re not going to want to sandbag and put in an artificially low number. But if given the opportunity, of course they’re going to want there to be some upside from the mark.

Friedman: I would also just make the point: it depends on who the investor is how much valuations matter. If as an individual if I’m a personal investor in private equity what I focus on is what cash did I put in and what cash did I get out of it? But for certain types of investors such as pension funds that valuation matters cause they’re looking at their assets -­‐ how much over or under funded is that plan? And the valuation of those assets do some into play, and that entity may have to make contributions, additional contributions based on the value of those assets. So whether it’s pension funds, certain endowments, it really does matter for them. So it really depends on which type of investor, how important this issue is at the end of the day.

Snow: So Colin what do GPs need to know about the requirements of their own investors such that they might take more seriously the need to create very robust valuation methodologies?

Sanderson: I think as Darren indicated that the type of investor in the fund may have very different views of how of the actual evaluations and the importance of that. Institutional investors certainly getting that NAV of the fund and having it on a basis that is you know, reasonable is, is very important. What I mean by that is: over the last two years the accounting guidance has allowed investors in alternative investments to simply take the net asset value from a practical expedient perspective as the fair value of the fund. They don’t have to do any further analysis as long as the fund is recording its assets and liabilities on a US gap basis. And so really accordingly, being consistently under the value is also just as much as Darren had indicated, you know, you don’t always want to err on the conservative side. You want to make sure that it reflects real world scenarios, and when we as auditors go back and look at this information, we really look at retrospectively how the models are simulating market participant’s view.

Snow: Final question, let’s say a firm decides that it does indeed need to improve or refine it’s valuation methodologies, what are some basic next steps that can be taken to do this and what have you seen out there?

Friedman: I’m happy to start on that I mean we’ve seen a lot of different things out there from firms, hiring experts, accounting firms or other valuation experts who they are essentially outsourcing as much as they can their quarterly valuation work. So they’re getting a third party to opine, so it takes biases on individuals out of the equation. Clearly the, the individuals at the GP have to provide all

the data to the valuation expert and work with them, and make sure that data gets transposed correctly to them. But they are making that valuation, and also I think from an LP’s perspective the GP can say look, “I have a third party expert who is doing the valuation. So if I sell companies for higher or I have to mark them down significantly it’s not something where I was trying to quote-­‐ unquote game the system.” We have a third party opining.

Snow: How about you, John?

Lambrech: I would add one additional step. I agree 100% with what Darren said, and I think that the logical step to improve the valuations is to seek out professionals who do this for a living and can bring something else to the table. But one interim step is to simply look at your outcomes, look at your models that provided the marks and say, what could I have done differently? Maybe I was relying too much on comps, too much on an option-­‐pricing model, too much on discounted cash loans.  And maybe I ought to rethink about how these exits typically get priced in the market. And there can be some learning and adjustments just done internally based on, on how the GP thinks of things and what sort of models they actually employ. Not suggesting that that’s always going be the solution but there may be some low hanging fruit there to adjust the model.

Sanderson: You know from an auditor’s perspective, auditors do love consistency. However, it’s very important that the GP does evaluate its models based on new information, based on potentially looking at those exits, having a process in place to evaluate them. What were the reasons here why the exit value differed so much from the, the essential carrying value leading up to that exit? And if we’re not using multiple models maybe we should. If we’re relying on too much of an averaging of the various methods should, should we maybe tweak that? And it’s fine from an auditor’s perspective to do that. Consistency is not the Holy Grail, it’s really the qualitative aspects and considerations that also go into this valuation as to -­‐ should I just rely on the one model? Should I be using a different rating? And considering that over time, and as long as that’s, the reasons for that are plausible, I think that’s much better than just being static and being consistently following a method up to you know, its fault at the end of the day.

Snow: And just very briefly is there ever cultural resistance to improving valuation methodologies where perhaps a founding partner says look that’s not the way that I’m used to doing things and therefore

I would prefer to have the conservative approach that we’ve always used? Or is that old news now -­‐ the fair value is here to stay and those who would prefer it wasn’t here simply don’t have as much of a voice anymore?

Lambrech: I do have one other thing to the discussion here, and I think it’s important, at least from W Capital standpoint. We primarily play in syndicated deals. So on any given growth equity company, there are going to be three to five institutional investors around the table. You always hope that there is perfect alignment amongst those three to five investors. But we now in the real world, that’s not always the case. It doesn’t mean that their views of the company are mutually exclusive. That’s not the case, but different investors come in at different times, different investors have slightly different expectations. Different investors underwrite to different durations and multiples, now they’re all going tp probably be in the same ballpark right. But on the margins you know, an acceptable outcome from one GP may be very different than an acceptable outcome for another GP in a syndicate. And then you come into the notion of control, well who is gonna push the outcome here. And if it’s a case where there is three or four investors and management has a big piece it’s not always clear who is going to control that exit. It’s much different in a controlled buyout situation where you have one sponsor who is really leading the deal. But I thought it was important to mention that because I think it’s a very real dynamic in the real world that does play into valuations and timings of exits, and ultimately the value that you get out of companies.

Expert Q&A with Colin Sanderson of RSM

What is unique in the way that RSM works with private equity funds?

Sanderson: RSM is the fifth largest accounting firm in the United States and has significant global capabilities. We work with 1,200 private equity funds globally. We are able to serve private equity funds from an order tax, as well as consulting perspective, both at the fund and at the portfolio level, as well as over the life-­‐cycle of the fund.

What services does RSM offer private-­‐equity firms through the investment life-­‐cycle?

Sanderson: Our financial services groups work with firms in terms of structuring their fund, from a tax perspective as well as working with their counsel.

Also, we’re able to serve the fund, post the deal, and form an assurance tax, as well as consulting perspective, whether that be merger integration, or they’re looking at technology process improvements at that company.

Our 90 offices allow us to work with private-­‐equity funds in any geographic location to mobilize a team quickly, to that location or from that location, to serve them.

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