The recent upheaval in the private and public markets caused by the COVID-19 pandemic has created uncertainty for companies and investment funds alike. Investment advisors struggle to forecast the duration and severity of the impact caused by the quarantine and the related government mandated shutdowns on the fair values of their portfolio company investments.
Calibration may be the right tool in the arsenal to address the issue at hand. Considering most market transactions are based on some sort of Trailing Twelve Month (TTM) or Last Twelve Month (LTM) financial data, investment advisors can update their initial models using the latest financial information to develop a defined starting point for their valuations. Additional considerations and adjustments may be necessary to account for specific risks and uncertainties identified at the portfolio company level.
This article will explain what calibration is, how it works and how to apply it to the valuations of your debt and equity investments.
What is Calibration and How Does it Work?
The AICPA issued the Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (Valuation Guide) to help investment companies, auditors and valuation specialists align expectations and provide best practices for valuation approaches, methodologies and procedures for financial reporting purposes.
Since its release, one of the key points of convergence for auditors and valuation specialists has been the adoption and integration of Calibration (Chapter 10 of the Valuation Guide) in the valuation processes and procedures of their clients with hard-to-value investments.
When a Private Equity or Venture Capital Fund enters into a transaction, as part of its due diligence, it identifies key performance indicators (KPIs) and financial metrics as a basis for the transaction price at the transaction date. Relevant market data is also incorporated to capture industry trends and market conditions that existed at the transaction date.
Calibration is the process of adjusting the relevant KPIs, financial metrics and market data originally identified at the time of the transaction to the current valuation date to determine what the transaction price would be, if the transaction were to happen today (i.e., determine the exit price or fair market value).
Calibration promotes consistency in the valuation techniques and assumptions used by the investment companies and anchors them to a market data point used at the time of the transaction thereby promoting more transparency and insight for the investment company in their valuation process.
FASB Accounting Standards Codiﬁcation (ASC) 820-10-35-24C states the following:
"If the transaction price is fair value at initial recognition and a valuation technique that uses unobservable inputs will be used to measure fair value in subsequent periods, the valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price. Calibration ensures that the valuation technique reﬂects current market conditions, and it helps a reporting entity to determine whether an adjustment to the valuation technique is necessary (for example, there might be a characteristic of the asset or liability that is not captured by the valuation technique). After initial recognition, when measuring fair value using a valuation technique or techniques that use unobservable inputs, a reporting entity shall ensure that those valuation techniques reﬂect observable market data (for example, the price for a similar asset or liability) at the measurement date."
Applying Calibration in Valuing a Debt Investment using an Income Approach
When valuing a debt investment, the most common valuation technique used is the discounted cash ﬂow (DCF) analysis approach. This approach estimates the most likely or expected cash ﬂows for the debt instrument (including any expected prepayments, if prepayment is required upon a liquidity event) and then discounting them at a market yield (the yield a market participant would expect for an instrument with similar duration and risk). This valuation technique is referred to as the yield method.
The market yield for debt as of the subsequent measurement date can be measured relative to the issuance date yield by observing and calibrating for the following:
- The change in credit quality of the company, if any
- The change in credit spreads for comparable debt instruments, considering the characteristics of the debt compared to comparable traded debt, including the seniority, strength of the covenants, company performance, quality of the assets securing the debt, maturity and any other diﬀerences that drive debt value
- For ﬁxed-rate debt, the change in the referenced rate matching the remaining maturity of the debt (e.g., the change in the London Interbank Oﬀered Rate [LIBOR], swap rate or treasury rate, etc.)
For example, take a debt instrument that was issued with its original rate based on the Prime Rate + 200 Basis Points (bps), and a 5-year maturity. To calibrate this investment, assuming nothing changed within the issuer, you would look at the credit rating that corresponds with a 200 bps spread and see what the movement is for the market yield, as of the valuation date. If that 200 bps spread corresponds with a BB+ rating at issuance, and the credit spread for debts rated BB+ has increased from 200 bps to 600 bps, then the estimated market yield as of the valuation date would be Prime Rate + 600 bps. The DCF model would be adjusted for that new market yield to determine the fair value of the debt as of the valuation date.
Applying Calibration in Valuing an Equity Investment using a Market Approach
In valuing an equity investment in a private company, one approach is to estimate the overall enterprise value using a multiple of EBITDA, revenues or other ﬁnancial metrics, and then subtract the value of net debt. These multiples are selected based on comparable public data or transaction data and, therefore, this valuation technique is a form of the market approach, commonly known as the comparable company method.
For example, suppose that a company is acquired for $150 million, with $100 million in equity and $50 million in debt. The company is expected to outperform the public guideline companies in the same industry. The transaction price implies a 10x EBITDA multiple, while the guideline company multiple is 8x EBITDA (roughly 25% greater than the public multiple). The difference between the implied paid multiple and the guideline comparable company multiple is due to the expected performance of the subject company. It typically would not be appropriate to ignore the multiple implied by the transaction in the next measurement period by simply using only the implied guideline company EBITDA multiple. Instead, in subsequent measurement dates, the valuation would be adjusted for the subject company’s growth and changes in the observable market data.
Continuing with the example, in the subsequent measurement date to the transaction, assume that the subject company is performing as expected and its EBITDA has improved by 10%, additionally, the median public guideline comparable company multiple has improved from 8x to 9x. After considering the subject company’s performance, you would adjust the comparable company multiple up by the 25% performance premium and then adjust it slightly down by a percentage determined appropriate to capture the subject company’s growth from the transaction date to the valuation date and the decrease in its forecast to outperform the guideline comparable companies. This is to take into account that while the subject company is still expected to outperform the guideline comparable companies, it is not going to be to the same extent as at the time of the transaction. Assuming it is determined that a 10% adjustment down is appropriate, the final EBITDA multiple used would be 10.125x, resulting in an enterprise valuation of approximately $167 million.
Calibration aligns the judgments, inputs and assumptions as of the valuation date to those at the transaction date and minimizes the use of subjective inputs. The process of calibration involves identifying the quantitative and qualitative changes within the specific KPIs, financial metrics and market conditions driving the changes in the valuation as of the measurement date. Investment companies are encouraged to proactively review and update their policies and procedures to incorporate the use of calibration in their valuation practices.
For more information on which valuation methods are appropriate for you, Weaver can help. We are available to support your transaction needs along with any tax, audit or advisory guidance for your funds and business.