In addition to developing a strong valuation policy, market pressures require investment funds to continually reassess their valuation process. To do this, fund managers should consider implementing a process of “backtesting,” also known as a retrospective review, to analyze the qualitative factors used in valuing an investment and to identify the primary drivers of the differences between a fund’s valuation of an investment and the subsequent sale price.
While differences between these two values do not necessarily indicate a flawed valuation process, understanding the reasons behind the differences can provide insight into how a fund’s valuation policy is working and where fund managers should make improvements.
The Backtesting Process
The AICPA’s Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies provides guidance in this area and outlines three steps in the analysis:
- Determine what information and factors were known or knowable when management valued the investment.
- Assess how the valuation process considered these factors.
- Identify any factors relevant to the sale price that the valuation process did not consider.
The third step is central to the backtesting process. To help in this step, the Valuation Guide provides these questions for fund managers to consider:
- What facts and circumstances that buyers used in estimating a sale price changed between the fund’s valuation date and the sale of the investment? Were these facts and circumstances known or knowable on the valuation date? What do those changes in facts and circumstances suggest regarding the fund’s valuation process?
- What other metrics or additional facts might the buyer have considered in estimating the sale price that the fund might not have considered in the valuation process?
- Was the buyer included in the universe of market participants used during the valuation? If not, why not?
- Are the implied assumptions in the sale price reasonable when compared to the assumptions used in the valuation?
- What other factors that occurred between the valuation date and the sale date could have affected the value of the investment?
How Funds Can Apply this Process
A number of factors could lead to differences between the fund’s valuation and the sale price, including differences in the portfolio company’s position, the outlook for its business or the external market. The following examples show how funds can use the backtesting process to consider these factors and assess the effectiveness of their valuation process.
Example 1: Investment sold at a discount within six months of valuation:
Fund A valued its investment in Company A at the median LTM EBITDA multiple of 7.5x. Six months later, it sold the investment to Fund B at a multiple of 6.5x.
In considering the factors that might have contributed to the difference between the valuation and the sale price, Fund A’s management noted that there were significant changes in market conditions as a result of the COVID-19 pandemic.
Fund A’s management determined that changes to its valuation process were not needed because the impending COVID-19 pandemic was not known or knowable to Fund A when it valued Company A.
Example 2: Investment sold at a premium within six months of valuation:
Fund A valued its investment in Company A at the median LTM EBITDA multiple of 7.5x. Six months later, it sold the investment to Fund B at a multiple of 8x (Valuation Guide, Example 11.24).
In considering the factors that might have contributed to the difference between the valuation and the sale price, Fund A’s management noted that there were no significant changes in market conditions and Fund A included Fund B in the universe of market participants.
During negotiations, Fund A learned that Fund B, which owned Company B, was willing to pay a premium for Company A because Fund B’s management believed there would be synergies in combining Company A and Company B. Further, Fund B’s management believed Company A’s CEO had the requisite skillset to lead the consolidated company.
These assumptions contributed to Fund B’s willingness to pay a premium to the valuations indicated by the EBITDA multiple of comparable companies. Fund A’s management determined that changes to its valuation process were not needed because Fund B’s assumptions were not known or knowable to Fund A when it valued Company A.
Example 3: Investment sold at a premium within a month of valuation:
The same circumstances mentioned in Example 1 apply except that Fund A began negotiations for the sale of Company A to Fund B before its valuation process was finalized. It completed the sale within a month of valuation.
Fund A’s management identified Fund B’s perception of the value of combining Company A and Company B as the key factor in the difference between Fund A’s value and the sale price. Management also determined that the deal team knew that Fund B believed there were synergies in combining the companies but did not incorporate that information into the valuation.
Fund A’s management concluded that any known assumptions related to a market participant’s perception of value and any ongoing sale negotiations should be incorporated into the valuation process. Fund A’s management will be able to improve its valuation process by ensuring that any indications of value known by the deal team are incorporated into the valuation. Citing conservatism as a key consideration, fund managers are often hesitant to adjust valuations, even when there are indications of value known by the deal team, unless there is a letter of intent (LOI) in place. Fund managers should be aware that this practice could lead investors to question the effectiveness of their valuation policy.
Example 4: Investment sold at a premium to valuation discounted by sale execution risk:
Fund A valued its investment in Company A at $20 million. A month later, Fund A sold Company A to Fund B for $25 million.
Fund A’s management noted during the valuation that Fund A had a letter of intent from Fund B to purchase Company A for $25 million. However, Fund A applied a 20% discount to its valuation, representing the execution risk of the sale.
With the benefit of hindsight, Fund A’s management determined that this discount was not appropriate given how far the sale had progressed. In the future, Fund A management will be able to improve its valuation process by ensuring the size of discounts related to execution risks are adjusted as the sale process progresses.
How Weaver Can Help
We understand valuation policies and their role in providing comfort and transparency to regulators and investors. Weaver’s experienced team members can advise fund managers on ways to incorporate backtesting into their valuation policy in order to gain insight into how a fund’s valuation policy is working and where fund managers should make improvements. If you have questions, please contact us.
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