Article

Navigating portfolio valuation in the current climate

Accurately assessing the point-in-time value of investments and reporting on the development of portfolio value over time are central disciplines in the good governance of fund management.

Published: 15 June 2006

Share

Written by:

Jim Davies

Partner

Financial Advisory London

For fund managers, the robust valuation of investee companies is a pre-requisite, impacting stakeholders’ assessment of fund performance, influencing entry and exit decisions, and playing a crucial part in accurate financial reporting. The absence of procedures and controls around valuation can lead to misstatement of portfolio value, which in turn may have a detrimental impact on the decision-making processes of both investment managers and investors. Furthermore, stringent governance procedures are high on the list of qualities that investors demand, so a robust and credible valuation function is not only crucial to a fund meeting its regulatory, audit and governance expectations, but also to maintaining and attracting investment.

The valuation of portfolio investments has come a long way since the early days of entry and exit prices with the development of fair value accounting standards, the emergence of guidance such as the Internal Private Equity and Venture Capital Valuation (IPEV) Guidelines, and regulatory intervention such as the Alternative Investment Fund Management Directive (AIFMD).

Valuing illiquid assets during a recovery market is significantly more complex than during a stable market as pricing metrics and benchmarks are highly volatile and recovery pathways so varied. Jim DaviesCorporate Finance

Nonetheless, the valuation of alternative and illiquid investments remains challenging, highly subjective and a key focus area for auditors. The depth of challenge, degree of subjectivity, and extent of audit scrutiny have all been exacerbated in recent quarters due to the impact of the global pandemic and a myriad of economic challenges.

Valuation in a volatile or recovery market is substantially more complex than valuation in a stable market and it is increasingly more critical that periodic reporting on the value of fund investments is fit for purpose, up-to-date and in line with best practice.

Independance

Perhaps the most important consideration when establishing or reviewing a fund’s valuation function is independence. Across Europe, the AIFMD requires that an Alternative Investment Fund Manager (AIFM) has appropriate and consistent procedures so that a proper and independent valuation of the investments can be performed.

The directive states that the valuation function can be performed either by an external valuer which is independent from the AIFM, or the authorised AIFM itself provided that the valuation task is functionally independent from portfolio management and remuneration policy; and that other measures are in place to ensure that conflicts of interest are mitigated and undue influence upon the employees is prevented*1.

It also says that “where the valuation function is not carried out by an external valuer, the home regulator may require the authorised AIFM to have its valuation procedures and/or valuations verified by an external valuer”.

Similarly, the IPEV Valuation Guidelines emphasise, as best practice, the use of external advisers and/or independent internal valuation committees to review valuation methodologies, significant inputs, and fair value estimates for reasonableness*2.

Evolving economic conditions

COVID-19 has been a global public health crisis for several quarters, leading to an extended period of economic volatility, operational challenge and disruption to established business models. All sectors have been impacted in different ways and companies within sectors have been impacted differently in terms of operational and financial performance, and the profile of recovery.

Recent months have also been characterised by a myriad of economic challenges ranging from supply chain and energy price issues to changing consumption patterns and inflation.

This brings significant challenges to assessing the value of illiquid investments such as privately held companies, and a greater degree of complexity to the determination, review and audit of the carrying value of portfolio investments.

Every investment will need extra analysis…strong valuation processes should continue to be followed. International Private Equity and Venture Capital Valuation Guidelines

Even in dislocated markets, fair value remains the most relevant and reliable information for Limited Partners (“LPs”). However, such volatility naturally decreases the shelf-life of valuations, leading to more frequent assessment of value being demanded.

Portfolio investment valuation is no longer just a year-end concern but is increasingly being considered through full quarterly valuation cycles to ensure investors in alternative assets are provided with timely valuations that reflect current economic conditions. Some private equity firms are doing a lot more than others to broaden the analytical underpinnings of their valuations, ensure up-to-date reporting, document subjective judgements, and substantiate conclusions.

External scrutiny

External scrutiny of the practices supporting investment values comes in many forms, not just via the demands of LPs. The selection and application of methodologies as well as the subjective inputs and assumptions that underpin fair value estimates have become increasing focal points for both auditors and regulators.

A recent publication by the UK’s largest auditor, PwC, stated that “the big question for firms is whether your results will stand up to intensifying investor, regulator and auditor scrutiny, particularly around the effects of the pandemic on the value of your portfolio investments”*3. Also noting that the strength of the valuation function is “likely to be an important differentiator, both now and as we emerge from the covid-19 emergency over the long-term”.

Similarly, the Financial Accounting Standards Board (FASB) has included the assessment of fair value as one of the topics that should be “top of mind for auditors and their clients” in upcoming audits.

A ‘Special Valuation Guidance’ paper issued by the IPEV board highlights several important considerations in light of the challenges and uncertainties brought about by recent events*4, noting that:

Every investment will need extra analysis
Strong valuation processes should continue to be followed
Valuers are encouraged to think critically when estimating fair value
LPs continue to be best served by GPs providing timely fair value information

Certainty of independence

Questions around independence regularly arise from auditors and investors where significant parts of a fund’s valuation function are managed internally. Oversight of the valuation process and the reporting of carrying values are the ultimate responsibility of the fund manager, but transitioning core parts of the valuation function to external valuation providers will often lead to greater certainty and perception of independence. However, independence remains a key consideration even when external valuation advisers are involved. Retaining the same external provider for extended periods of time can run the risk of diminishing the degree of independence, where increasing ‘familiarity’ with an investment may lead to a gradual reduction in the extent of ongoing challenge around the selection of methodologies and subjective assumptions.

Where the valuation function is not carried out by an external valuer, the home regulator may require the authorised AIFM to have its valuation procedures and/or valuations verified by an external valuer. Alternative Investment Fund Management Directive

Genuine best practice

Dedicated valuation practitioners that are active in providing independent valuations throughout the deal cycle, across industries, and in a variety of contexts, can bring considerable insight and experience to the valuation process. Being active in the market allows technical expertise and commercial reasoning – both of which are critical to robust valuation – to evolve in line with market developments and valuation best practice.

Navigating complexity

Valuing illiquid assets during a recovery market is significantly more complex than during a stable market as pricing metrics and benchmarks are highly volatile and recovery pathways so varied. All valuation approaches are impacted, and significant care must be taken when applying methodologies, conducting analysis, and interpreting results. In a climate that requires a greater appreciation of both the technical and commercial aspects of valuation, the support of dedicated valuation experts can help ensure robust processes and appropriate outcomes.

The big question for firms is whether your results will stand up to intensifying investor, regulator and auditor scrutiny, particularly around the effects of the pandemic on the value of your portfolio investments. PwC, the UK’s largest audit firm

Reduced burden

Transitioning workload to advisers with a day-to-day focus on both valuation accuracy and process efficiency reduces the time commitment of internal resources, whilst ensuring that the valuation function is supported by appropriately qualified experts.

Time consuming processes such as information gathering, research, benchmarking, valuation analysis, critical thinking, cross-checking, drawing conclusions, documentation, review and reporting can be conducted efficiently by dedicated valuers, whilst the burden of audit review processes can be largely transferred to advisers well versed in liaising with auditors, and having their work reviewed.

Conclusion

Ensuring that the valuation function is optimised and fit-forpurpose in the current environment is an important consideration for all funds. With greater complexity in valuation, increasing expectations of investors and more stringent oversight from auditors, tailored external support may enhance and de-risk the valuation process.

FRP Corporate Finance provides a suite of services to support the valuation function of private equity, venture capital and hedge funds ranging from review of policies and procedures, through to periodic valuation of entire portfolios: