In the context of a fund’s portfolio of investments, valuation can be viewed as the window to the performance of the fund’s investments over a period of time. Apart from its interpretative value, the valuation process also serves to assist fund managers comply with regulatory requirements, financial reporting. When balancing the informative role of valuations along with the compliance, globally accepted guidance on such valuations become imperative. The International Private Equity and Venture Capital (“IPEV”) valuation guidelines (“the guidelines”) issued by the IPEV Board are the most widely accepted guidelines adopted by funds globally.
With the latest version being published in December 2022, the IPEV valuation guidelines are recommendatory in nature. Their goal is to align the fair valuation of investments of private capital with International Financial Reporting Standards (“IFRS”) and United States Generally Accepted Accounting Principles (“US GAAP”). Application of these guidelines makes it convenient for investors to be able to measure and compare fund performances across geographies. We have discussed the critical aspects of the IPEV guidelines in this article.
Fair Value Definition
The definition of fair value used by the guidelines is consistent with the definition of fair value per ASC 820 and IFRS 13, except that it excludes the terms “paid to transfer a liability”, since the focus of the guidelines is to determine the fair value of portfolio company investments, i.e., “assets.”
Key Valuation Concepts – Calibration and Back Testing
The key events in the lifecycle of a portfolio company investment are the time of investment and that of exit by the investor. The concepts of calibration and back testing, idiosyncratic to the PE/VC world, tie back the transaction values at entry and exit to the fair values for reporting purposes. These topics are discussed in the following paragraphs:
Calibration is the process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with the same assumptions that are consistent with the original observed transaction or a more recent observed transaction in the instruments issued by the portfolio company.
Under the market approach, calibration provides an indication of the way that market participants would value the investment as of the transaction date given the differences between the portfolio company and the selected guideline companies or transactions.
Company A is acquired for an enterprise value of USD $600M comprising of USD $300M in debt. The trailing and forward EBITDA of the company are USD $60M and USD $90M respectively. The resultant implied multiples are 10x trailing EV/EBITDA and 6.67x forward EV/EBITDA. The guideline public companies’ EV/EBITDA multiples are as follows:
- Trailing EV/EBITDA: 8x
- Forward EV/EBITDA: 5x
The difference between subject company and peer group multiples reflects a market participant’s expectations of Company A outperforming the peer group. On subsequent measurement dates, one would assess whether the delta between the subject company and the peer group still holds. Such assessment is made based on certain pre-defined milestones pertaining to the Company’s financial and non-financial metrics. A simple application of the peer group multiples to the Company’s financial metrics would not be appropriate. Let us say after 6 months, Company A’s performance is on track. Similarly, market multiples have also improved to 9x trailing EV/EBITDA and 6x forward EV/EBITDA. Comparing the Company’s progress with the market, it is concluded that a market participant would still expect the Company to outperform the market, but to a lesser extent as compared to the situation as on the transaction date. Thus, for the valuation analysis, a trailing multiple of 10.5x EV/EBITDA and a forward multiple of 7x EV/EBITDA shall be considered.
Backtesting is the process of comparing an actual liquidity event in an investment to the most recent fair value estimate. This process is aimed at testing the rigor of the fair value estimation process. This process does not imply that the realization proceeds of the exit event should be equal to the most recent fair value. There may have been substantial events between the date of the most recent fair value exercise and the date of the exit event. The purpose of back testing is to improve the valuation process which is where it distinguishes itself from the assessment of subsequent events in compliance with financial reporting standards.
Backtesting helps provide meaningful insights as to what the factors that changed between the measurement date and the exit date and whether these factors were known or knowable as of the measurement date. It can be thought of as a retrospective review and is an important part of the control process in valuation. It need not be thought of as an inspection of errors in the valuation, but rather just an additional step in the process.
An illustration of backtesting well incorporated in the valuation process is discussed below:
Fund ABC (“the fund”) holds 100% interest in Company A and valued its investment in the Company at 8x EV/EBITDA multiple as of March 2023. The 8x multiple is calibrated from the original investment date multiple of 6.5x EV/EBITDA multiple as of December 2021. The fund is not aware of any extraordinary factors that are likely to have a significant impact on the multiple considered.
The valuation was completed in April 2023. Fund ABC has the practice of relying on the audited financials of the latest quarter available for Company A for the purpose of the valuation analysis. For the valuation as of March 2023, the fund relied on the financials for the quarter ended December 2022.
In April 2023, Company A signed a term sheet to be acquired by Company XYZ. Along with signing the term sheet, Company XYZ was also awarded 2 months of exclusivity to conduct due diligence. In May 2023, when the March 2023 quarter financials were finalized, it was discovered during the due diligence that Company A had to pay a significant penalty for certain environmental infractions that it was committing. The penalty also damaged the reputation of the Company apart from its financial impact. This discovery led to a lowering of the transaction price that Fund XYZ offered for the acquisition, implying an EV/EBITDA multiple of 5x.
How would back testing apply here?
In assessing the difference between the multiple offered by Company XYZ and that considered by Fund ABC, it was evident that information about the penalty was known and knowable as of the valuation date, had the fund accessed the draft financial information. Fund ABC determined that access to the latest financial information, even though in draft form should be a key step before finalizing the valuation. Additionally, having direct access to the management of the Company would also be key for the fund.
Consistency With the International Valuation Standards
The IPEV Board has entered into an understanding with the International Valuation Standards Council (IVSC) with the objective of promoting consistency between the IVS and the guidelines. The IPEV guidelines will be considered as providing sector-specific guidance of the IVSC.
The IPEV valuation guidelines need not to be viewed as a separate area of application of valuation concepts. It is indeed an adaptation of widely used valuation principles to the world of private equity and venture capital. Their purpose is to act as a guiding torch for any valuer performing valuation of private capital investments. It is highly recommended for private equity and venture capital funds to adopt these guidelines to ensure comparability and consistency in their valuations.