At a recent Breakfast Briefing, hosted by The Drawdown, a panel of experts discussed current approaches to portfolio valuations employed by GPs, how technology can be leveraged to deliver valuations faster and better, and how streamlined valuation data can improve other aspects of operational performance.
The panel:
Moderated by Jon Whiteaker, editor of The Drawdown
The Drawdown (TDD): How have private market valuation processes adapted to the volatility seen in public markets?
Samuel Williams (SW): At Cinven, most of our assets lend themselves to an earnings valuation methodology and within that there are both transaction and trading comps. Transaction comps do give some stability to the valuations versus taking a pure public market perspective.
There’s also discount rates within the valuation methodology to reflect the differences between the portfolio company and the peers, this can include differences with geography, margin, growth rates and product offering.
We at Cinven are alpha investors and have a strong portfolio team. We spend a lot of time on our value creation plans and that delivers in terms of the Ebitda growth we see within our portfolio, which gives us some natural buffering.
Frederic Docquier (FD): Not everyone will agree with me but I think volatility is something that I would expect. If your trading multiples go up or down, I would expect to see the same from a valuation perspective. Though there are criteria that impact that. For example, if you’ve a capital structure with preferential rights and that you are invested in the most senior shares, the volatility impact might be much lower than if you had a fully diluted approach without preferential shares. The external world would expect full volatility not taking this into account.
Even though you see markets go up and down, you don’t always have the same effect on private marks. But my fundamental philosophy is: why shouldn’t we have volatility with private equity? That is definitely what I would expect to see.
Laurent Gijbels (LG): I think we are comparing two things that are completely different. Private and public markets have inherent differences due to the nature of the investments and therefore it is normal to see differences in terms of valuations. The investor base is not the same, and we have different investment horizons and levels of risk tolerance.
TDD: Is there a need for greater standardisation in private market valuation processes?
Yann Magnan (YM): We have seen regulators pushing more on valuations, even in private markets. Regulators perceive private markets as less private than previously thought, actually. As some of the industry players are beginning to attract investment from high-net-worth individuals, regulators think they need to step in. The US is at the forefront of this trend but in the UK, the FCA has also issued a statement saying it wants to investigate private market valuations.
This is definitely having an impact on private market valuation processes. The answer to this is consistency. If you have an issue, you have to address it in the same way each time – and technology is the solution. Consistency is not the same as standardisation. Standards can help but most important is being consistent in your approach.
LG: There is not one single approach that fits all. Even if we are all using the same type of methodologies, there is not one single way of addressing a whole portfolio valuation.
Obviously, there is a need in the industry for greater standardisation from a transparency and reporting point of view. It helps with comparability and investor confidence, and helps to address potential conflicts of interest that could arise.
There is also a need for more standardised valuation processes, for example, for the use of committees that are independent of both management and investment management teams. Sometimes, the use of a third party can be helpful to confirm the marks that we have.
There is definitely an appetite for greater standardisation, with local regulators and professional associations promoting standard guidelines for best practice. We also recognise that there is a need for regular reviews of the model by the appropriate level of authority.
TDD: Greater participation by retail investors in private markets will demand greater frequency in valuations. How will this be managed?
YM: As a technology firm solving for this very issue, this is of great interest to us. It is possibly more of a topic of discussion in the US right now, but it is likely to gain prominence in Europe soon. It is the next phase of major growth when it comes to the alternative investment industry. The expectations are that private markets will grow from around $15trn AUM to somewhere between $80trn and $100trn AUM. That is massive growth.
That means even more value created by the industry. It also means an increased number of portfolio companies and a lot more processes and valuations. It will also mean evergreen funds, open-ended funds, a higher frequency in terms of redemptions, and higher frequency in terms of valuations.
Valuation, in that framework, is going to become ever more relevant. In a closed-ended fund, you are doing quarterly evaluations for financial reporting. As soon as you are talking about redemptions for retail investors, that has a direct impact on cash.
So that is where you need technology to accelerate the process, create greater efficiency and create a standard framework. This is essential so you don’t lose time to the process.
TDD: How do you incorporate external audits into your valuation processes?
SW: We have done a lot of work with our accounting team on the external audit process to make it as efficient as we can. There have been a number of things we have done to ease that process, including using iLevel as our portfolio monitoring tool.
We’ve used the iLevel data directly feeding into the valuation process from an earnings and net debt perspective, and that’s meant the auditors have been able to do control testing on our iLevel governance process, reducing the amount of substantive testing they have to do on these inputs.
The next efficiency was around the bridge from valuation Ebitda/net debt to reported Ebitda/net debt. Again, the iLevel data made the process a little bit more automated and straightforward, with backup saved down and plug-and-play for the audit team.
The next level to that, which we are working on with 73 Strings, is to platform that within the tool so that it is really end to end. So the iLevel data feeds in, the Cap IQ multiples feed in, all of the adjustments are fully audited within the tool and backed up there. Then there is an automated report that sets out every asset that we are holding, which then effectively enables the audit team to have a full pack that backs up everything in the quarterly valuations.
FD: We use 73 Strings and the advantages for the audit are clear: you can immediately see where the data comes from, which board pack for example, and for the auditors this is a huge gain. All the data is accessible for auditors and third-party evaluators as well.
Internally, if you make an adjustment to Capital IQ data or anything like that, it’s transparent to anyone. This creates efficiencies in the process. Using these tools allows us to spend more time on qualitative analysis of individual valuations, instead of having to spend that time on checking and controlling.
TDD: So what we are seeing is a rapid change in valuation processes driven by technology?
LG: In the valuation process, we know there are tasks that are not value-add but still need to be performed and require resource allocation. When you have more frequent valuation obligations, from yearly to semi-annual, quarterly or even monthly, that also puts added strain on the process.
So, to integrate technological tools into the valuation process is extremely helpful. The aggregation and collection of data can be much faster than what you could achieve on a manual basis. You can even standardise a very complex model, thereby reducing input and formula errors.
These platforms can streamline reporting and anticipate scenarios, allowing you to incorporate recent macro events to see what impact or potential impact they may have on your portfolio. Finally, it is much more helpful to have this sort of platform when you want to assess coherence across the valuation of your investments.
YM: I definitely think AI is going to transform the way these processes are being done, mostly in the facilitation of data collection and stressing the data. But I don’t think it will solve all of the issues and AI will not replace people in every aspect of the valuation process. I have been saying for 25 years that valuation is both science and art. AI can add to the science part but lacks human judgement.
The problem with AI is that you can build an algorithm that spits out the perfect value of an asset but it can’t explain it. And who is going to be accountable? It is the same as with an automated car – if it hits someone, who is held responsible? I think it is going to be very difficult to solve that. But for standardisation and efficiency, AI is going to continue to help.
TDD: How are your valuation processes informing value creation efforts?
SW: There are two branches for us. The first is value attribution and scenario analysis, and the second is how that feeds into monetisation planning. The valuation process is incredibly important to understand where we are driving the equity value that we are delivering for our LPs.
It enables us to split our thinking between revenue and Ebitda levers and the strategic transformation that we try and drive through our whole investment period, and really challenge ourselves on how successful we are at building regional leaders.
On exit readiness, we spend a lot of time at portfolio review committee level thinking about how we segment our portfolio in terms of growth compounding potential etc... and how we phase exits based on those categorisations.
We run wholesale analysis every year looking at what we could sell an asset for now versus one year’s time versus two years’ time. The valuations model is core to enabling us to flex assumptions systematically, overlay this thinking, and roll that up into the fund level outcomes.
FD: We provide transparency on the evolution of fair values. What is due to the markets or evolution of the multiples, what is coming from the performance of the company, and what is coming from the capital structure.
Before, it took a lot of time to do in Excel, which was quite cumbersome. Today, I wouldn’t say it is 100% automated but the tools give us a huge advantage to dig deeper in our analysis.
YM: Being able to bring all these data points and calculations together in one place adds huge value to the industry because then you can start doing many more things. You can focus on performance and start, as Sam was saying, to test a few assumptions and scenarios so you can optimise your performance based on certain operational parameters.
This will clearly transform the way the industry operates going forward.