Due Diligence Matters - March 2024

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Time for a (re)valuation? By James Newman, Co-Head and Co-Founder.

In the private markets space, level 3 assets are generally initially valued at cost, and thereafter periodically valued using a model, similar market transaction or an alternative method. One could argue that, even on the purchase date, the GP should document how it has determined that “cost” is equal to fair value, since other factors may play a part, as discussed below.

Valuations of privately traded instruments, which are typically unrealisable estimates unlike tradeable stock, can be used by LPs to evaluate returns on existing portfolios and generate new commitments into follow-on funds or new opportunities. As most interim valuations are not based on transactions, there is a degree of estimate inaccuracy resulting from a number of factors, including information rights, varying quality of inputs, human judgement/error and/or limitations. In some circumstances, GPs charge quarterly management fees based on net asset value, whereby the valuation impacts the fees the GP receives. As a result, valuations throughout the life of an investment do matter, and not only to LPs, but to regulators too.

In late 2020, the SEC adopted the Fair Valuation Rule for SEC-registered advisers which, to cut a long story short, requires securities for which there are no readily available market quotations to be fair valued in good faith by the fund’s board of directors (if present), and not just by the GP. This initiative to introduce a greater level of oversight and challenge is a sound one, but how has it been reflected in practice? Ronan Guilfoyle, co-founder of Calderwood, a fund governance firm, has seen an uptick in firms setting up valuation committees, which include some or all of the independent board members. “Often the committee will review minutes from the investment manager’s meetings, third party valuations or models used to value certain illiquid assets”. But a challenge exists for INEDs’ scrutiny of valuations in the private markets space: “Often there is no way of confirming which method is most appropriate to use to value these hard-to-value assets and, in most cases, they are carried at cost without any other information to use on which to base a different valuation”. The FCA is focussing on the subject too announcing in September 2023 a review of the way investment funds value private assets.

Is the use of purchase price (cost/transaction) as an approximation of fair value for initial valuation purposes following best practices? Arguably a sale between related parties with potential conflicts, or a fire sale, market dislocation or non-primary market sale, could be problematic for valuation purposes, even on the initial investment date. The accounting rules under both IFRS and US GAAP are specific about fair value being the amount which is received (for an asset) in an orderly transaction at the measurement date. For due diligence analysts, it is important to understand what factors and assumptions have been used before accepting cost as the default or conservative valuation, free of misstatement.

Thereafter, fair valuation must be applied at least at the end of every financial year or at each reporting date, and usually GPs state that cost is used for a certain period of time after initial acquisition. Policies and procedures should be clear on how fair value is estimated, citing valuation techniques and methodologies to manage potential conflicts of interests and/or other circumstances that can impact the fairness of the valuation. In extreme circumstances, there is the risk of inflating valuations – a charge the SEC made against Abraaj Capital in April 2019. “Proper documentation of a valuation process from the valuation policy through to the valuation committee’s final fair value determination is vital for asset managers” said Chris Franzek, Managing Director at Stout, a group specialising in valuation and transaction advisory, among other services.  

GPs should have robust valuation policies that dictate transparency, consistency, principles applied (e.g. GAAP, IPEV), independent internal challenge and, where relevant, engagement with external valuation agents. Where valuation agents are used, it is important for LPs to be informed about the scope of their work, as well as the frequency of their valuation and the proportion of the portfolio to which it applies. Pertinently, Chris adds, “any credible third-party valuation firm should be happy to discuss the scope of their valuation with any LP of their client, with the client’s permission” 

 Valuation is a perennial hot topic and, despite a combination of investor persuasion, best practice and regulatory rule making, achieving fair valuation in private markets remains as challenging as ever.

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