As of January 2019 private capital investments valuations will need to be implemented according to the latest International Private Equity and Venture Capital Valuation Guidelines released late last year.
With only a month’s notice prior to implementation, the changes will have to be integrated into valuation processes immediately.
There have been some significant changes and we foresee potential implementation challenges. For the first time, the guidelines also explicitly state what sections are encouraged as best practice. It further emphasises the need for calibration and back-testing, a written valuation policy, proper documentation of the valuation process and the use of independent persons to be involved with the valuations process.
Here is a summary of the guidelines.
The most significant change is that Price of Recent Investment (PORI) was removed as a valuation method. This is a substantial deviation from the prior standard. It is likely the result of the guidelines around assessing the PORI for relevance being poorly applied. In essence, the standard setter has just changed the order of priority. Previously PORI was a valuation methodology and needed to be assessed for material changes and other indicators to check if the price was no longer representative of the fair value. Under the new standard, the asset must be valued using any of the acceptable valuation methodologies (of which PORI is not one). The PORI may only be used to assess the reasonability, given material changes and other indicators that price was not representative of fair value.
The second change to the standard is the additional guidance on the active market concept. An active market is defined as a market that trades often and with enough volumes (according to the judgement of the valuer) to provide pricing information on an ongoing basis. All quoted instruments on an active market are valued using the market price.
The updated guidance still requires application of judgement by valuers, but has expanded on how this is applied. It now includes the following “For example, if a Fund holds an investment in a traded security where the public float represents a small percentage of the total outstanding shares and trading activity is dominated by only a few holders, the Valuer may consider this level of activity not to reflect an active market that would provide reliable pricing information”.
Although this increased guidance is helpful, there is some practical problems with its application. The percentage free-float is readily available from data providers for most exchanges, but understanding the number of unique counter-parties, is an entirely different issue.
Further guidance has also been given, that, “Even if the market is not considered to be active, observable transactions would still provide an indication of value, and would need to be considered in the Fair Value estimate.”
This is another requirement that may prove difficult to implement as the movements in price in non-active markets are often difficult to understand from the outside and is unrelated to the fair value movements of the company.
Calibrating the transaction price to the listed market price on transaction date, may provide a way to “consider the observable transactions in the Fair Value estimate”.
The need to consider observable transactions is particularly relevant in the debt markets and the guidance includes a new section addressing the quality of information obtained from brokers’ quotes and pricing services. According to the guidelines the valuer should be aware of how the price quoted by a broker or pricing services is obtained. It also outlines individual factors for pricing services and brokers quotes.
On the subject of Discounted Cash Flow (DCF) methodology, the standard setters removed the following paragraph:
“However, because of its inherent reliance on substantial subjective judgements, and because of general availability of market-based techniques, the Valuer should be cautious of using this valuation technique (DCF) as the only basis of estimating fair value for investments that include an equity element.”
Elsewhere in the document it still emphasises that market-based techniques such as multiples are preferred but removed the cautionary wording above. We believe this to be a sensible change as the lack of high-quality market inputs (such as highly comparable companies) we experience in the developing world, weakens the value of market-based techniques and on occasion the reliability of a DCF may exceed that of a weak market-based valuation.
Apart from these comprehensive changes, a couple of smaller changes was made to the guidelines. These include guidance on:
- The acceptable methodology for the terminal value calculation which includes the Gordon Growth Model and an exit multiple.
- Calibrating debt transactions at transaction date and an explicit statement that amortised cost is not an appropriate methodology for estimating the fair value of a debt investment, even if the debt is held to maturity.
- Scenario-based and option pricing methods and how they can be used for seed, start-up and early-stage investments.
- Transactions costs that are not a part of the investments value and should not be included.
- Small section addressing Real Estate and Infrastructure were included. Both mostly detail current practice, the infrastructure section however highlights that the choice of either a free cash flow to equity (“FCFE”) or (“DDM”) should be driven by the Market Participants view.
- A section detailing how dilution should be dealt with. Only dilutions that have vested on measurement date and ownership at measurement date should be taken into account, except where it forms part of scenario analysis.
- Replacing the term Private Equity with Private Capital to be in line with the extension of the guidelines.
The guidelines also for the first explicitly state what they encourage as best practice in process when applying the guidelines. They emphasize the need for calibration and back-testing, a written valuation policy, proper documentation of the valuation process and the use of independent persons to be involved with the valuations process.
In many ways, with more emphasis on private debt investments and a drive towards a higher level of transparency and governance in the valuation process, the updated guidelines reflect the changes in the industry. This is a positive step for investors who need consistent and transparent valuations.
– Heleen Goussard,
head of unlisted investment services, RisCura