Striking the Balance: Integrating Automated Models with a Best-in-Class Valuation Process

Changes in the market environment, increasing complexity of securities, and heightened scrutiny of valuations are adding complications to fund managers’ valuation processes. Finding the right balance between greater transparency and efficiency is now paramount. While the use of automated models may result in improved efficiency, relying solely on technology-driven results poses risks from a regulatory and audit perspective.

Background: Changes in the PE/VC Landscape

In a recent article, we mentioned that scrutiny by stakeholders (regulators, auditors, investors) had sharpened dramatically as a result of (i) the changes in the market landscape, (ii) the rise in the number and value of illiquid securities held by funds, and (iii) the increasing complexity of securities. We concluded that estimating and supporting fair value is more challenging now, requiring experienced judgment and additional supporting documentation.

LP investors have recently been struggling with a lack of distributions; the limited number of transactions and delayed exits also results in a lack of recent data points to which a valuation analysis can be calibrated. Further, approximately 30% of VC-backed transactions during 2024 occurred at flat or down rounds (per Pitchbook), which is something we have not seen in over a decade. Moreover, we believe this number may be conservative given (i) the more prevalent use of SAFEs (Simple Agreements for Future Equity) and convertible notes (as the dilutive component may not be always evident), as well as (ii) the fact that a flat round may implicitly lower the value of previously issued securities if liquidation preferences (or other security features) differ from those securities.

Together with a significant increase in AI-related transactions (about 30% of U.S. deals were in AI companies), another trend we have observed lately is the use of more complex terms, including increasing liquidation preferences or minimum returns, and changing ownership claims over time, adding complexity to the valuation process.

Against this backdrop, investors are demanding greater transparency and valuation governance. In particular:

• Process-oriented questions are now a focus for investors and regulators.
• Independence—via the use of valuation experts—in valuations is viewed as a best practice.
• Fair value can help LPs in making appropriate asset allocation decisions.

It is therefore crucial to have a robust valuation process that follows the industry’s best practices and complies with the applicable reporting standards. Likewise, developing a thorough understanding of how values change over time is a critical component of the valuation process. In this regard, a “value bridge analysis” can be an invaluable tool to monitor changes in the value drivers of portfolio companies.

Achieving Balance between Greater Transparency and Efficiency: Considerations on Automated Models and Reliance on Latest Round of Financing

Alternative asset managers are increasingly adopting valuation software tools to enhance efficiency in managing data flow, automating repetitive calculations and standardizing valuation processes. These tools provide consistent methodologies, integrate diverse data sources, and make valuations more accessible, even to users with limited financial expertise. However, current software tools often lack the flexibility and judgment required to capture the nuances of valuation analyses, such as changing market sentiment, company performance, and unique investment characteristics.

Automated models or software tools typically rely heavily on data and treat comparability as a fixed relationship, which may overlook material changes in a company’s development or market conditions. Additionally, as stand-alone solutions, they may fail to meet regulatory and audit standards, including compliance with International Valuation Standards. While software can increase efficiency, regulatory and accounting guidance highlights that expert judgment remains essential to ensure valuations are both supportable and auditable, mitigating regulatory risks.

Similarly, reliance on the cost or value indicated by the latest funding round is increasingly viewed as a potential valuation issue because of the current limits in transaction availability. Additionally, with shifting economic conditions, value can materially change between funding events.

Given the above considerations, we recommend that software tools be integrated with a best-in-class valuation process, including relying on expert judgment (internal, external or a combination of both).

Concluding Thoughts

As valuations face increased scrutiny, achieving the right balance between demands for transparency, enhanced documentation, and efficiency becomes crucial. While automated models can boost efficiency, relying solely on technology carries inherent regulatory and audit risks. By integrating technology with a best-in-class valuation process, these risks can be effectively mitigated.