Portfolio Valuation - A Well-defined and Supported Valuation Process as Defense to Increasing Inquiries

Valuations are now more critical than ever, given the current market uncertainties, growing concerns on transaction values and increased scrutiny by investors, regulator and auditors. A robust valuation process is crucial. Further, for early-stage valuations, a Calibrated Market Approach often provides the support needed.

Market Environment: Growing Concerns on Valuations Amidst Increased Scrutiny

Limited financing events, delayed exits, and the need for critical capital leading to down rounds or dilutive financings are currently putting more pressure on a Manager’s valuation process than in the past. Estimating and supporting fair value is a growing challenge as the securities held by investors are increasingly complex.

Given the dramatic rise in the number and value of illiquid securities held by Fund Managers, pensions and even retail investors, the scrutiny and attention to fair value reporting standards by investors and regulators has sharpened dramatically. It is thus imperative that reported fair values be accurate and supported by a well-defined, well-documented and consistently applied valuation policy that complies with the relevant reporting standards.

Valuation Challenges for Early-Stage and High-Growth Companies

A steady flow of financing events and the ability to calibrate valuation assumptions to these transactions has allowed the venture capital industry to enjoy a long period of relatively easy and objective supporting information for a Manager’s valuations. However, with increased scrutiny, the specialization of disruptive business models and limited information coming from transactions, valuations now require much more judgement and supportive documentation.

Valuation challenges for early-stage and high-growth companies include:

• How changes in the performance are recognized in terms of fair value
• Value of liquidation preferences and other protective rights
• How achieved growth might compress multiples over time
• What are best practices for supporting and documenting valuation analyses?

A Calibrated Market Approach Often Provides the Support Needed for Early-Stage Valuations

Recognizing that many early-stage investments are valued based on milestone-based progress and efficient cash-burn management, companies that are starting to generate revenue may rely on a Market Approach to estimate value. However, because revenue is still at a nascent stage (often with significant YoY growth), the implied multiples are typically not meaningful when compared to the publicly-traded peer group, and thus selecting multiples in a traditional Market Approach framework will be challenging. Likewise, relying on either the initial transaction multiple or the latest calibrated multiple may not be appropriate given that, when there is significant growth in the metric (e.g. revenue), the implied multiples typically decrease over time in a process known as “compression”. Indeed, as the investment achieves the forecasted growth, the expected future growth rates at subsequent valuation dates decrease over time, and so do the implied multiples as a result. As such, when the calibrated multiple is materially different than the observed market multiples, the representative multiple for the company is expected to converge toward the market multiples over time.

To overcome these obstacles, a Calibrated Market Approach may be utilized. In a Calibrated Market Approach framework, the initial implied transaction multiple (or the latest calibrated multiple) is adjusted with the following factors:

Multiple Compression Adjustment

As mentioned above, this reflects the compression that multiples experience over time when there is significant growth in the valuation metric. This effect can be quantified based on its underlying value drivers:

• The rate at which the reference valuation metric grows.
• The rate at which the enterprise value (EV) accretes value (which, in turn, is based on the underlying rate of return adjusted by the impact of the cash flow generated between the calibration and the valuation date).

Company-Specific Adjustment

Reflects changes in the financial outlook and risk profile of the portfolio company as of the valuation date relative to the calibration date. For instance, if the outlook at the valuation date is less favorable than that at the calibration date, a negative adjustment to the multiple may be applied. The selection of a company-specific adjustment can be quantitative and/or qualitative based on the following value drivers:

• Level of achievement of the budget initially estimated
• Changes in future growth rates relative to those estimated as of the calibration date
• Changes in future free cash flow margins (e.g., changes in margins, tax rates, capex and/or working capital requirements) relative to those initially estimated
• Changes in the risk assessment of the investment
• Data on secondary activity and anticipated financing rounds

Market Adjustment

Reflects the change in the multiples of comparable companies from the calibration date to the valuation date. A correlation factor between 0 and 1 is often applied to the observed market movement. Given the private nature and early-stage status of VC-backed portfolio companies, their valuations typically do not move in sync with the public peers.

Illustrative Example:

Valuation Process Best Practices and Benefits of Third-Party Valuations

Accurate estimates of fair value resulting from a well-documented and consistently applied valuation policy are required for all leading entities investing in alternative assets. Generally, third-party valuations enhance transparency and consistency, reduce potential conflicts of interest, mitigate risk and, ultimately, enhance credibility. The benefits of third-party valuations are summarized below.

How Kroll’s Portfolio Valuation Advisory Group May Assist

Kroll is a market leader in providing illiquid portfolio pricing valuation services to the alternative investment community, specifically for securities and positions for which there are no “active market” quotations available. Having authored or contributed to the leading regulatory and industry guidance related to fair value matters, technical excellence and thought leadership are at the core of what we do. Kroll brings extensive and unparalleled industry specific experience through years of working with some of the world’s foremost investors in alternative assets. We assist our clients through the valuation challenges of a single investment to entire portfolio of investments. We advise on valuation policy including performing independent “diagnostic” assessments of a client’s existing valuation policy to assisting in the development and implementation of valuation “best practices.” Contact our experts to learn more here.