Private Asset Valuations / Too High, Too Low, or Just Right?

Regulators also question the rigor surrounding private market valuations. There have been a number of press reports questioning the veracity of private investment valuations. The UK’s Financial Conduct Authority is in the process of surveying valuation practices of leading private fund managers. Luxembourg regulators, historically reticent about fair value reporting, also focus on the robustness of private valuations. Globally, there is more of an more interest in “retail” funds, with private investment content. The U.S. SEC continues to maintain valuation as one of their key priorities in examinations.

As 2024 comes to a close, the volatility and judgment inherent in private market valuations is causing consternation among LPs. Some believe that GP reported values are too high, and some believe that certain managers have allowed the pendulum to swing too far and are reporting values that are too low. What steps need to be taken so that GPs, LPs and regulators can come to a conclusion that values are just right?

Background

While arguably repetitive of our past writings, it is important to remember why we use fair value for financial reporting and what fair value means. One of the most troubling aspects of GP/LP interactions is the seeming inability of both sides to fully understand the perspective of the other with it comes to valuation. Many GPs hold on to the mistaken belief that “conservatism” in estimating values is good for investors, while conservatism really has the impact of purposefully understating values. Many LPs hold the view the GPs are biased toward overstating values, especially when raising a new fund. In addition, a significant number of GPs also hold on to the mistaken belief that if there are downside protective terms for an investment (liquidation preferences), these preferences are absolute in protecting value, and there is no need to consider the potential for increased risk that the GP will be able to monetize protective rights if needed. Most of these GPs believe that LPs are averse to reporting volatility with respect to investment values (volatility of course exists, of course, whether or not it is reported). Both views—understating values (conservatism) or overstating values (ignoring risks)—are completely incongruent with financial reporting standards, regulatory requirements and investor needs.

Further, LPs don’t always articulate the reasons they need fair value reporting. Often, LPs are inconsistent in providing GPs with a perspective that fully aligns with the LP’s institutional needs. LPs need fair value because:

• Fair value is the basis that investors (LPs) use to report periodic (quarterly/yearly) performance to their investors, beneficiaries, boards, etc.
• Fair value is the only appropriate basis for LPs to make “apples to apples” asset allocation decisions.
• Fair value is an important data point in making interim investment (manager selection) decisions on a comparable basis.
• Fair value is often necessary to make incentive compensation decisions at the investor level.
• LPs need consistent, transparent information to exercise their fiduciary duty. Fair value provides such information on a comparable basis for monitoring interim performance. An arbitrary reporting basis, such as cost, does not allow comparability on a like-like basis.
• Most investors are required by relevant Generally Accepted Accounting Principles (GAAP) to report their investments on a fair value basis.
• New investment vehicles, which report net asset value on a monthly or daily basis, use GP-reported values as key inputs for determining fair value.

These are paramount requirements for an LP to manage its operations properly and protect the interests of their stakeholders. However, not all LPs articulate their needs as described above. Some may even tell GPs that they prefer “cost.” In many cases, this failure to communicate occurs because “deal” team members of LPs speak with “deal” team members at the GP and may not fully articulate all of the investor’s needs.

Definition and Use of “Fair Value”

Under the accounting framework, fair value is defined as the amount that would be received in an orderly transaction at the measurement date using market participant assumptions and considering current market conditions. This definition of fair value is not dissimilar to the “willing buyer, willing seller” determination of value that has been used historically. Fair value, with its “exit price” premise, is the basis under which value is reported, whether under U.S. GAAP (FASB Standards), International Accounting Standards, U.S. government accounting standards (GASB) or industry standards, such as the International Private Equity and Venture Capital Valuation Guidelines and the American Institute of Certified Public Accountants Private Equity and Venture Capital Valuation Guide.

Over the past almost two decades, application of the above definition and premise of value has provided a consistent, concise and well-articulated perspective on what fair value represents. Yet the rigor applied by GPs when estimating fair value continues to vary.

Fair Value in the Current Market Environment

Over the past several years, increases in interest rates, spikes in inflation, and COVID-19-induced economic impacts combined with market volatility and uncertainty created an environment where the application of valuation judgement is at a premium. The rise and fall of digital currencies and the related companies providing digital asset infrastructure, regional conflicts, political uncertainty, etc. are all factors that impact the judgment required to come to supportable fair value conclusions. Stagnant valuations, those that do not take into account current market conditions, will lead to over- or undervaluation estimates and, in turn, harm investors as they under- or overallocate their exposure to the alternative asset market.

Why, then, do some LPs believe that some GPs are undervaluing investments and some are overvaluing investments—sometimes the same exact investments? What stands behind this seemingly incongruent view of value? Based on our work with numerous GPs and LPs, we have identified the following impacts on value that are not always taken into account by GPs or understood by LPs:

1) Access to information:

• Fair value is derived based on what is known and knowable to the GP as of the measurement date.
• Each individual GP should assess available information to determine the impact on value. GPs’ individual judgments may differ. LPs need to consider the reasonableness of GP estimates but should not assume that differences in GP reported fair value, for the same investment, is necessarily wrong.

2) Using cost or primary transactions to approximate fair value or values that are sticky (don’t move), especially given the current macro environment, raise a red flag as to the appropriateness of the GP valuation judgment. In particular, consideration should be given to the following:

• When is the last financing round no longer representative of fair value? There is no safe harbor, especially in times of market volatility or dislocation.
• The ability to monetize an investment matters, especially for protective rights; the need for more capital will likely change seniority and dilute existing investors, specifically in a down market.

3) Exposure to market conditions depends upon a company’s:

• Stage of development
• Cash balance, control over cash burn and cash runway
• Need for additional capital
• Support from the investment syndicate or alternative financing sources
• Customer acquisition costs versus recurring and profitable revenue

4) Liquidation preferences and whether such preferences have demonstratable and supportable real value

5) New financing are a masked-down round where dilution is likely. Examples may include:

• Bridge/SAFE (Simple agreement for future equity) financing
• Special terms:
  • Guaranteed MOIC (Multiple of invested capital)
  • Accreting LP or PIK (Payment in kind) dividends
  • Discount rights in follow-on rounds
  • Qualified events, if unmet, allowing for an increase in ownership stake
• Convertible bonds with returns similar to equity, but essentially an alternative to conducting a new primary round of financing

It is appropriate for LPs to question the valuation rigor applied by GPs. However, LPs should consider the overall robustness of the GP valuation process. If the GP has a robust process in which they include inputs from deal teams, independent GP valuation teams, and third-party valuation support, it is likely that the GP’s valuation judgment is supportable and defendable. LPs should be cautious in allowing their own biases to influence their assessment of GPs’ valuation conclusions.

It is difficult to generalize the direction of fair value for investments in given market conditions as each individual investment is valued using facts and circumstances specific to the individual investment. However, all else being equal, the current market environment argues for the value of investments to be flat or down without specific facts to the contrary. If risks or required returns have increased for a particular portfolio of investments, not reporting such factors in the estimation of fair value will likely harm LPs. Desired exposure to investment categories (PE and VC) tends to be firm. Not allocating appropriate (new/additional) capital to a category when market conditions support doing so will adversely impact LP returns as underperforming sectors recover (or revert to long-term historical means).

Conclusion

Estimating fair value requires experienced, informed judgment. Transparent and consistently and rigorously determined fair values allow GPs to report in accordance with regulatory requirements, provide LPs with decision-critical information, and are a critical input to daily or monthly retail valuations. Fair value impacts asset allocation, which in turn drives overall returns, cash flow, IRR(internal rate of return) and opportunity cost/benefit. Fair value estimates should not be too high or too low, but just right.