In the Ever-Evolving Private Capital Space, Valuation Risks Sustain

The private markets asset class has experienced a continuous and steady increase of capital allocation over the last several years, with a popularity amongst institutional investors which has led to increased requirements and scrutiny by professional investors. However, one challenge that remains persistent and of top concern is the risk that accompanies private investment valuations.

Here, Sebastien Sacre, COO of Northern Trust Private Capital Fund Services, and Vincent Molino, Head of Operational Risk Management Solutions, discuss the ever-changing trends and challenges surrounding private investment valuation and what investment managers and institutional investors should keep in mind.

1. As demand for private investments has increased, how has that impacted the importance of understanding the valuation of investment holdings?

SS: In working with private capital managers, we at times see wariness coming from their investors or prospective investors when it comes to the role of valuation as a marketing tool, particularly alongside cheap borrowing. Both have an impact on Internal Rate of Return, the most widely used performance metric. Often, when a certain percentage of the committed capital is deployed, managers can go and start fund raising for the next fund, and so investors could worry that they’re shown a rosier picture than what the reality might be at that time. As competition between private capital managers increases, managers may feel a growing pressure to turn to this tactic, and investors will become more skeptical.

VM: I would add that the diversity of private capital investor categories has increased, and so the scrutiny and due diligence of valuation processes has also increased. The asset class is no longer limited to some of the largest institutional investors, but has broadened to include traditional investment firms, family offices, high net worth registered investment advisors, and potentially defined contribution, or 401(k), plan participants. The common risks with private investment valuations still exist, but now there will be a greater demand for increased transparency, and potential increased regulatory compliance, as a result of new investors entering the space.

2. Vin, you identified that part of the ongoing popularity of private capital has included traditional investment managers who have increasingly entered the private investment area with new or increasing allocations within their portfolios. What bearing do they have on the private capital space?

VM: There have been a number of examples in recent years, and some in recent months, where traditional managers, such as those that manage mutual funds, have invested a percentage of their otherwise public securities portfolios into private investments. Unfortunately, this has resulted in a number of firms running into issues in both valuations and liquidity, either due to a lack of experience in conducting appropriate due diligence, or allowing themselves to be almost totally reliant on someone else’s valuation process. This has been particularly acute with some traditional firms investing in venture capital.

Ultimately, the risks and potential negative consequence of this are twofold: First, the valuations of their portfolios are being impacted by potential restatements or write-downs that occur when adverse values materially impact their portfolios. Second, the funds they manage may no longer have the liquidity marketed to investors, which can result in both withdrawals from the fund and adverse regulatory consequences. If more traditional investors, and perhaps retail investors, invest in private investments, it is a near certainty that private investment firms would see increased scrutiny of their valuation methods.

SS: I would just add on top of what Vin mentioned that, until recently, the fact that these vehicles were truly closed ended limited the risk, to some extent, around the valuation process over the life of the fund. Investors would be made whole at the end of the day no matter what, except for in the relatively rare occurrence of a partner transfer. That is changing with more open-ended types of PE vehicles allowing investors to exit the fund under specific conditions and timelines.

3. Venture capital (VC) has played a big role in the overarching private capital space for some time, but it has encountered a new spike of capital deployed in 2021. What specific valuation challenges do managers and investors encounter in the VC realm?

VM: VC valuations are particularly challenging, since investment firms obviously have to apply a valuation method to the startups they invest in, but with little, if any, ability to compare it to equivalent companies that may be found in the public markets – assumptions and best guesses inevitably come into play. Investors often assume that an appropriate valuation method has been applied, but we have seen examples of some  startups encounter high profile valuation restatements due to non-standard methods or ambitious assumptions made by some general partners.

SS: In light of what Vin discussed, we have noticed that, when investing in the VC space, most sophisticated investors tend to focus, even more than in the traditional PE space, on investment managers with a good track record and only reserve a tiny fraction, if anything, from their overall capital commitment to new players. On the fund administration side of things, funds investing in the VC space tend to hold a large number of smaller investments which require the use of a robust and flexible platform to track them adequately, both from an accounting and performance standpoint.

4. Have we begun to see the effect of cutting-edge data management practices and tools play out when it comes to producing private investment valuations?

VM: I would say there is a growing effect of technology on how information is either transmitted or made available to private market investors. Specifically, as artificial intelligence and machine learning is applied to data management, I don’t see any reason why the investment managers of private market firms cannot provide additional and enhanced information of their portfolio companies through transmitting detailed valuation information to their investors. In addition, as blockchain technologies become more prevalent, the general partners themselves can potentially use that information to conduct due diligence and produce better valuations based upon information received from their underlying portfolio companies, such as using a blockchain to document the financial information of a company they have invested in.

SS: There is definitely a shift, as Vin indicated, with a wider use of technology and data management to fine comb the valuation process but we are still in the early stages of what could be a significant shift in the valuation methodology. As we all know, the valuation of PE assets has always been tricky given the lack of reliable data points and industry standard measurement policies; there is a significant level of interpretation by the valuation committees and, even knowing that they are required to act in good faith, it leaves a rather high level of uncertainty. Many would argue that it still follows the old adage: You only really know what the investment is worth the day you buy and sell it. Unlike public securities, there is a lack of observable prices and inputs to assess the fair value of the investments. As Vin discussed, this is changing through better use of data management and machine learning but there is still a long way to go.

With the lack of observable quoted prices, investment managers are required to value their assets based on the FAS 157 guidelines (also known as Accounting Standards Code Topic 820), and more specifically use the public market and private transaction (if available) comps and discounted cash flow models. The weighting of those  widely used methodologies can fluctuate significantly across PE firms. We should keep in mind as well that there is a discrepancy across the industry with some firms solely relying on their internal valuation committee compared to others more systematically using valuation firms. However, use of third-party valuation firms has increased recently due to investor requests, among other things. In that regard, the auditors play an important role as they will perform their own testing around the valuation and inquire when there is a change in the valuation methodology (such as different comps, change in valuation multiples or the ability to factor in data points related to similar companies that are in the public market) but it can be difficult to effectively challenge some of the valuations. Last but not least, there are other factors to consider that may or may not be impacted by an increased reliance on data management which includes a changing exit timeframe or strategy that can have a meaningful impact on the valuation of a given asset.

5. How have new assets classes and Covid-19 have affected the valuation model for private investments?

SS: New asset classes, such as cryptocurrencies, can be highly volatile and inherently difficult to valuate, especially for vehicles that typically report on a quarterly basis. Other accepted industry practices, such as keeping the investment at cost for multiple quarters (or until a significant event occurs brings back the issue around the accuracy of the valuation in the interim). Same with unpredictable events like Covid ⁠as it makes it very difficult to value the assets over a few reporting periods given the macro level of uncertainty and lack of similar past events to compare to as a starting point. With that said, it should be noted that the PE space has been fairly resilient during past major economic crises and the decrease in valuation was in most cases lower than in the public market. In the end, investment managers were often less aggressive in marking down their assets during the downturn and similarly less aggressive writing them up during and after the recovery.

All of the above has resulted in the need for PE firms to be even more transparent to the various stakeholders regarding their valuation process. Not to mention that there has been a shift over the past decade or so with investors expecting additional visibility and transparency in the valuation of the assets. For example, some have pushed for the investment manager to adopt the ILPA standards which include an increased focus on valuation.

VM: From an operational risk and due diligence perspective, the pandemic has presented its share of challenges in both the exchange of information and not being able to physically review internal valuation documents. However, over the course of the past year, both investment managers and investors have adapted to a new normal of utilizing technology to achieve due diligence goals, and as such many private market general partners have utilized data rooms and other controlled means to provide sensitive information to their investors. In fact, one general partner I worked with not only provided the necessary valuation documents, but provided the underlying financial statements and calculations that went into producing a valuation, as there was a clear comfort level with how far the technology and its controls have come.

6. To you, what is the ultimate takeaway for private capital managers based on all these trends swirling in the private capital space?

SS: As a fund administrator working with private capital managers, we can see them taking steps that move the practice of valuation in the right direction. For example, we’re seeing that managers are adding more context and details around their investments, valuations and exit strategies.  

VM: Ultimately, investors need to do their homework. Partners like Northern Trust can provide guidance and support, but it’s important to have an idea of the risks you’re taking as an investor, or the appropriateness and diligence of your valuation process as an investment manager.