The International Private Equity and Venture Capital (IPEV) guidelines for valuation principles have been updated and published recently (here) as a consultation paper for immediate adoption by the industry. It updates and extends the previous guidelines issued four years ago.
The investment world has seen enormous change in recent years and there are a number of fundamental pillars that have contributed to this.
Firstly, we have gone through many seismic financial events, the most significant in the last ten years being the financial crisis of 2008. Despite some more “normal” years since that date it is generally accepted that markets cannot expect to post returns enjoyed during the 1980s and 1990s on a regular basis.
Secondly, technology and information flow have improved and have become more widely accessible. This in turn has lead to a certain “democratisation” and generated a more level playing field, between issuing or capital raising institutions and investors (be they institutional, advisory or individual). This means more transparency and demonstration of true added value is expected from institutions and their representatives.
Thirdly, regulation has become an increasingly important factor in all aspects of investing and financial services. National and international regulators have mobilised and co-ordinated themselves over the last ten years (we could take the adoption of MiFID I in 2007 as a reasonable starting point of this process) and there has been a raft of regulation ever since, affecting institutional and retail markets, liquid and private capital, as well as functions of risk and performance.
Arguably, the world of private capital (the term now used by the IPEV to incorporate private equity, private debt and other related disciplines) has been one of the last pockets of the investment community to be affected by these changes. The financial crisis of 2008 was a big wake-up call and directly led to the Alternative Investment Managers Directive (AIFMD) in 2013 which was the first attempt in Europe to meaningfully and directly regulate the sector. Although private capital investing will always rely on opportunity, confidentiality, quality of information and calculated risk-taking, it simply operates in a different environment now.
It is within this context that the current IPEV guidelines have now been issued. The consultation document is a very well written and comprehensive coherent framework and has benefited from originating from a single highly qualified and motivated body, unlike comparable regulatory directives. Anyone interested in this subject cannot fail to learn and absorb important ideas and approaches around valuation and governance in private capital.
The role of fair value
One of the early observations that this paper makes is “The IPEV Board confirms Fair Value as the best measure for valuing Investments in and by Private Capital Funds. The Board’s support for Fair Value is underpinned by the transparency it affords investors in funds which use Fair Value as an indication of performance of a portfolio in the interim.”
This is an important statement, and states the preference of “fair value” over the alternative concept of “prudent valuation” that has become prevalent in different circumstances, such as to measure bank-wide risk management and capital adequacy.
Page 8 of the paper details some “Application of the Guidelines” and as such forms a short but well crafted set of items which would form an excellent basis in the creation of an investment or valuation governance document and process. This sets the tone for the clarity and thoughtfulness of the rest of the guidelines.
The purpose of these guidelines is to talk primarily about principles and procedures although some discussion does also follow on individual techniques. This is an important distinction and it clearly defines the scope of the paper and is precisely where the industry needs guidance and standardisation. Individual techniques depend on the asset class, a firm’s view of risk and the skill set and methodologies they have built up.
The guidelines also emphasise the importance of consistency:
“Once a Valuation Technique or Techniques have been selected, they should be applied consistently (from Measurement Date to Measurement Date); however, a change in technique is appropriate if it results in a measurement that is more representative of Fair Value in the circumstances.”
Our firm’s interest in private capital comes from our work this year in the valuation of private debt, a growing asset class that has seen increased take-up in Europe and the US in recent years. Over many years we have used and developed techniques in the valuations of Level 2 instruments (such as structured products and derivatives) as part of our core business lines. We see the adoption of such approaches (suitably modified) as having great value in private capital valuations and I am encouraged that we independently take a very similar view to that which the IPEV has now laid out.
Within this consultation paper, valuation methods used for private equity and private debt do diverge in many places because of the fundamental differences in the two. This article will mostly concentrate on the sections relevant to private debt (which has attracted substantive detail for the first time in IPEV guidelines).
It is clear from the consultation that in private capital applying simple valuations to debt instruments is commonplace, this is touched on various places, for example:
“It should be noted, however, that if debt is a standalone Investment, a Market Participant would take into account risk, coupon, time to expected repayment, and other market conditions in determining the Fair Value of the Debt Investment, which may not be equivalent to Par Value”.
“At each Measurement Date, Fair Value must be estimated using appropriate valuation techniques. The Price of a Recent Investment is not a default that precludes re-estimating Fair Value at each Measurement Date.”
I applaud these sentiments and it is one example where the private capital industry has historically preferred to operate within its own terms of reference. With illiquid instruments there must be care in assigning valuations that do not have first line validity (ie market values) and that some fund raising parties and long term investors feel comforted by the idea that assessment of a company’s prospects is key and not subject to short term “mark-to-market” changes.
While private capital will always be fundamentally different to liquid markets a blurring of the two domains has occurred in recent years. This together with the regulatory and business pressures to account regularly and fairly for investments means that provide no valuations or those obtained superficially is no longer a tenable position. The IPEV guidelines make these points very well.
One of the approaches covered in detail in the paper is that of calibration. In liquid markets prices are available continuously and represent “true” values where trades will take place. In private capital, price availability is much scarcer and less accessible. Calibration describes the process of taking an initial or earlier observed price and fitting to some kind of model and using this to help generate further fair value valuations in the future.
An example of calibration is described for valuing illiquid debt:
“For example, at inception the internal rate of return (IRR) for a given Debt Investment is known as are the price paid and the expected cash flows. An implied spread for the Investment can be derived by subtracting the risk-free rate from the implied IRR. The spread can be compared to observable spreads for issuances with similar duration and credit quality. At subsequent Measurement Dates, the risk-free rate is adjusted based on market conditions and the spread adjusted based on changes in credit quality and changes in market conditions.”
Such an approach is similar to the concept of implied volatility in option pricing. However one key difference is that relying on the validity of a single price in the private capital space is rather different to observing prices for a liquid instrument. This paper describes situations where caution should be applied, for example: “a new investor motivated by strategic considerations; or the transaction may be considered to be a forced sale or ‘rescue package’.”
The next concept is that of backtesting – that is retrospectively analysing fair values compared to subsequent realised values. This is the practice of comparing valuations to the later obtained “right answer”. This technique is very valuable for such an asset class. While parties should devise comprehensive methodologies to assess fair value at the required measurement dates, comparing to realised prices is an important feedback loop which should be used. Exactly how this fits into the procedures of a valuation group and how any lessons learned are incorporated into future valuations is a question that should be carefully considered as part of a robust valuations process.
An extract is as follows:
“Backtesting can provide meaningful insights that could be applied when developing future Fair Value estimates. Over time, Backtesting provides the Valuer with a tool to assess whether there are inherent biases (e.g. overly conservative assumptions) built into the valuation process and thereby identify areas for potential improvement.”
In summary, the new IPEV guidelines should prove invaluable reading and insight for those seeking to perform valuation and governance roles and services in private capital. We detect the introduction and adoption of many sound approaches used in other asset classes which should help to move the governance of private capital as an asset class forward in today’s world.
Tim Mortimer is managing director of Future Value Consultants.