The Changing Landscape for Portfolio Valuations
Unlike public equity and fixed income fund managers, venture capital and private equity funds lack an active exchange to price the changing value of their investments. Instead, they perform valuations – oftentimes on a quarterly basis – so they can report updated values to their investors.
This year, the disruption caused by the COVID-19 pandemic presented new challenges for valuation updates at a fund.
First off, many of their investors are on edge. Who can blame them? It’s an election year, and they recently witnessed the public markets take a nosedive in March and bounce back in a euphoric manner over the summer. This has undoubtedly increased their interest (perhaps their anxiety too) in the performance of their private market holdings.
At the same time, unique market dynamics have made the valuation process more complex. Interest rates, for example, are as low as they’ve been in our lifetimes, while public valuation multiples are as high as they’ve been in the technology industry since the dot-com bubble.
One might say the stakes are higher and the burden is greater than in the recent past. However, this is a trend that’s been developing over several years. Let’s take look at the factors that are forcing fund managers to raise their valuation game – or to outsource the effort to the experts.
FACTOR #1: Highly unique market dynamics during the 2020 COVID-19 pandemic
As the Wall Street Journal recently noted, the pandemic presented a market environment that made valuations significantly more difficult. There are many reasons for this, including (but not limited to) the following:
Valuations are influenced by the future prospects of the company but the pandemic has resulted in uncertainty on a scale which founders and investors have never experienced.
Fund managers require insight from the founders of their portfolio companies, but in a pandemic their founders are being pulled in a hundred directions to keep their business on-track (or afloat). Providing information to funds becomes a burden, leaving fund managers scrambling.
At the same time, public market valuations and interest rates, which have historically been considered reliable inputs for determining the valuations of private companies, now imply significantly different values for private companies from day to day, much less quarter to quarter. Large write-ups or write-downs in the values reported on fund financial statements as a result of public market fluctuations may not accurately reflect fair value.
Consider the example of the general partner (“GP”) of a venture capital fund who’s incorporating public multiples of tech companies into the valuations of his tech-heavy private company portfolio. Using the Nasdaq (^IXIC) index as a barometer for the change in tech stocks, he would have seen the following variance between quarterly valuation updates:
1/1 – 3/31: Down 14%
4/1 – 6/30: Up 31%
7/1 – 9/22: Up 9%
In typical years, public company multiples might shift up or down from quarter-to-quarter. Here, “shift” would be a gross understatement; words like “crater,” then “skyrocket” come to mind.
If relying on public company multiples, the GP is left to decide whether the downturn in Q1 warrants a (dreaded) write-down of his investment. Then, three months later, should he follow suit with a substantial write-up?
Would such a fluctuation reflect the true economic reality of his holding? There’s the perception to consider, too. How would this fluctuation look to the VC’s co-investors, i.e. his limited partners (“LPs”)?
The following chart shows the roller-coaster ride for the Nasdaq and how it was performing at the quarterly milestones for private company portfolio managers.
Funds should not commit to (and do not desire) significant write-ups or write-downs unless they’re absolutely warranted. Yet a back-of-the-envelope valuation exercise based on public company multiples could very well point to the need for a large write-up or write-down. This is why valuation expertise is so important, and individual company analysis is a requirement.
What if the individual company provides a newly coveted solution like the videoconferencing app Zoom or the on-demand restaurant ordering service ChowNow?
The status of these types of companies has undoubtedly been lifted in a pandemic environment, regardless of how the broader market has performed. A more nuanced and sophisticated appraisal would capture that trend; a sloppy one might not.
In summary, the value of the portfolio company – more than ever – depends on the company’s business and how it functions in the current market environment. The question then becomes: How equipped is a fund to incorporate that analysis into its valuations?
FACTOR #2: Demand from investors for greater transparency and standardization
A decade or two ago, investors expected less transparency in fund reporting than they do today. They viewed PE and VC investments as highly illiquid and understood that the value would be realized when they were sold years down the road.
This dynamic is changing. As a result, funds are realizing that periodic valuation updates – performed professionally – are as important as they’ve ever been. There are two primary reasons why: transparency and standardization.
The push for transparency
First off, what’s driving the shift to greater transparency?
Growth, for starters. More money tends to bring more sophistication in all areas of the market. One could point to the 400% increase in the dollar amount of VC deals between 2009 and 2019 to illustrate the scale of growth.
Then there’s the rise of secondary markets. Platforms like EquityZen and Sharespost are two examples. These may be small players today, but they still offer liquidity for some private investors that didn’t exist before. It’s not a stretch to say that new opportunities to buy and sell private market shares also lead to increased investor interest in the valuation of those shares.
Finally, there’s the influence of startups gone awry. The Theranos scandal. Or WeWork’s debacle. WeWork’s inadequate valuation exercise became a mainstream headline. Our take: WeWork was never “valued” at $47 billion to begin with.
Size is influential. So are savvy investors who are keen to the risks they are taking. As such, expect the trend of greater visibility and advanced valuation techniques to continue.
The push for standardization
At the same time that transparency demands have increased, so have valuation standards. The most recent development to that end was the publication of a robust new guide by the AICPA.
In August of 2019, the AICPA published guidelines that aimed to provide a “common language” for market participants to arrive at their valuation estimates. At more than 600 pages this new reference tool is known as the Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.
This guide is the first of its kind for funds, and it goes a long way to establishing more standard practices across the industry. Prior to publication, fund managers had more flexibility in their valuation practices. Today, there are specific frameworks and methods laid out for appraisers to consider when performing a valuation in a fund environment. In addition, there are best practices and recommended resources to consult. Finally, there are case studies that illustrate how to think about the guidance in the context of a specific fact-pattern.
As mentioned before, the amount of money in PE and VC has swelled in recent years. They’re evolving. In the meantime, so are the industry’s operating standards.
How funds are responding
As the trend towards more technical and standardized valuations for VCs and PE funds grows, funds too must get more sophisticated. This is evidenced in a survey conducted by the advisory firm Ernst & Young, the results of which were reported to the Wall Street Journal as follows: “Forty-four percent of firms said investment in new technology related to valuation has increased operating expenses – the highest figure for any back-office function.”
While some are increasing their in-house capabilities, however, others are opting to save on overhead and are teaming up with a reliable third-party appraiser instead (i.e. “outsourcing”).
In these cases, fund CFOs will work with appraisers who can leverage a wider variety of tools, data, and techniques to value the portfolio. Appraisers understand the framework for valuing illiquid assets as laid out in the regulations, i.e. FASB ASC 820.
For funds, the capabilities of the third-party appraiser makes the valuation process more digestible and the end-result, ideally, more defensible. Even during a unique market dynamic involving pandemic. Even when every new twist and turn seems “unprecedented.”
About Portfolio Valuation at Redwood
Our Director of Portfolio Valuations (ASC 820), Tim Montgomery, has performed analyses for venture capital and private equity firms for over 12 years. Prior to joining Redwood, Tim worked in investment management and business valuation for Bank of America, Deloitte & Touche, Duff & Phelps, and Quist Valuation.