“Do you know what your private equity portfolio is worth?”

What is this investment worth?” This is one of the key questions asked by limited partners in the private equity industry. The answer to it is both simple and complicated. The private equity investor, unlike an investor in virtually every other asset class, has no liquidity for fund ownership. In the public securities markets, you can sell stock, trade bonds, and liquidate real estate, with each sale determining the value of an asset – arguably the essence of a true market and the accompanying market price. One of the uniquely “private” aspects of private equity is that there is no ongoing pricing mechanism for the assets within it.

The private equity secondary market, where limited partners sell their interests in one or many private equity fund(s), can be seen as a benchmark of value, but that is a flawed pricing model for this purpose. The secondary market exists today with limited participation from both buyers and sellers.

Furthermore, secondary transactions do not occur on a regular basis, making the establishment of meaningful pricing that is relevant beyond the particular circumstances of that particular transaction all the more difficult. In reality, private equity cannot rely on market pricing to determine a value for its assets, nor can it rely on general partners' reported valuation, as these groups do not adhere to any consistent standard or industry norm.

The answer to that opening question therefore can take a number of forms – and requires a process far more protracted than anything to be found in the second-bysecond pricing of those aforementioned public markets. Unless the vendor is prepared to take whatever a buyer is prepared to offer, some form of formal valuation is required. And that's where a valuation agent comes in.

The valuation agent
The valuing of private assets has been a part of private equity from the beginning but has become more common due to the recent public equity market crash and increasingly nervous investors.

The notion of an “official valuation agent” for private equity assets came about as a result of the growing private equity securitisation market. In a securitisation, limited partners contribute their private equity fund assets into a structured vehicle. The vehicle then issues bonds and equity in exchange for all future cash flows associated with the underlying funds. To date, these transactions have been done on both a rated (by a major rating agency) and non-rated basis. In order for the rating agency to set the ratings of the bonds and to properly determine collateralization levels, a value must be determined for the portfolio assets. These valuations are done on a portfolio company basis, utilising a variety of methods and accessing a myriad of information resources, more fully explained later. This is the role of the valuation agent, and Hamilton Lane is one such firm.

Determining value
When considering the valuation process in relation to private equity assets it should be noted that each valuation project varies in its depth and scope – depending on the use of the valuation. Ultimately, the portfolio owner determines the scope of the project with input from outside parties, such as a rating agency or the bondholders.

One valuation approach focuses on understanding the relative health and competitive positioning of the portfolio company and the potential up/down sides associated therein. Here, given historical financial and economic data, analysis can be performed to determine the underlying strengths and weaknesses of an investment and to develop sound inferences with respect to less quantitative elements such as operational efficiency.

A thorough, fundamental analysis will require close examination of a host of other qualitative variables: management quality, strategic vision and direction, operational sophistication and so on. This is insight gained only by individual examination of the company, its team and operations.

In dealing with a specific portfolio company's performance and positioning, the valuation process must include a thorough review of the following:

  • Historical financial performance:

    – Growth – revenue, earnings, margins.

    – Operational performance metrics – productivity, distributional efficiency.

    – Financial metrics – return on equity (ROE) and free cash flow.

  • Current economic/financial conditions:

    – Market position and competitive landscape.

    – Financial strength and capital structure.

  • Growth potential – estimates of fundamental variables:

    – Industry – size, growth, penetration rate.

    – Franchise value – technology, know-how, brand name recognition.

    – Operational and financial – revenues, earnings, net income.

  • Further, the valuation process should examine relative measures, using both public and private comparable companies to assess the following:

  • Industry and sector performance – determining whether the target company falls within “normal” ranges.
  • Stage of development relative to peers.
  • Leverage ratios relative to peers.
  • The second valuation approach is the calculation of a specific portfolio company valuation. If this result is required, the valuation process must include a bottom-up analysis, where portfolio company valuations are then aggregated to the fund level. Each company would be examined to determine the best method for valuation – several valuation options being available.

    A clear distinction will at once be made between public and private companies. For public companies, value is based on the share price at the time of the valuation exercise. Public companies may be discounted (generally 10 to 50 per cent) to reflect factors such as lack of trading volume, sector volatility, and/or lockup on the general partner's shares in the company. Conversely, though more rare, shares may be valued at a premium to reflect an existing control position.

    Private equity cannot rely on market pricing to determine a value for its assets

    For private companies, different valuation methodologies are employed. The decision of which method or combination of methods to use includes length of investment period, size of company, access to information and stage of company (i.e. early-stage venture capital versus leveraged buyouts). The various methodologies are listed below. In certain circumstances, multiple methodologies are utilised and a weighted result is calculated.

  • General partner reported value – This figure represents the value reported by the general partner, as presented in the fund's current financial statements. This methodology is often used when an investment has been held for less than 12 months and no meaningful event(s) has transpired since the purchase, thereby making cost of investment a reasonable measure of value.
  • Public company and private transaction comparables – These methodologies entail valuing portfolio companies at a multiple of an activity measure, such as revenues, earnings before interest taxes, depreciation and amortisation (EBITDA) or earnings before interest and taxes (EBIT). Public company comparables are generated using the publicly traded enterprise value of companies operating within the same industry and which are of similar size as the portfolio company. Private company comparables are generated using the selling price of comparable companies, through merger and acquisition transactions, operating within the same industry and, again, where they are of a similar size as the portfolio company.
  • Discounted cash flow analysis (DCF) – The DCF method estimates a future equity value and then discounts this value back to the valuation date. In order to perform this calculation, five inputs are required:

    – The trailing operating performance metric (i.e. revenues, EBITDA, EBIT);

    – Valuation multiple;

    – Forecast growth rate of performance metrics;

    – Debt pay down rate;

    – Discount rate.

  • Index value method – The Index Value Method is an extension of the Capital Asset Pricing Model (CAPM), incorporating considerations for skewness and leptokurtosis of returns, time-varying Beta and correlations and liquidity. It can be presented thus:
    Where:
  • It is a public market index that is carefully chosen as a proxy for estimating the fair value and expected value of the portfolio company.
  • Specifically, each portfolio company is categorized by an industry sector corresponding to an appropriate public market index. The fair value is calculated by applying the percent change in value of the applicable index to either price per share, reported value or cost basis, adjusted for Beta. The change in index value is calculated between the date of the last round of financing and the valuation date or expected exit date.

    Assessing the potential return of an investment is equivalent to estimating the payoff function, expected share price or expected market value of the investment at a future date. The expected market price of an investment can be encapsulated in the following functional form: Where:

    And:

  • pi is the (a priori and ex post) probability of event I = 1,…, I;
  • xi is $ value of the investment if event I occurs;
  • yt-1 is the information available at time t–1;
  • ? is the lagged expectation function;
  • at is company specific factor (i.e. debt);
  • ϵ is economic or industry specific influence.
  • The valuation process begins, however, with a thorough review of the partnership financial statements. From here, the valuation agent accesses information in its database, as well as publicly available information to assess operating and financial conditions of portfolio companies and other factors affecting value.

    Further, where possible, the valuation agent holds discussions with the general partner sponsoring the fund to determine imminent realisation events, exits completed after the financial statement date, expected write-downs and write-offs, expected financings and other factors likely to impact the reported value.

    Good relations and access to the broader general partner community is essential for success in this process therefore.