Portfolio valuation

Portfolio Valuation For Venture Capital Funds

Best practices for quarterly and year-end marks.

Introduction

For many emerging fund managers, the first serious challenge to their portfolio marks arrives with the year-end audit, and the challenge tends to intensify as the fund's vintages mature. The financing rounds that once anchored each valuation recede further into the past, and the evidence supporting the marks grows stale with them.

The pressure is often most apparent as a fund enters its harvesting period, when portfolios tend to bifurcate: a small number of companies attract fresh financing and remain straightforward to evidence, while others raise no new capital for long periods and become increasingly opaque. It is these positions without recent financing activity, rather than the recently financed companies, on which the audit tends to concentrate.

The most effective response is usually a consistent, documented valuation process maintained throughout the year, rather than an argument assembled at the year end, so that each mark is already supported by contemporaneous documentation when the audit begins. This guideline sets out that process. It has been prepared from the author's experience of supporting funds through quarterly marking cycles and year-end audits, and its observations about market and audit practice are made on that basis.

The best practices set out in this guideline can be summarised as follows:

• estimate fair value for every investment at every measurement date, including investments carried at or near zero;
• calibrate valuation techniques to the price of the most recent orderly transaction, and update the calibrated inputs for current market conditions at each subsequent measurement date;
• apply valuation techniques consistently from period to period, changing them only where the change produces a more representative measure of fair value, and documenting the rationale for any change;
• maintain a written valuation policy and document the inputs, assumptions and significant judgements behind every mark, together with the rationale for the conclusion of value;
• subject marks to independent challenge, through a valuation committee, individuals outside the deal team or a third-party valuation specialist;
• incorporate backtesting, comparing actual exit outcomes to prior marks to improve the process; and
• apply the same methodology and rigour to quarterly marks as to year-end marks, with the depth of documentation and evidence increasing at the year end to support the audit.

The basis for the marks themselves is usually fair value. The International Private Equity and Venture Capital Valuation (IPEV) Board confirms fair value as the appropriate measure for valuing investments in and by private capital funds, a position underpinned by the transparency it affords investors who use fair value as an indication of the performance of a portfolio in the interim. Institutional investors also require fair value to make asset allocation decisions and to produce financial statements for regulatory purposes.

The primary focus of this guideline is funds reporting under US generally accepted accounting principles (US GAAP), where fair value measurement is governed by the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 820. The position under International Financial Reporting Standards (IFRS) is flagged where relevant. The two frameworks are closely aligned for fair value measurement: ASC 820 and IFRS 13 share a converged definition of fair value and substantially converged measurement and disclosure guidance, and under IFRS, financial instruments measured at fair value under IFRS 9 are measured in accordance with IFRS 13. The IPEV Guidelines, the practitioner layer that sits above both frameworks, are drafted to be compliant with IFRS 13 and ASC 820 in particular.

The guideline covers the valuation toolkit, the recurring areas of particular judgement in venture portfolios, the process and governance that surround the numbers, and the interface with the year-end audit and limited partner (LP) reporting. Fund-level matters, such as management fee calculations and carried interest waterfalls, are outside its scope.

The Fair Value Framework

The requirements that make a valuation process defensible begin with the definition of fair value and the timing of its measurement.

What fair value means

Fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date - effectively an exit price. The measurement is market-based rather than entity-specific: what matters is the assumptions market participants would use, not the fund's own intentions for the asset. A forced transaction, involuntary liquidation or distressed sale does not set fair value.

Every fair value measurement is built from inputs (the assumptions market participants would make), and entities should maximise the use of relevant observable inputs and minimise the use of unobservable ones. The inputs form a hierarchy. Quoted prices in active markets sit at the top; unobservable inputs (Level 3) sit at the bottom. Shares in private companies have no quoted prices in active markets, so the valuer must estimate fair value using one or more valuation techniques, and where the measurement rests on unobservable inputs it falls within Level 3, the category with the most extensive disclosure requirements.

None of this removes the judgement involved. Private capital valuation is inherently based on forward-looking estimates and judgements about the investee company, its market, the state of the mergers and acquisitions market, and stock market conditions at the measurement date.

Fair value is required at every measurement date

The fair value of each investment should be assessed at each measurement date, that is, each time a fair value based net asset value (NAV) is reported to LPs. Private capital managers usually report fair value to their investors on a quarterly basis, in accordance with the reporting requirements of the fund agreement. Fair value will generally change from one measurement date to the next, because portfolio company performance changes and markets change; however, it is possible that fair value at a subsequent measurement date is the same as theprior one.

A quarterly mark is therefore not a lighter form of valuation. The valuation techniques should be consistent from measurement date to measurement date, absent a change in market or investment-specific factors. What may reasonably differ in practice is the depth of documentation and refreshed evidence, which typically increases at the year end to support the audit. See the section on the year-end audit and LP reporting for more details.

The Valuation Toolkit

Calibration typically anchors venture marks, so it is taken first; the treatment of recent financing rounds and the techniques suited to early-stage companies follow from it.

Calibration

When the price of the initial investment in a company is deemed fair value (generally the case if the entry transaction is an orderly transaction), the valuation techniques expected to be used in the future should be evaluated using market inputs as of the date the investment was made. This process is known as calibration. It validates that the techniques, using contemporaneous market inputs, generate fair value at inception, and therefore that the same techniques, using updated market inputs at each subsequent measurement date, will generate fair value at each such date. Calibration is required by accounting standards.

Illustration (drawn from the IPEV Guidelines): an investment is purchased at fair value at an implied 8x earnings before interest, tax, depreciation and amortisation (EBITDA) multiple while comparable companies trade at 10x; the comparison implies a 20% discount that captures liquidity, control, growth and other differences. If comparable multiples later move from 10x to 15x, the valuer may conclude that the investee multiple increases to 12x, maintaining the calibrated discount – although the valuer would apply judgement rather than automatically carrying the initial difference forward.

Calibration is most relevant when the measurement date is close to the transaction date. However, even where a substantial period has passed, calibration can be used to check that unobservable assumptions remain consistent with the transaction price and that their evolution over time is reasonable, and to test whether the movement in the valuation between measurement dates is reasonable in the absence of a recent transaction. For a maturing portfolio, this is a mechanism for keeping an ageing entry price connected to current market conditions.

The price of a recent round as a calibration input

The fair value indicated by a recent transaction in the investee company's equity is used to calibrate inputs to valuation techniques; the price of a recent investment should not be considered a standalone valuation technique. It is also not a default: at each measurement date, fair value must be estimated using appropriate valuation techniques, and the price of a recent investment does not preclude re-estimating fair value.

Where the price at which a third party has invested is being considered as an input, the background to the transaction must be taken into account. Factors that may indicate the price was not wholly representative of fair value include:

• different rights attaching to the new and existing investments;
• disproportionate dilution of existing investors arising from a new investor;
• a new investor motivated by strategic considerations;
• market conditions existing when the price was agreed, regardless of the timing of close; and
• a transaction that may be considered a forced sale or rescue package.

One further caution applies. The value of a round of financing should not be applied automatically to other share classes without considering differences in rights and preferences; where such differences exist, the post-money equity value may not equal the value of the round, and it may be necessary to estimate the post-money value using a valuation technique.

Techniques for early-stage companies

For certain early-stage investments, option pricing models (OPM) or probability-weighted expected return models (PWERM) are deemed by some to provide a reliable indication of fair value where a limited number of discrete outcomes can be expected. Enterprise value could be estimated by assigning probabilities to value-increasing (future up round), flat, value-decreasing (down round) and value-eroding (zero return) scenarios, taking into account anticipated dilution, and discounting at an appropriate weighted average cost of capital. Selecting inputs for such techniques is highly subjective. When OPM or PWERM are used, they require initial calibration to fair value transaction values and recalibration for subsequent fair value rounds.

Areas Of Particular Judgement

The positions described in the introduction raise the recurring judgement calls in venture portfolios: rounds that have gone stale, financings that reset value, and positions written down towards zero. The IPEV Guidelines are clear that even in such situations the valuer must still come to a conclusion as to their best estimate of the hypothetical exchange price between willing market participants.

The stale round

A common situation is an investment whose last financing round is now several years old. The price of that round, if resulting from an orderly transaction, generally represented fair value as of the transaction date; but at subsequent measurement dates adequate consideration must be given to current facts and circumstances, including changes in significant market conditions and in the performance of the investee company. In practice, the calibrated valuation techniques should be used with then-current market inputs. Where the range of reasonable estimates is significant, reference to broad indicators of value change, such as relevant stock market indices, may assist; in some circumstances the valuer might reasonably conclude that the prior fair value remains the best estimate.

Illustration: a fund holds a Series B position priced several years earlier at elevated multiples. At each subsequent quarter-end, best practice is not to hold the round price until the next financing, but to run the calibrated technique (for example, a revenue multiple calibrated at entry) with current comparable company multiples and current company trading, and to document why the resulting movement is reasonable.

Down rounds and insider rounds

Where a financing is undertaken with existing investors participating in proportion to their holdings (an insider round), the commercial need for the transaction to be priced at fair value may be diminished, and the valuer needs to assess whether the transaction was appropriately negotiated. A financing with existing investors priced below the previously reported valuation (an insider down round) may nevertheless indicate a decrease in value and should be taken into consideration. Insider down rounds may take various forms, including converting all outstanding preferred shares into common equity, combining outstanding preferred shares into a smaller number of shares (a share consolidation), or cancelling all outstanding shares before a capital increase.

The zero mark

A misconception encountered in practice is that an investment marked to zero, or close to it, no longer requires the same valuation process and documentary support as the rest of the portfolio. The requirements make no such distinction. The fair value of each investment should be assessed at each measurement date; the valuer's rationale should be documented for all significant judgements; and scenario techniques treat a value-eroding, zero-return outcome as one probability-weighted branch, not as a default.

Two further points follow. First, the valuer should be wary of applying excessive caution in exercising judgement; marking an asset down to zero without analysis is therefore not a conservative safe harbour. Second, a zero mark that is later contradicted by an exit or refinancing is the situation that backtesting is designed to surface and explain, and it should be supported by the same documented view of what was known or knowable at the measurement date.

Process And Governance

Good marks depend as much on the process around them as on the techniques themselves: the written policy, the consistency of its application, the quarterly cycle and the discipline of backtesting.

A written policy, applied consistently

In addition to the application of the guidelines themselves, a robust valuation process will incorporate industry best practice regarding process and documentation. Best practice would include:

• a written, robust valuation policy that requires documentation of the procedures and methodologies used to determine the fair value of each investment in the portfolio;
• documentation of the inputs, assumptions and significant judgements included in the valuation analysis, and the rationale supporting the conclusion of value;
• use of an independent internal valuation committee and/or external advisers to review methodologies, significant inputs and fair value estimates for reasonableness; and
• incorporation of backtesting as a component of the valuation process.

Consistency is typically the first thing auditors and investors look for, and the guidelines require it: fair value should be estimated using consistent valuation techniques from measurement date to measurement date, unless there is a change in market conditions or investment-specific factors that would modify how a market participant would determine value. A change in technique is appropriate if it results in a measurement that is more representative of fair value in the circumstances. If a change is deemed appropriate, the basis for it should be clearly documented, including its nature and rationale.

The interpretive guidance on the standards takes the same line: in KPMG's view, it is not appropriate for an entity to change its valuation technique or policies to achieve a desired financial reporting outcome. Auditors tend to scrutinise frequent changes in methodology, and a documented rationale prepared at the time of the change is likely to be considerably more persuasive than one reconstructed at the year end.

Events that might appropriately lead to a change in technique include:

• a change in the investee company's stage of development (from pre-revenue to revenue to earnings);
• the development of new markets;
• new information becoming available;
• information previously used ceasing to be available; and
• changes in market conditions.

The quarterly cycle

A model quarterly marking process, consistent with the best practices above, runs as follows. The steps are a recommended articulation rather than a prescription of the guidelines themselves.

• Collect. The fund obtains current trading information from each portfolio company (revenue, cash, runway and any financing developments), together with market data for the calibrated comparable set.
• Prepare. A designated preparer updates the calibrated valuation technique for each investment with current inputs, documents the inputs, assumptions and significant judgements, and drafts the rationale for the conclusion of value.
• Challenge. A reviewer independent of the deal team examines the methodology, inputs and judgements; appropriate challenge requires the right level of seniority and expertise.
• Approve. The valuation committee (or equivalent) reviews the marks for reasonableness and approves them for reporting.
• Record. The pack for each mark, including preparer, reviewer, comments and approvals, is retained so that each quarterly mark has a complete audit trail from input to conclusion.
• Learn. Where exits or new financings have occurred, the realised outcome is compared with the prior marks, what was known or knowable at the time is articulated, and the lessons inform the next cycle.

Independence matters throughout. Challenge should be performed independently and avoid conflicts of interest, which can be achieved by involving individuals from outside the deal team, independent non-executives or a third-party valuation specialist.

Backtesting

Valuers should seek to understand the substantive differences that legitimately occur between the exit price and the previous fair value assessment. Backtesting compares an actual liquidity event (a sale, initial public offering (IPO) or round of financing) to recently determined fair value estimates. The exit price need not equal the previous mark; the comparison is an input to continuously improve the rigour of the estimation process. Valuations provide useful interim indications of the progress of an investment, but it is not until realisation that actual results are determined.

The Year-End Audit And Lp Reporting

The quarterly process culminates in the year-end audit.

Consistency of methodology and depth of evidence at the year end

Because valuation techniques, once selected, should be applied consistently from measurement date to measurement date, the year-end mark should not differ in methodology from the quarterly marks that preceded it, absent a documented change that produces a more representative measure of fair value. What changes at the year end, as noted above, is the depth of evidence: the audit tests the marks, and the documentation should anticipate that testing.

Regulators are focused on the same areas. Global regulators continue to focus on the private asset industry and are advocating for independence and transparency in valuation processes and methodologies. In the US, the staff of the Securities and Exchange Commission (SEC) has observed advisers that did not value client assets in accordance with their own valuation processes or disclosures, and noted that such failures led in some cases to overcharging management fees and carried interest on the basis of overvalued holdings.

Common areas of auditor focus, and the documentation that answers them, typically include the following, organised around the guidelines' requirements.

The qualifications of the valuer

It is clearly important to ensure that the people responsible for the marks have the expertise the task requires: providing appropriate challenge requires the right level of seniority and expertise. Independence can be achieved by involving individuals from outside the deal team, independent non-executives or a third-party valuation specialist within the governance framework.

My own perspective, from Verified Metrics' work supporting funds in valuing billions of dollars of assets each year, is that where an internal team lacks sufficient valuation experience, the year-end process tends to become more difficult. The audit challenge extends beyond the work to the credentials of those who performed it. In such cases it is common to engage a third-party valuation firm for independent insight and experienced professionals; the investment is usually repaid at the year end: audit processes tend to run more smoothly, and LP reporting becomes more robust and more consistent from quarter to quarter.

I would add a caveat. A third-party specialist does not displace the manager's responsibility for the fund's marks; the governance framework, the policy and the documentation remain the manager's to own.

Closing Remarks

The audit pressure described at the outset of this guideline is better answered during the year than at its end. Marks that are calibrated to recent transactions, produced under a consistent written policy, documented, independently challenged and backtested against outcomes are likely to withstand audit scrutiny and to support credible reporting at each measurement date, including for the older positions without recent transactions, where audit questions concentrate.

The effort needs to be tailored to the circumstances of the fund, the stage of its portfolio and the expectations of its investors and regulators. Investors in private capital expect valuers to apply sound valuation governance with a strong control framework, and regulators are advocating for independence and transparency in private asset valuations. The practices set out in this guideline reflect those expectations.