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Transparency and disclosure: valuation best practices in private equity

Even as a growing number of private equity funds embrace best practice standards in valuations, monitoring and reporting, some industry insiders warn there is little agreement among players as to what these mean. GPs proclaiming to act in the spirit of best practice often have widely divergent views on their application, even when following available guidelines, such as those issued by International Private Equity and Venture Capital (IPEV).

Some point to inherent difficulties in adopting standards across an industry operating diverse business models and investment types. Best practice is open to interpretation, they say, especially in the selection of comparables and multiples because standards cannot apply to every circumstance. There are also commercial sensitivities that often prevent GPs from disclosing their assumptions.

However, it is also the case that GPs can be either unable or unwilling to bring about the changes to their practices and processes that are required. Best practice often implies an overhaul of a GPs’ existing systems and operations, as was the case for UK-based global firm Apax Partners in 2006, when it applied IPEV Guidelines in 2006 as part of a strategic review.

“Our approach was to endorse transparency and good disclosure at the highest level. That means that we allocated the necessary resources, and built up all the required processes and reporting structures,” says Ivor Charlton, Funds Operations Manager at Apax. “The truth is that we see plenty of GPs that haven’t done that, and who only pay lip service to best practice, but don’t necessarily like the additional disclosure.”

Additional costs in infrastructure or human resources must be viewed in the context of what is happening more broadly across the investor market, he adds.

“The amount of detailed information requests from LPs during fund-raising has risen exponentially,” says Charlton. “They’re looking to analyse the portfolio and the GPs to an unprecedented extent, and if you consider that regulators are also under pressure to control risks in our industry, you can see this is a trend that will increase in the years ahead. GPs simply have to respond.”

While disclosure factors are unlikely to alter an investor decision, he says, fund-raising GPs with strong disclosure practices have the advantage of presenting fewer barriers during the due diligence process.

“The important thing in valuations is consistency year after year. Typically, the easiest way valuations are distorted is through the use of assumptions. We strive for consistency so that when we buy a company within a certain comp set or sector, we’re very clear on what assumptions will be used.”

According to Colin Southall, Director at independent valuation firm Markit, best practices from GPs will only be widespread as investors request it as part of their due diligence. In valuations, GPs can already differentiate via the use of a third-party valuator if investors are comfortable with the additional cost, which is not always the case.

“The bottom line is that good transparency and disclosure requires infrastructure and that inevitably has its costs. Whether these are of concern to GPs or LPs ultimately depends on the view of what private equity funds are earning their management fees for,” says Southall, adding that “transparency boils down to whatever’s been agreed between them in advance and is given in the quarterly reports.”

LPs want a robust process in place for valuations that can validate their capital allocation process. When expected outcomes don’t occur, then the question that arises is; how did the valuation impact their capital allocation process?

“Valuations must be prepared on a consistent basis over time so that performance can be calculated correctly,” he says. “There is a need for a controlled source of standardised data for input to valuations, in which only reviewed and approved inputs are used, and changes to inputs are tracked. This means that the valuation process can be repeated, if necessary, and that the impact of changes to input data can be assessed.”

According to Jorge Hansen, Director at private equity software company Baxon Solutions focused on Valuations and Portfolio Monitoring, LPs will generally welcome any initiative that gives more transparency to the ways in which GPs are managing their portfolio companies, including valuations and reporting and monitoring. Operating in a transparent, consistent and accurate way should be the default practice for every GP and not just a discussion topic during fund raising.

“GPs that operate in an efficient and transparent manner over time create awareness among LPs and no longer have to remind them about their practices. They have the processes and a platform that’s ready to go,” he explains. “Investors will understand how these internal processes work and what systems they use and how scalable they are.”

Hansen believes PE funds mostly find best practice too cumbersome to implement when they don’t have the appropriate tools to support the process.

“In many cases valuations are decentralised and done by different people from the various deal teams, which makes the process harder. A clear, defined and robust process, and the tools to support it are needed, but this is often seen to be out of reach,” he says. “Many of the smaller GPs may either not be aware of the existence of solutions for this particular process or have the perception that they are too expensive. This is increasingly not true, as the technology is becoming cheaper and there are new platforms that address these needs.”

Technology is helping to drive transparency, consistency and quality across the industry, he argues. GPs using a database-driven master repository of reliable and updated information on their portfolio performance and valuations can report more detailed information at short notice. They also reduce the need for human intervention and improve their accuracy and transparency.

A cross portfolio platform can also provide other functionality, he adds, such as the ability to simulate future exits and calculate the impact on returns at a fund level using multiple ‘what if?’ scenarios. These are projections that LPs are interested in seeing, but which GPs are often reluctant to provide. Traceability of changes and audit trails, as well as pre-defined validation rules and sign-off workflows are also basic elements required to conduct a transparent and robust valuation process.

For Apax’s Charlton, GPs of any real size will find it indispensable to use dedicated monitoring and reporting software to deliver the efficiencies they require for best practice. Apax manages 45 portfolio companies that are collectively worth some 20 billion dollars, he explains, and would have to hire significantly more headcount if it didn’t have a central platform to keep track of its performance.

“We use a flexible cloud-based platform that gives us the ability to sign on anytime and present our data as we want to,” he explains. “This means we can track our monthly performance based on the numbers the portfolio company CFOs and CEOs put into the system, and because of the platform we use we’re able to bring the data points together quite easily.”

Small GPs with just a handful of portfolio companies can still rely on spreadsheets and punching in the numbers manually, he adds, but those seeking to grow and access larger and more sophisticated investors will need to define their processes more clearly and have the tools in place to support them.

A comprehensive data management system can allow GPs to respond more effectively to increased investor demands for better and more insightful information, says Charlton, and in doing so remove the operational barriers to best practice implementation.

Matt Gower, Senior Writer for the Financial Services Industry

This article was written for the 2016 Preqin Global Private Equity & Venture Capital Report. For more information about the report, please visit www.preqin.com/gper or email info@preqin.com

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