(Estimated reading time: 4 minutes 21 seconds)
The article in brief:
- Private equity and private debt investors are acutely focused on new AICPA Guidance that recommends a “calibration” approach for valuing private securities.
- Calibration, especially for debt, leaves a great deal of room for judgment on the part of valuation professionals as to the appropriate inputs, notably around original issue discounts (OIDs) and origination and commitment fees.
- While investment fund managers are rapidly becoming comfortable with the concept of calibration, they would do well to make sure their investors, auditors and other interested parties fully understand their policies and procedures.
The private equity and private debt investors VRC works with have made great strides in recent months in their understanding of the AICPA’s nearly finalized Guidance, “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” and their plans for incorporating the Guidance in their ongoing portfolio valuation processes and periodic NAV determinations (the “Guidelines”).
The most discussed element of the Guidance is the concept of calibration, which it defines as:
“The process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the original observed transaction as well as any more recent observed transactions in the instruments issued by the portfolio company.”
To put that in more straightforward terms, calibration is figuring out what the day-one estimated yield and price is for debt, or the multiple and price is for equity as well as selecting and establishing the at investment relationship to respective debt and equity valuation benchmarks.
Subsequent to the calibration, the investment valuation is reviewed by portfolio managers and third-party valuation professionals and potentially modified by adjusting key valuation variables (such as yield spreads for debt and market multiples for equity) based on changes in the market benchmarks as well as changes in the subject company’s performance relative to comparable market performance.
As they look to begin applying this concept to their portfolios, investors are finding that in lieu of definitive, prescriptive direction, the Guidance leaves significant scope for judgment, including on the debt side. In other words, they are discovering—and slowly but surely getting comfortable with—the notion that the AICPA Guidance is just that, Guidance, and that benchmark calibration is as much art as it is science.
Calibration for Equity
For equity, the calibration process is relatively straightforward. It essentially entails building a set of comparable public companies and understanding if and why the subject company transaction was executed at a premium or discount to these benchmarks. This discount or premium would be modified over time based on the subject company’s relative performance.
Also, normally for private equity style investment, both control and minority ownership positions, are treated equally as they are part of the same investment group. Control investors give minority investors valuable information and liquidity rights over the targeted hold period, effectively leveling the playing field, so all interests are aligned. Hence, minority or illiquidity interest discounts are not often applied to minority positions for private equity transactions. Liquidity discounts may be subsequently applied if the minority equity investors seek to leave the control group by giving up their rights and seek to sell their minority interest piecemeal.
Another point of clarification in the new Guidelines is around purchase transaction fees. All transaction fees and expenses incurred to close the business purchase are to be excluded from the calibrated purchase price and valuation multiple. Consequently, this would result in a Day 2 loss in the actual equity outlay/cost equal to the amount of the transaction costs.
Calibration for Debt
Calibrating debt investments, particularly those of middle market companies, can be trickier, both because comparable securities that match or approximately match in terms of both sector and maturity can be a challenge to find and because of the tenuous correlation between bonds and large syndicated bank loans that trade publicly and the less liquid, and in many cases less volatile, privately negotiated debt instruments contemplated by the Guidance.
Because of fundamental differences between the two markets, mechanically benchmarking private loans to off-the-shelf indices of publicly traded credits can produce questionable outcomes. For example, private debt market participants have pointed out that the public credit market dislocations that marked the final few months of 2018 hardly caused a ripple in private credit markets. Despite significant spread widening in public debt markets, private first lien debt held fast in the LIBOR+400-500 range in late 2018, while unitranche deals were still being originated around L+600.
VRC employs a proprietary matrix approach to private credit benchmarking that draws on a wide variety of sources: yes, secondary market indices of syndicated bank loans have their role in the calibration process, but we find we can improve comparability by custom tailoring syndicated loan indices to only include middle-market borrowers.
Other sources for VRC’s matrix include direct lending data from Reuters and conversations with capital markets professionals (since primary market deal levels are often a better indicator than secondary, which can be muddied by active traders and distressed borrowers).
Last but not least, we look across our book of business, which entails looking at hundreds of private credits across multiple clients every month, and apply those insights back to security-level valuation. Similarly, we recommend investors include data from their firm deal origination to calibrate credits they already own.
The Practical Context for Calibration
Private equity and private debt funds are becoming increasingly comfortable with the calibration concepts delineated in the Guidance, but other interested parties may require some education. As they incorporate calibration concepts in good faith, fund managers should prepare for pointed questions from their investors—who, after all, is mostly focused on the public markets—as well as from auditors and even regulators, all of whom are going to be latching on to calibration.
It is fair to assume their questions will increase if the current record economic expansion runs out of steam, some assets become stressed, and the fundamental differences between how public and private markets respond to stress are brought into even sharper detail.
Our best advice for investors is to get out in front of the issue now by documenting their calibration policies and procedures, making sure they are consistently applied, and investing time and energy educating LPs and other constituencies on their approach.
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