Private Equity Valuation Guidelines

Below is a summary and personal interpretation of the International Private Equity and Venture Capital (“IPEV”) Guidelines to estimate the fair value of investments as part of a private equity funds’ reporting to its limited partners.

These guidelines contain a useful wrap-up of valuation best practices in a private equity context.

Please refer to the following link to access the actual guidelines as published by IPEV in December 2022 and related disclaimers: IPEV Valuation Guidelines 2022

The concept of fair value

• Fair value is the price that would be received to sell an asset:
  • Under current market conditions.
  • In an “orderly transaction” (not a forced liquidation or distressed sale).
  • Between “market participants” (buyers and sellers that are independent , knowledgeable, able to transact, and motivated but not forced to do so).
  • At the “measurement date” (date for which valuation is being prepared).
• For actively traded (quoted) investments, available market prices should be the exclusive basis to measure fair value.
• For unquoted investments, fair value assumes the investment is realized or sold, whether or not shareholders intend to sell shortly.
• Fair value should be estimated using consistent valuation techniques:
  • From one measurement date to the other, unless changes in market conditions or specific factors would warrant changing the technique:
    • Stage of development changes (pre-revenue to revenue to earnings).
    • New markets develop.
    • New information becomes available.
    • Information previously used is no longer available.
    • Valuation techniques improve.
    • Market conditions change.
  • For similar investments:
    • Characteristics.
    • Industries.
    • Geographies.
• The unit of account must be determined based on the likely exit:
  • Company as a whole (derived from Enterprise value).
  • Individual instruments.

Principles of valuation

• Assess each investment’s fair value at each measurement date.
• Exercize prudent judgement, using appropriate techniques and reasonable current market data and assumptions.
• Calibrate valuation inputs using the price of a recent investment (if such investment was done at fair value).
• Perform backtesting to improve future value investment estimates.

Allocate Enterprise Value

• For private equity investments, derive the price of each instrument using Enterprise Value (“EV”):
  • Determine EV using one of the valuation techniques described below.
  • Derive Adjusted EV by adjusting for factors that a purchaser would take into account e.g., surplus assets, excess liabilities, other contingencies and factors:
    • Excess or deficit vs. steady-state working capital.
    • Excess cash and other surplus assets.
    • Incentive compensation, bonuses, tax, deferred consideration, pensions and other on- or off-balance sheet liabilities, etc.
    • ESG related factors, e.g., decommissioning provisions, mandatory contributions, expected legislation.
  • Derive Attributable EV by deducting senior and/or dilutive instruments:
    • Deduct the value of any financial instruments ranking ahead of the highest-ranking instrument of the fund in a sale of the company:
      • Principal and prepayment penalties of higher-ranking debt if the latter would be repaid when the enterprise is sold.
      • Hypothetical negotiated value of higher-ranking debt otherwise, factoring favorbale or unfavorable terms (such as interest rates).
    • Factor dilutive instruments:
      • Options & warrants if fair value exceeds their strike price.
      • Applicable liquidation preferences.
      • Anticipated dilution at ultimate exit for early-stage investments.
  • Apportion Attributable EV between instruments per their ranking.
  • Allocate the amounts according to the fund’s holding in each instrument.

Exercize prudent judgment

• Apply care in exercizing judgment and making estimates.
• Beware not to apply excessive caution.
• Consider information that is known or knowable at the measurement date:
  • Value of a traded share at the measurement date.
  • Most contemporaneous financial information, adjusted for the known differing trend in performance.
  • Transaction anticipated to sign or close after the measurement date.

Calibration

• Calibrate valuation techniques using entry price and entry market inputs.
• For the multiple approach:
  • If an investment is made at a fair value of 10x EBITDA vs. 12x EBITDA for comparable companies, the difference (2 turns or 17%) incorporates liquidity, control, and other differences at entry.
  • If comparable companies move from 12x to 15x, one could maintain a consistent absolute or relative (percentage) movement, leading to a fair EV of 12.5x or 13x EBITDA, though the entry difference should not be automatic but only serve as a point of reference.
• For the DCF approach:
  • The implied WACC and implied company-specific risk premium can be derived from the initial price, initial BP and initial interest rates.
  • The WACC can then be updated (using the initial implied risk premium and prevailing interest rates) and applied to the udpated BP to derive subsequent fair value.

Backtesting

• Backtesting seeks to understand:
  • The substantive differences between the actual exit price and previous fair value assessments.
  • What information was known or knowable as of the measurement date and whether such information was properly considered.
• Backtesting can help identify areas of improvement for future fair value estimates:
  • Inherent biases (e.g., overly conservative assumptions).
  • Reliability of assumptions (e.g., maintainable EBITDA, normalized net debt).

Valuation methods

General principles

• Reflect exit expectations:
  • If exit is likely to be realized through a sale or IPO of the entire company, determine the fair value of each instrument by calculating and allocating estimated EV.
  • If a minority stake is being valued or if the fair value of the instruments depends on their specific cash flows and risks, EV may not be an appropriate starting point.
• Translate using the bid spot FX rate at the measurement date if the reporting currency of the fund differs from the instrument’s currency.

Apply judgement in selecting the appropriate valuation technique

• Use one or more of the following valuation techniques:
  • Market approach:
    • Multiples.
    • Industry benchmarks.
    • Market prices.
  • Income approach:
    • Company DCF.
    • Instrument DCF.
  • Replacement cost approach:
    • Net Assets.
• Calibrate the inputs to the price of a recent investment.
  • The price of a recent investment, if resulting from an orderly transaction, generally represents fair value as of the transaction date.
  • At subsequent dates, it may be an appropriate starting point for estimating fair value.
  • However, adequate consideration must be given to the current facts and circumstances (e.g., changes in market conditions or in the performance of the company), especially if there is a long period between signing / closing and the measurement date.

Multiples

• This technique involves applying of an appropriate multiple to a performance measure (e.g., earnings or revenue) of the company.
• Multiples have:
  • As their numerator a value, such as price or Enterprise Value.
  • As their denominator an earnings or revenue figure for any specified period of time (historical, current, or forecast).
• It is appropriate for an investment in an established business with an identifiable and maintainable stream of earnings or revenues.

Appropriate multiple

• When using the comparable company multiple approach, identify an appropriate set of publicly traded comparable companies.
• The best comparable company available may be a direct competitor or have similar performance metrics.
• Once a peer set is established, it should be consistently maintained unless other market information becomes available.
• The underlying accounting basis should be consistent, e.g.:
  • R&D costs.
  • Leases.
  • Revenue recognition.

Use of earnings multiples

• A number of earnings multiples or ratios are commonly used:
  • Price/Earnings (“P/E”)
  • EV/EBIT (Earnings Before Interest and Tax)
  • EV/EBITA (Earnings Before Interest, Tax and Amortization).
  • EV/EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization)
• The methodology to calculate a multiple should not change without good reason, and the reasoning should be appropriately justified.
• Where EBITDA multiples are available, these are commonly used.
• When EBITDA multiples are not available, P/E multiples may be used.
  • For a P/E multiple to be comparable, the entities should have similar financing structures and levels of borrowing.
  • Therefore, the P/E multiple should be applied to an EBIT figure adjusted for the impact of finance costs, working capital needs and tax impacts.

Use of revenue multiples

• Multiples of revenue may be appropriate for companies:
  • That have not yet attained sustainable profitability.
  • With negative earnings, if:
    • Losses are considered to be temporary.
    • A level of normalized maintainable earnings can be identified.
• They are often based on normalized earnings assumptions:
  • Sustainable profit margin, applied to
  • Forecast or historic revenues, adjusted for:
  • • Discontinued operations.
    • Terminated customer contracts.
    • One-time special revenue generating project.
    • Other non-recurring historical revenue sources.

Acquisition multiples vs quoted company trading multiples

• Multiples are usually derived from current market-based multiples:
  • Market valuations of quoted companies.
  • Price at which companies have changed ownership.
• The multiple derived from the acquisition price is calibrated with the multiple of comparable companies expected to be used in ongoing valuation estimates.
• Monitor and adjust over time the differences between the acquisition multiple and the comparable companies’ multiples, given differences between the company and comparable companies.
  • Assume the fair price of an investment implied an EV/EBITDA multiple of 8x when comparable company multiples were 10x.
  • In future periods, judgement is required as to whether such discount should remain based on changes in the company or comparable companies.
• Market-based multiples are assumed to be indicative of the value of the company as a whole, even though the market capitalisation of a quoted company reflects the price at which small parcels of shares are exchanged.

Identifying similarities and differences

• Identify companies that are similar, in terms of risk attributes and earnings growth prospects, to the company.
• This is more likely where the companies are similar in terms of
  • Business activities.
  • Markets served.
  • Size.
  • Geography.
  • Tax rates.

Impact of gearing (leverage) and tax on P/E

• In using P/E multiples, note that the P/E ratios of comparable companies will be affected by their financial gearing and tax rates.

EBITDA multiples and depreciation / amortization

• EV/EBITDA multiples, by definition, remove the impact of depreciation of fixed assets and amortization of goodwill and intangibles.
• If EBITDA multiples are used without sufficient care, one may fail to recognize that decisions to spend heavily on fixed assets or to grow by acquisition rather than organically have real associated costs, which should be reflected in the value.

Adjusting for points of difference

• Adjust the earnings multiple of comparable companies for differences in risk and  earnings growth prospects.
• Risk arises from a range of aspects, including:
  • The nature of the company’s operations.
  • The markets in which it operates.
  • Its competitive position in those markets.
  • Potential positive or negative impacts from legislation.
  • The quality of its management and employees.
  • Its capital structure.
  • The ability of the private equity fund to effect change.

The impact of lack of liquidity

• When considering adjustments to multiples, consider the liquidity difference between the company and its quoted peers.
• The risk is greater for a shareholder who is unable to control or influence a sale process.
• As a result, a purchaser would likely assign a higher risk to a minority position than to a control position.

Calibration

• Calibration provides a technique to objectively assess the value attributed to a lack of liquidity.
• Calibrate the acquisition multiple against market comparable multiples.
• Understand the differences, if any, at entry, as similar differences may be expected at subsequent valuation dates.

Other reasons for adjustment

• Other reasons why comparable company multiples may need adjusting include:
  • Size and diversity, and thus ability to withstand adverse economic conditions.
    • Diversity of product ranges.
    • Diversity and quality of customer base.
    • Reliance on a small number of key employees.
  • Rate of earnings growth.
  • Level of borrowing.
  • Any other reason the quality of earnings may differ.
  • Risks arising from the lack of liquidity of the shares.

Comparable recent transactions

• Recent transactions involving the sale of similar companies are sometimes used as a frame of reference in seeking to derive a reasonable multiple.
• Since such transactions involve the transfer of whole companies, one could argue that they provide a more relevant source of multiples than quoted comparable companies.
• However, recent transaction data is often undermined by the following:
  • Quality and availability of information:
    • Reliable pricing information for the transaction.
    • Generally lower reliability and transparency of reported earnings figures.
    • Lack of forward-looking financial data.
    • Other information to allow points of difference to be identified and adjusted for.
  • Amount of time that has passed since the transaction was negotiated.
    • Changes in market conditions.
  • Impact of reputational issues.
• Depending on the case, transaction multiples, comparable company multiples, or a combination thereof may best reflect buyers’ perspectives at the measurement date.
• In times of market dislocation judgment, it may not be appropriate to use transaction multiples, even if very recent, if the market is changing very rapidly.

Maintainable earnings / Maintainable revenue

• There is therefore a trade-off between the reliability and relevance of the earnings/revenue figures available.
  • The earnings/revenue figure should be reliable, which might favor the use of audited historical figures rather than unaudited or forecast figures.
  • However:
    • Quoted markets more often think of value in terms of current and forecast multiples, rather than historical ones.
    • In a dynamic environment, valuation should reflect the most recent available information.
• In any case, ensure the retained figure represents a reasonable estimate of maintainable earnings:
  • This implies the need to adjust for:
    • Exceptional, non-cash or non-recurring items.
    • The impact of discontinued activities and acquisitions on a pro-forma basis.
    • Forecast material changes in earnings.
  • Such adjustments should also be reflected in the multiple derived from comparable companies.

Industry valuation benchmarks

• Some industries use specific valuation benchmarks, such as price per bed (for nursing home operators) and price per subscriber (for cable television companies).
• Other industries use multiples of revenues as a valuation benchmark (e.g., financial services, IT, services withlong-term contracts) .
• These industry norms are often based on the assumption that:
  • Investors are willing to pay for turnover (revenue) or market share.
  • The normal profitability of businesses in the industry does not vary much.
• The use of industry benchmarks is more likely to be useful as a sanity check of values produced using other techniques.

Market prices

Quoted investments

• Instruments quoted on an active market (a market in which transactions take place with sufficient frequency and volume to provide pricing information on an ongoing basis) should be valued at the price within the bid / ask spread that is most representative of fair value.
  • For certain quoted investments, there is only one market price quoted representing, e.g., the value at which the most recent trade in the instrument was transacted.
  • For quoted investments that trade less frequently, e.g., certain debt investments, there may be two market prices: the lower bid price quoted by a market maker (i.e. a seller’s disposal price) and the higher ask price (a buyer’s purchase price).
  • An alternative to the bid price is the mid-market price (i.e., average of bid and ask).
• Even if a market is not considered active, observable transactions still provide an indication of value, and need to be considered in the fair value estimate.

Blockage factors and discounts

• Blockage factors adjusting quoted price because normal daily trading volume is not sufficient to absorb the quantity held should not be applied.
• Discounts may be applied if there is a governmental, or other legally enforceable restriction attributable to the security (e.g., shares which are not legally registered to be traded on an exchange), but not to the holder (e.g., limitations on sale imposed by holding a Board of Directors seat or by a lockup).
• The discount applied should appropriately reflect the time value of money and the enhanced risk arising from the reduced liquidity.

Observable prices

• In the absence of an active market for a financial instrument, fair value should be estimated by one or more of the other valuation techniques.
• When observable prices are available, such observable prices should be supplemented by additional valuation techniques.

Broker quotes and pricing services

• Funds investing in debt instruments and other infrequently traded instruments commonly use third-party sources—such as pricing services, quotes or indicative offers from brokers, dealers or other potential buyers—to assist in their fair value estimation process.
• Understand how a quotation or a price provided by a third-party source was determined: (1) who at the broker or dealer provided the quote, (2) whether the broker or dealer is active in assets of this type, (3) whether the quote is contemporaneous and binding, (4) whether the price is based on transactions of similar or identical instruments, and representative of a market to which the fund has access, (5) what disclaimers from the broker or dealer accompany the quote.

Company Discounted Cash Flows (“DCF”) or Discounted Earnings

• This technique involves deriving the value of a business by calculating the present value of expected future cash flows (or as a surrogate, the present value of expected future earnings):
  • Derive the Enterprise Value of the company, using reasonable assumptions and estimations of expected future cash flows (or expected future earnings) and the terminal value, and discounting to the present by applying the appropriate risk-adjusted rate that captures the risk inherent in the projections.
  • Derive Adjusted EV, by adjusting for surplus or non-operating assets or excess liabilities and other contingencies and relevant factors.
  • Derive Attributable EV by (1) deducting any financial instruments ranking ahead of the highest-ranking instrument of the fund in a liquidation scenario and (2) factoring the effect of any instrument that may dilute the fund’s investment.
  • Apportion Attributable EV between the relevant financial instruments.
• The cash flows and terminal value are those of the company, not those from the investment itself.
• Merits of the DCF technique:
  • Flexibility, as it can be applied to any stream of cash flows (or earnings).
  • Helpful to corroborate fair value estimates determined using market-based techniques.
• Drawbacks of the DCF tehcnique:
  • High subjectivity in estimating (1) detailed cash flow forecasts, (2) terminal value and (3) an adequate risk-adjusted discount rate.
  • Sensitivity to small changes in these inputs.
  • It is risky to apply this technique to businesses undergoing great change (e.g., rescue refinancing, turnaround, strategic repositioning, loss making, start-up).
• There is no hierarchy of valuation techniques, but the use of multiple techniques is encouraged.

Instrument DCF

• This technique applies the DCF concept and technique to the expected cash flows from the instrument itself.
• It is particularly suitable for valuing non-equity instruments, such as senior debt or mezzanine:
  • The value of such instruments derives mainly from instrument-specific cash flows and risks rather than from the value of the company as a whole.
  • Risk and corresponding rates of return are central commercial variables, thus there exists a frame of reference against which to develop discount rate assumptions.

Terminal value estimation

• Where the investment comprises equity, the terminal value is usually derived from the anticipated value of the company at exit.
• This will usually necessitate making assumptions about future business performance and developments and stock market and other valuation ratios.
  • In the case of equity investments, small changes in these assumptions can materially impact the terminal value.
  • In the case of non-equity instruments, the terminal value will usually be a predefined amount, which greatly enhances the reliability of the valuation conclusion.
• The terminal value should be based upon assumptions of the perpetuity cash flows accruing to the holder of the investment.
  • In some cases, this may be through a steady-state growth rate similar to long-term inflation, such as a Gordon Growth Model.
  • In other cases, the terminal value may be more appropriately estimated using an exit multiple.

Realization imminent and pricing agreed

• Where exit is imminent, and the price has been substantially agreed, instrument DCF is likely to be the most appropriate technique:
  • As a surrogate, a simple discount to the expected realization proceeds or flotation value may be used.
• The implied discount rate is calibrated at entry and adjusted over time for changes in the company and the market.

Valuing debt investments

• The fair value of a debt investment, absent actively traded prices, is generally derived from a yield analysis factoring credit quality, coupon, and term.
• Par value or cost value is not automatically fair value, even if there is sufficient EV to cover the liability.
• Debt investments, other than those traded in an active market, are generally valued using a DCF.
• The DCF paramaters are calibrated and adjusted over time: 
  • At entry, the internal rate of return (“IRR”) for a given debt investment can be calculated from the price paid and the expected cash flows.
  • An implied spread can be derived by subtracting the risk-free rate from the implied IRR.
  • The spread can be compared to observable spreads for issuances with similar duration and credit quality.
  • At subsequent dates, the risk-free rate is adjusted based on market conditions and the spread adjusted based on changes in credit quality and market conditions.
• Observable transactions are used to corroborate the results of the DCF analysis.
• The fact that a debt investment may be held to maturity is not relevant as fair value presupposes an exit transaction at each measurement date.
• Non-performing collateralized debt is often valued based on:
  • The value of underlying collateral.
  • The risk of converting the collateral into cash.
  • The time required to convert the collateral into cash.
• Non-performing debt which is uncollateralized or expected to be restructured is valued based on expected discounted recovery proceeds.

Net assets

• The Net assets technique involves deriving the value of a business by reference to the fair value of its net assets:
  • Derive the Enterprise Value for the company using the perspective of a purchaser to value its assets and liabilities.
  • Derive Adjusted EV, by adjusting EV for surplus or non-operating assets or excess liabilities and other contingencies and relevant factors.
  • Derive Attributable EV by (1) deducting any financial instruments ranking ahead of the highest-ranking instrument of the fund in a liquidation scenario and (2) factoring the effect of any instrument that may dilute the fund’s investment.
  • Apportion Attributable EV between the relevant financial instruments.
• This technique is likely to be appropriate for a business:
  • Whose value derives mainly from its assets rather than its earnings, such as asset-intensive companies and investment businesses (e.g., fund-of-funds).
  • That is not making an adequate return on assets and for which a greater value can be realized by liquidating the business and selling its assets:
    • Loss-making companies.
    • Companies making only marginal levels of profits.

Calibrating to the price of a recent investment

• Use the fair value indicated by a recent transaction in the company’s equity to calibrate inputs used with various valuation methodologies.
• Assess at each measurement date whether changes or events subsequent to the relevant transaction would imply a change in fair value.
• Do not use the price of a recent investment as a standalone valuation technique.
• Where an investment was made recently, its cost may provide a good starting point to estimate fair value or recalibrate inputs to the valuation model.
• Do not automatically apply the value of a round of financing to other share classes without consideration of different rights and preferences among share classes. When such differences in rights and preferences exist, other share classes may be subject to different risks and return expectations, impacting the value of those share classes relative to the investment. In such cases, the post-money equity value may not be equal to the value of a round of financing, and it may be necessary to estimate the post-money value using a valuation technique.

Price of Recent Investment is not a default

• The price of a recent investment is not a default that precludes re-estimating fair value.
• Where the price at which a third party has invested is considered as an input , the background to the transaction must be taken into account.
• The following factors may indicate that the price was not wholly representative of fair value at the time:
  • Different rights attach 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 upon by parties regardless of timing of close.
  • The transaction may be considered to be a forced sale or rescue package.
• In times of market dislocation, it may not be appropriate to use recent transaction prices, especially those negotiated before a market dislocation.

Complex capital structures

• Many early-stage companies are financed by a combination of different classes of equity, each of which provides its holders with unique rights, privileges, and preferences.
• Often, these companies issue both preferred and common shares, and options or warrants, with the preferred stock comprising several series resulting from successive rounds of financing, each of which has rights that likely differ from those of other series.
• When estimating fair value, determine how each class of equity would participate in distributions from a sale or other liquidity event and the implications for the fair value of each class of equity.

Valuing seed, start-up and early-stage (pre-revenue/pre-earnings) investments

• Early-stage investments, pre revenue or pre earnings, may require additional judgment in determining fair value.
  • Early-stage investments often have less measurable key performance indicators and may have limited outcomes: success, liquidation, or failure.
  • It may be difficult to gauge the probability and financial impact of success or failure of R&D and to make reliable cash flow forecasts.
  • The “headline” value (fully diluted value of all shares times the price paid per share for a recent financing round) rarely takes into account the rights and preferences of more junior share classes.
• When valuing early-stage investments, at each measurement date, consider the qualitative factors impacting value:
  • Is the investee company performing at, above, or below expectations;?
  • Is cash burn above, at or below expectations?
  • Is customer or market acceptance of the product or service meeting expectations?
  • Has the company changed its strategy or pivoted to a new market?
  • What is the likelihood, timing, and pricing of the next financing round?
  • How is the broader market performing with respect to comparable companies?
  • How close is an exit and who would be the buyer: IPO, Strategic M&A, Financial Sponsor, Liquidation?
  • Based on an assessment of these and other factors it can generally be determined whether fair value has increased, decreased or stayed the same. The magnitude can be determined using calibrated models.
• The following valuation techniques may be helpful to value seed, start-up and early-stage investments:
  • Milestone or scenario-based method: A forward-looking method that considers one or more possible future scenarios, using industry-specific benchmarks/ milestones. These methods include simplified scenario analysis and relative value scenario analysis, which tie to the fully-diluted (“post-money”) equity value, as well as full scenario analysis, also known as the probability-weighted expected return method (PWERM).
  • The option pricing method (OPM), a forward-looking method that considers the current equity value and then allocates that value to the various classes of equity considering a continuous distribution of outcomes, rather than focusing on distinct future scenarios.
  • The current value method (CVM), which allocates the equity value to the various equity interests in a business as though the business were to be sold on the measurement date.
  • The hybrid method, a hybrid of scenario-based methods and OPM.
• Depending on the stage, likely exit, and level of influence of the fund, some techniques may be more appropriate than others:
  • Seed and early growth stage: Where there is expected to be a longer holding period prior to a sale or IPO (i.e., seed stage and early growth stage), share classes may be subject to different levels of risk and return expectations. In such cases, scenario analysis, OPM, or the hybrid method may help determine the relative value of each share class, while CVM may not be adequate.
  • Exit to a financial sponsor: Accounting practices in certain jurisdictions place more weight on a hybrid approach or OPM approach during early stages of an investment when the likely exit would be to another financial sponsor who would take into account rights and preferences of various security classes.
  • Exit via IPO or M&A: As an investment progresses to nearing an exit through an IPO or a strategic M&A transaction where all shareholders may receive the same price per share, more weight is generally given to a common stock equivalent or fully diluted approach to estimating value.
  • Influence over liquidity event: CVM may be most appropriate where the fund has significant influence to effect a liquidity event and a liquidity event for the whole business is anticipated in the near future.
  • Benchmarks/milestones: Many seed, start-up or early-stage investments are valued using a milestone approach or scenario analysis given there are no current and no short-term future earnings or positive cash flows. Missing a benchmark/milestone may provide indication of a decrease in value while exceeding a benchmark/milestone may provide evidence of an increase in value.

Common milestones / benchmarks

• For an investment in early or development stages, a set of agreed milestones is typically established at the time of making the investment decision. These will vary across types of investment, companies and industries, but are likely to include:
  • Financial measures:
    • Revenue growth.
    • Profitability expectations.
    • Cash burn rate.
    • Covenant compliance.
  • Technical measures:
    • Phases of development.
    • Testing cycles.
    • Patent approvals.
    • Regulatory approvals.
  • Marketing and sales measures:
    • Customer surveys.
    • Testing phases.
    • Market introduction.
    • Market share.
• In addition, the key market drivers of the company, as well as the overall economic environment, are relevant to the assessment.

Typical indicators of a change in fair value

• In applying the milestone analysis methodology, assess whether there is an indication of change in fair value.
• Considering whether there have been significant changes:
  • In the results of the company compared to budget plan or milestone.
  • In expectation that technical milestones will be achieved.
  • In the market for the company or its products.
  • In the economic environment.
  • In the observable performance or valuation of comparable companies.
  • In internal matters such as fraud, commercial disputes, litigation, management, or strategy.

Adjustment to fair value in such circumstances

• If there is an indication that fair value has changed, estimate the amount of any adjustment.
• These adjustments are likely to be based on a mix of objective data from the company and experience, but their necessity and magnitude require a large amount of judgement.
• Where deterioration in value has occurred, the carrying value of the investment should be reduced to reflect the estimated decrease.
• If there is evidence of value creation, consider increasing the carrying value as viewed by a purchaser.
• In the absence of additional financing rounds or profit generation, consider what value a purchaser would place on these indicators, taking into account the potential outcome and the costs and risks to achieve that outcome.

DCF technique may be useful as a cross-check

• In the absence of significant revenues, profits, or positive cash flows, other methods such as the earnings multiple are generally inappropriate.
• The DCF methodology may be used as a cross-check.
• However, the disadvantages of DCF, arising from the high levels of subjective judgement, may render it inappropriate without corroborating support.

Valuing fund interests

General

• To measure the fair value of an interest in a fund, the proportion of the last reported fund net assset value (“NAV”) may be used, if such NAV:
  • Is derived from the fair value of underlying investments.
  • Has been adjusted for significant known or knowable changes and for incentive payments.

Adjustments to NAV

• NAV should be adjusted such that it is equivalent to the amount of cash that would be received if all underlying companies were realized as at the measurement date.
• Factors which might result in an adjustment to the last reported NAV include:
  • Reported NAV is not fair value based.
  • Significant time has elapsed since the measurement date of the fund NAV, especially if:
    • The fund has made subsequent investments or realizations.
    • There have been subsequent changes in the fair value of underlying companies.
    • There have been subsequent changes in market or other economic conditions.
  • Information from an orderly secondary transaction.
  • Appropriate recognition of potential performance fees or carried interest in the fund NAV.
  • Waived management fees included in NAV.
  • Impact of clawback provisions.
  • Features of the fund agreement which are not captured in the NAV.
  • Materially different valuations by different general partners (GPs) for common companies and identical securities.
  • Other facts and circumstances which might impact underlying fund value.

Secondary transactions

• The transaction price of an orderly secondary transaction in the fund must be a component to measure fair value.
• Such transactions are typically infrequent and opaque.
• Factors unique to the counterparties may influence secondary prices.
• If orderly secondary transaction prices are available but not deemed active, other valuation inputs (e.g., NAV) should also be considered.

Other valuation approaches

• When NAV cannot be used as a starting point and market information is not available, a DCF analysis of all future cash flows of the fund may be used.

Additional considerations

Unit of account

• Enterprise Value is generally the appropriate starting point.
• When the investment is in multiple securities or tranches:
  • If market participants would be expected to purchase all positions simultaneously, then fair value should be measured for the aggregate investment.
  • If individual tranches would be purchased individually, the unit of account would be the individual tranche.

Insider funding rounds

• When a round of financing only involves existing investors in the same proportion, the price may not be reflective of fair value.
• However, a financing round with existing investors priced at a lower valuation may indicate a decrease in value.

Distressed or dislocated markets

• Geopolitical, macroeconomic or other significant events may give rise to dislocated or excessively volatile markets.
• In such times, the premise of fair value remains the same.
• Heightened focus should be placed on the following:

Company operational or performance impacts

• Determine the market impact on the company’s revenue/customers, supply chain, and operations currently and forward looking.
• Assess whether revenue and earnings metrics are maintainable.
• Assess the impact of the market conditions on cash balances and the impact of one-time cash demands.
• Determine whether market participants would use metrics based on last twelve months (LTM) or next twelve months (NTM).
• Assess the impact of extended reduced cash flow due to depressed operations; including potential covenant breaches.

Comparable company valuation impacts

• Determine appropriate multiples reflecting the current market environment (including risk and uncertainty in projections and historical results).
• Ensure multiples are consistent with the metrics to which they are applied.
  • The percentage change in market capitalization of comparable public companies may provide a good proxy for the magnitude of change in multiples.
  • Determine whether company performance metrics have been adjusted for current conditions and future expectations when comparable public company results do not yet reflect the change in results and expectations.

Valuation techniques

• Determine whether a scenario analysis is necessary to incorporate the probability of extended market dislocation.
• Determine alternative markets or valuation techniques for listed securities where trading has been suspended.
• In times of market dislocation, if performance metrics have been adjusted to take into account lower expected results, an appropriate multiple should be applied rather than a multiple derived from comparable public companies whose metrics have not yet included lower expected results.
• When using an income approach the discount rate should be consistent with the risk inherent in the cash flows used.

Impact of risk

• Greater uncertainty translates into increased risk and required rates of return, thus lower multiples, even in the absence of recent transaction data.
• Assess the direct and indirect impact of government sanctions on the company.
• Assess the possibility of increased counterparty risk including the ability for insurance claims to be paid out.

Distressed transactions

• Consider the following indicators to assess whether a transaction is distressed or forced:
  • Legal requirement to transact, e.g., regulatory mandate.
  • Necessity to dispose of an asset immediately with insufficient time to market that asset.
  • Existence of a single potential buyer as a result of the legal or time restrictions imposed.
  • Seller is in or near bankruptcy or receivership.
  • No adequate exposure to the market to allow for usual and customary marketing activities.
  • Transaction considered an outlier.
• If the transaction is not orderly based on the factors above and not because of market conditions, then its price may not reflect fair value and other valuation techniques should be employed.

Bridge financing

• Funds may grant loans to a company pending a new round of equity financing (bridge financing), e.g., in anticipation of an initial or follow-on investment by the fund.
• In the case of an initial investment, the bridge loan should be valued in isolation:
  • If the financing is expected to occur in due course, cost may be the best indicator of fair value, unless market or company specific conditions indicate otherwise.
  • If the company is expected to have difficulty arranging the financing, and its viability is in doubt, fair value should be reassessed.
• If the bridge financing is provided in anticipation of a follow-on investment, it should be included, together with the original investment, as a part of the overall package being valued to the extent a market participant would be expected to combine the overall investment.

Debt investments

• Debt investments take many forms (senior debt, mezzanine loans, shareholder loans, etc) and include a cash or payment-in-kind (“PIK”) interest, and/or equity enhancements, such as warrants.
• The fair value of debt investments should generally be determined on a standalone basis.
• The price at which the debt investment was made or the loan was issued may be a reliable indicator of fair value.
• The value of warrants should be disaggregated when calibrating the initial yield and fair value of the debt and option components.
• If debt is a standalone investment, a market participant would take into account risk, coupon, time to expected repayment, and other market conditions in determining its fair value, which may not be equivalent to face value.
• At subsequent dates, consider whether changes in credit risk or required yield would impact fair value.
• There may be observable trading activity which provides an indication of value. If trades occur, such information should be included in the valuation analysis, provided one has determined how a quotation or a price provided by a third-party source was determined and to what extent it is contemporaneous and actionable.
• Debt investments are typically valued by a DCF since the cash flows and terminal values may be predicted with reasonable certainty.
• Warrants attached to mezzanine loans should be considered separately from the loan.
  • An appropriate valuation technique should be selected for the company, and the % ownership that the exercised warrants will confer to that valuation should be applied.
  • If the warrant position is significant, an option and warrant pricing model may be used.
• If the debt investment is one of a number of investments held by a fund in the company, the debt investment and any attached warrants should be included as a part of the overall package being valued, to the extent that a buyer would combine the investments.
• At all times, but especially in times of market dislocation or distress, the following may require extra emphasis:
  • The fair value of a debt investment, in the absence of actively traded prices, is generally derived from a yield analysis factoring credit quality, coupon, and term.
  • Par value or cost value is not automatically fair value, even if there is sufficient EV to cover the liability.
  • Credit quality (repayment risk) must be assessed.
  • Non-performing debt is considered differently from performing debt.
  • Changes in interest rates, credit spreads, credit ratings, and other market terms and conditions will impact fair value.

Rolled up loan interest

• Many financial instruments accumulate interest that is only realised on redemption of the instrument (e.g. deep discount debentures or PIK notes).
• Assess the expected present value of the amount to be recovered, including anticipated enhancements such as interest rate step increases.

Indicative offers

• Indicative offers received recently from a third party for the company may provide a good indication of fair value.
• Before using the offer as evidence of fair value, consider the motivation of the bidder.
• Indicative offers may be made: 
  • Deliberately high:
    • To open negotiations or gain access to the company
    • But subject to stringent conditions or future events.
  • Deliberately low:
    • If the bidder believes the seller is in a forced sale position.
    • To increase their stake at the expense of other less liquid stakeholders.
• Accordingly, such offers are generally insufficiently robust to be used in isolation.
• As an offer moves to the contracting stage and ultimately to closing, more weight may be placed on it.
• A negotiated price for a transaction that has not yet closed, would be adjusted for the uncertainty associated with the pending transaction.

Impacts from structuring

• Structuring may include the following rights:
  • Stock options and warrants.
  • Anti-dilution clauses.
  • Ratchet clauses.
  • Convertible debt instruments.
  • Liquidation preferences.
  • Guaranteed IRR.
  • Commitments to take up follow-on capital Investments.
• These rights should be reviewed on a regular basis to assess whether these are likely to be exercized and the impact on value of the fund’s investment.
  • If the holder will receive an enhancement in value by exercizing, it should be assumed they will exercize.
  • Surplus cash resulting from the exercize price should be factored.

Contractual rights

• Deferred consideration contingent upon future events may be used where significant value lies in the outcome of future uncertain events.
  • Sellers may realize a price they think is fair, taking into account future performance they deem both valuable and likely, but that has not yet been achieved.
  • Buyers may delay paying for value before it fully crystallizes, and thus protect their investment.
• An income approach (DCF) will likely be the best tool to estimate fair value.
• The cash flows should be:
  • Probability weighted for expected outcomes.
  • Discounted using an appropriately chosen discount rate.

Non-control investments

• EV  is generally the starting point for determining fair value, because investors either have control or have invested together with other investors such that value at exit is maximised by the sale of the enterprise.
• In certain cases, the unit of valuation may not be the overall enterprise, e.g., where a non-controlling or minority interest is purchased, and the controlling shareholders interests are not aligned. In such cases:
  • Value may not be maximized through the sale of the enterprise.
  • The controlling shareholder may have no intent or need to sell the enterprise.
  • Fair value should be determined assuming the buyer is for the minority interest.
  • A market or income approach may be more appropriate.

Mathematical models & scenario analysis

• Mathematical option pricing models are not widely used in a private equity context.
• Option pricing models (OPM) or probability-weighted expected return models (PWERM) can be used for early stage investments with a limited number of discrete outcomes.
• EV could be estimated by:
  • Assigning probabilities to value increasing (future up round), remaining the same (flat round), decreasing (down round), and eroding (zero return), taking into account anticipated dilution.
  • Discounting the future funding event using an appropriate WACC.
  • Allocating EV, using estimated probabilities, to individual securities using a liquidation or exit approach meaningful for each scenario.

Sum of the parts (“SOTP”)

• Where the company has distinct parts with different metrics, fair value may determined by aggregating the individual fair values of each part.
• The allocation of overhead costs should be considered.

Real estate investments

• A market approach and/or DCF is generally used when valuing real estate investments.

Infrastructure investments

• Infrastructure investments are often valued using a DCF, based on free cash flow to equity (“FCFE”) or a dividend discount model (“DDM”).

ESG factors

• ESG factors are becoming an increasingly important focus of investors, regulators, and governments.
• They may impact fair value from both a qualitative and quantitative perspective.
  • Impact on projected cash flows, positive or negative, from ESG actions: e.g., alternative energy sources, employee, facilities and supply costs, etc.
  • Impact from changed risk profile (judgemental impact)
  • Comparability of peer companies.
  • Proximity of buildings to coastal areas and risk of flooding.
  • Impact of employing a more diverse workforce, management team or board of directors.
  • Likelihood of governmental action impacting a business model.