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12 Rules For Good Valuations - Hedge and PE

10/26/18 1:39 PM

Castle Hall recently attended Seward & Kissel's excellent 4th annual Private Funds Forum in New York. The event included a knowledgeable panel on valuation best practices for alternative funds. The discussion covered 12 points, which make great rules for effective valuation procedures, across both hedge and private equity.

  1. Create an effective valuation policy. The policy document should not be vague and generic: the policy should discuss, in detail, the pricing process in place for all material classes of instrument traded in the portfolio. A regurgitation of the generic language from the offering memo does not cut it.
  2. Any change in the valuation policy / valuation methodology should be documented. A noted risk was a stale valuation policy which has not been updated to reflect new types of investments added to the portfolio, or has not been amended to reflect new valuation methods adopted by the manager for particular securities.
  3. If the valuation policy says that the valuation committee will meet monthly. Any discrepancy between documented procedures and actual manager behaviour, in any area, is a clear invitation for SEC findings.
  4. Broker quotes #1: do not write in the valuation policy that the manager will take a minimum of 3 broker quotes and average - when, in the majority of instances, only 1 or 2 quotes are received. The policy should reflect the actual reality of the pricing process.
  5. Broker quotes #2: if a security is priced to a single broker quote, simply saying that the asset is Level 3 is not enough. Does the manager understand how the broker is pricing the asset themselves? Is the mark based on a recent transaction? Is it mark to model? Interpolation, matrix pricing? Investors expect accurate, fair and timely valuations: the manager should understand the basis of pricing for any instrument in the portfolio.
  6. Broker quotes #3. While the valuation policy may state that there is an "independent" valuation committee (majority of back office professionals), if broker quotes are used, who is responsible for sourcing the quotes? The SEC will quickly identify if quotes are actually sourced by front office investment professionals, inhibiting true independence in the valuation process.
  7. Broker quotes #4. Quotes should be used consistently. Who is responsible for creating the list of which brokers can be circularized? Who updates that list (with what documentation as the rationale for changes?) If there are 10 brokers on the list, but the manager only uses 2, what is the rationale? How are changes to brokers circularized determined and documented?
  8. Price over-rides: the rationale for price over-rides should be documented, and any price over-ride should be carefully reviewed. If price over-rides are frequent, then should the price methodology dictated in the valuation policy be updated?
  9. The manager cannot simply rely on pricing services. While pricing services provide third party independence, managers cannot simply go on valuation "autopilot". Is the manager trading in the securities and has actual transaction evidence at different prices? Does the manager have access to other pricing sources (e.g. broker quotes) which show materially different prices?
  10. PE Pricing: optimistic projections. The session also touched on PE pricing. The auditor will look at the pricing methodology for underlying portfolio companies: even if a valuation is indicative (no crystallization of an incentive fee in a PE company), the auditor will not accept an unduly optimistic financial forecast for a start up company.
  11. PE Pricing: recent transactions. If referring to "recent" transactions, a PE firm should ensure that the transactions are actually recent - not 2 years old plus. Equally, if a PE firm is taking account of recent transactions to support valuations, they should include all transactions - not maintain a static list which becomes outdated, ignoring more recent sales activity in the relevant industry. If a new transaction is excluded from the data set, is the rationale (e.g. a distressed sale) documented?
  12. PE Pricing: underlying portfolio company information. PE valuations, either on an income basis (discounted cash flow) or market basis (multiples of revenue / EBITDA) rely on the current financial position and future financial projections of the underlying portfolio companies. Valuation agents will typically obtain this information from the manager (GP), and not independently contact the portfolio company in question to obtain this foundational financial information. It is, equally, absolutely critical for the auditors to perform exactly the same procedure - they MUST get financial data from the underlying company, rather than rely on a spreadsheet given to them by the deal team. This latter point is, in Castle Hall's view, a pervasive weakness in PE land (although the audit partner on the Seward panel confirmed that his audits always require direct contact with underlying portfolio companies). Plenty more to write on this topic!

Many thanks to the team at Seward & Kissel for an informative event.

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