The Case for Improving VC Portfolio Valuation Methodology in 2020
By Nick Callais
With the first half of the year in the books, VC firms need to address valuations for their portfolio companies and factor in the large impacts of COVID-19 starting in Q1 and Q2. It’s more important now ever to be engaging third party valuers or employing a sophisticated blended approach to create valuations that remove large impacts from market uncertainty and individual assumptions that can drive valuation approaches. This is particularly true when only one method is used such as intrinsic value methods (DCF), cost, various relative valuation methods, or asset based approaches (as appropriate in certain industries).
The challenge for valuers this year comes from the uncertainty on the length and shape of the market recovery in addition to the direct impact of this event on each portfolio company. These recovery assumptions are different for each manager and the expectations of each VC firm will impact the results. Additionally, this negative environment may have managers adjusting their valuation process to provide more favorable results that show that their portfolio companies are minimally affected. Some will even attempt to keep the values constant despite the significant loss of revenue by claiming this is all very temporary. These are major reasons why outsourcing the valuation or employing a blended approach is best.
A consistent and reliable methodology is required across time to provide useful data to limited partners. The existing valuation playbook should not be dropped as a result of this negative event in the market. The methodology employed should only be enhanced by a better blended approach to address the uncertainty in the market in a more measured and thoughtful way.
The markets can take good news and the markets can take bad news, but what the markets hate is uncertainty
The recovery uncertainty and volatility is a huge part of what is hurting capital markets. Most economists believe that a partial to full recovery is likely, but it’s a question of when. Most portfolio companies who have strong fundamental business model strength and sufficient liquidity will likely see a recovery, but holding the valuation constant is most likely unreliable even with significant financial structuring of the particular transaction.
A survey from fund administrator Gen II Fund Services showed that 80% of private equity/VC managers believe there could be up to a 25% reduction in the value of portfolio investments in their Q1 valuations which should be complete at this point. The survey results indicated that there is a high degree of uncertainty regarding the long term effects of COVID-19 on investments as discussed above. This uncertainty is making groups question their valuation methodology and reliability.
To add to this challenge, the SEC’s 2020 examination priorities released early in January included valuation practices as an item of focus before the COVID-19 impact on the economy was realized. This means that its more important than ever for fund managers to assess their practices.
For Q1 and Q2 2020, many venture capital managers are finding solutions to this problem by:
1. slightly adjusting their previously applied valuation methodology,
2. relying on a robust and thoughtful combination of approaches, or
3. engaging with third party valuation groups to get more independent perspectives and methods.
A few small asset managers have said that their approach in the past was to leave their investments at cost or to apply an broad based % haircut to their portfolio, but these approaches are clearly not accepted in any environment. Cost is almost certainly unreliable as time progresses away from the initial financing tied with the potential of a major impairment from COVID-19. A sophisticated case by case approach is needed for each investment to question the validity of previous valuations with the results of the first half of the year on businesses. Some startups are effectively shut down, others are managing and adapting, and a lucky few are thriving! But even those that are thriving are suffering from weaker capital markets which impacts their ability to fund buyers, adds to the length of time to exit, and hurts their ability earn the same exit multiples from recent months.
70% of survey respondents said that they plan to hold recently made investments made within the last 12 months at cost. The survey also stated that 80% of respondents will primarily be relying on public market comparables in conjuction with other metrics in their valuation. This is an attractive option for most groups given the behavior of public markets relative to the impacts on the real economy, but relying on this approach may not be overly realistic for lower middle market companies that are not as diversified as the public comparables or have significantly less liquidity options and customer diversification as their public counterparts.
Some qualitative and quantitative issues that should be considered that can materially affect valuations for venture backed firms include: portfolio companies holding under 12-24 months of liquidity, broken supply chains, weak customer demand, weakening M&A (# of exit prospects, timing, and values), weaker comps, reduced outlook for equity and debt financing, lower asset values, and the effects of further dilution. There are many cases where valuers should consider marking down their investment to their liquidation preferences in downside scenarios if some of the above COVID-19 impacts are realized or the previously used methodology is not producing realistic results given the company’s realities.
The valuer can reduce the impacts of this market uncertainty by relying on a combination of approach which removes huge impacts of individual assumptions in relative or absolute valuationsg and by engaging independent valuation firms. In this blended approach, the industry of the subject portfolio company, stage of the firm’s growth, and reliability of cash flows matter in deciding the weightings of each valuation approach. The valuation methodology employed must be consistent and reliable across economic cycles. The overall process used by VCs right now should not be changed to produce more favorable results for their portfolio given the realities of our economic environment, but be willing to accept the valuation impacts that are being produced by their existing process. Some of the only things that should be changing across time are the new inputs that take the current reality into consideration including the future growth expectations, exit multiples, liquidity reality, and recovery time frame as it relates to the exit time frame. If input uncertainty is causing issues for the valuation’s reliability, then a more blended approach is warranted that’s appropriate for the firm’s stage and industry.
As the economic recovery progresses, this improved blended approach created (expanded) during this stressed economic environment will provide a better methodology going forward for limited partners that can better reflect market improvements as the public companies strengthen, cash flow becomes more predictable, and asset values improve.