Today’s market pressures require investment funds to reassess their valuation process often. Many fund managers are implementing a process of “backtesting,” also known as a retrospective review, as a best practice to analyze the qualitative factors used in valuing an investment.  Backtesting is also instrumental in identifying the primary drivers between a fund’s valuation of an investment and the resulting sale price.

Fund managers looking for areas to make improvements should know that differences between these two values do not necessarily indicate a flawed valuation process; however, understanding the reasons behind these differences can provide valuable insight into the effectiveness of a fund’s valuation policy.

The Backtesting Process
The AICPA’s recently published Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies provides guidance in this area and outlines three steps in the analysis:

1. Determine what information and factors were known or knowable when management valued the investment;
2. Assess how the valuation process considered these factors; and
3. Identify any factors relevant to the sale price that the valuation process did not consider.

The third step—identification of factors relevant to the sale process that the valuation process did not consider—is central to the backtesting process.

A trustworthy approach to backtesting should include following the questions developed by the Valuation Guide specifically for fund managers to consider when working to understand changes between the valuation date and sale of the investment:

• What facts and circumstances that buyers used in estimating a sale price changed between the fund’s valuation date and the sale of the investment? Were these facts and circumstances known or knowable on the valuation date? What do those changes in facts and circumstances suggest regarding the fund’s valuation process?
• What other metrics or additional facts might the buyer have considered in estimating the sale price that the fund might not have considered in the valuation process?
• Was the buyer included in the universe of market participants used during the valuation? If not, why not?
• Are the implied assumptions in the sale price reasonable when compared to the assumptions used in the valuation?
• What other factors that occurred between the valuation date and the sale date could have affected the value of the investment?

Going through the collection of necessary data is fundamental to your backtesting procedure. 

Practical Advice For Funds Implementing This Process
Differences between the fund’s valuation and the sale price can be attributed to numerous factors, including changes in the portfolio company’s position, the outlook for its business or the economic outlooks within external markets.

The following cases show how funds can use the backtesting process to consider these factors and assess the effectiveness of their valuation process.

Investment sold at a discount within six months of valuation: Fund A valued its investment in Company A at the median LTM EBITDA multiple of 7.5x. Six months later, it sold the investment to Fund B at a multiple of 6.5x.

In considering the factors that might have contributed to the difference between the valuation and the sale price, Fund A’s management noted that there were significant changes in market conditions as a result of the Covid-19 pandemic.

Fund A’s management determined that changes to its valuation process were not needed because the impending Covid-19 pandemic was not known or knowable to Fund A when it valued Company A.

Investment sold at a premium within a month of valuation: The same circumstances mentioned above apply except that Fund A began negotiations for the sale of Company A to Fund B before its valuation process was finalized. The sale was completed within a month of valuation.

Fund A’s management identified Fund B’s perception of the value of combining Company A and Company B as the key factor in the difference between Fund A’s value and the sale price. Management also determined that the deal team knew that Fund B believed there were synergies in combining the companies but did not incorporate that information into the valuation.

Fund A’s management concluded that any known assumptions related to a market participant’s perception of value and any ongoing sale negotiations should be incorporated into the valuation process. Fund A’s management will be able to improve its valuation process by ensuring that any indications of value known by the deal team are incorporated into the valuation. Citing conservatism as a key consideration, fund managers are often hesitant to adjust valuations, even when there are indications of value known by the deal team, unless there is a letter of intent (LOI) in place. Fund managers should be aware that this practice could lead investors to question the effectiveness of their valuation policy.

Danielle Darley is a partner in assurance services with Weaver, a national accounting firm. She can be reached at [email protected]. Kaci Howell is a managing director of valuation services with Weaver. She can be reached at [email protected].