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.

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