Calibration: Bringing Valuation Back to its Roots
By Steve Maiolica, CPA, Manager, Alternative Investment Group
With the 2020 year-end coming upon us, investors are eager to see how their private equity and debt investments fared during this extraordinary period of volatility and uncertainty resulting from the global coronavirus pandemic. With more than a year under its belt, the American Institute of CPAs (“AICPA”) “Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” (“Valuation Guide”) serves as a best practice aid for complying with FASB Accounting Standards Codification (ASC) 946, Financial Services – Investment Companies, and applying FASB ASC 820, Fair Value Measurements. One key technique worth highlighting is the concept of calibration, which is mentioned throughout the Valuation Guide and is discussed in detail in Chapter 10. This article will explain the process of calibration and why it’s such an important consideration when valuing private or illiquid investments.
What is Calibration?
Calibration is defined in the Valuation Guide as “the process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered into a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the original transaction assumptions and observed market data, as well as any more recent observed transactions in the instruments issued by the portfolio company.” In simpler terms, if a valuation technique using unobservable inputs such as projected cash flows, growth rates, or volatility will be used to value an investment at a future reporting date, the unobservable inputs should be adjusted or “calibrated” such that on the date of an initial transaction, the fair value resulting from that valuation technique is equal to the initial transaction price (assuming the transaction price is at fair value). Essentially, calibration involves monitoring the difference between the unobservable input at the initial transaction date and the comparable input as it relates to the comparable company set against which the initial transaction was benchmarked.
This process helps ensure that the valuation technique is properly capturing all of the relevant characteristics of the asset or liability being valued and could identify whether an adjustment to the valuation technique is necessary. At future measurement dates, the calibrated inputs are carried forward and adjusted to reflect the comparable (then current) market data from the same universe of public companies or transactions and changes in the company’s performance and projections. This process can continue from period to period as long as there has not been a significant change in circumstances that warrants a change in valuation methodology (portfolio company is about to be sold, declared bankruptcy, changes to business model, etc.).
Calibration is most relevant when the measurement date is close to the transaction date; therefore, if there have been additional observed transactions in the portfolio company’s instruments subsequent to the initial transaction, calibrating to the more recent transaction will typically be more relevant than calibrating to the original transaction.
As noted above, in order for calibration to be effective, the observed transaction needs to take place at fair value. Fair value is defined by FASB in ASC 820 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.” Some factors to consider when determining if the transaction took place at fair value would be whether the transaction is between related parties, takes place under duress, or is consummated in a market other than the principal or most advantageous market. However, even when the transaction does not take place at fair value, it is still best practice to compare the estimated fair value with the transaction price and reconcile the differences, giving consideration to the reasons that the transaction was not considered to take place at fair value and explaining the Day 1 gain or loss.
The concept of calibration can be used not only for financial reporting of fair value of investments, but for other purposes as well. For instance, the portfolio company itself performs valuations for supporting the issuance of stock-based compensation, for testing goodwill for impairment, for valuing other financial instruments, or for tax purposes. As a portfolio manager, to the extent that information is available, it is a best practice to understand the valuation framework and assumptions used in valuations performed at the portfolio company level and reconcile to your own fair valuation, if there are differences.
Implications of Calibration on Control Premiums and Marketability Discounts
One of the more significant challenges faced by the private equity and venture capital industry in the past has been assessing the valuation impact of the level of control and illiquidity of an investment. A common historical practice has been to refer to the “control premium” if a price reflects a premium to guideline public companies, and to the “marketability discount” if the price reflects a discount, without further analysis. This practice has made it difficult to determine if valuations are reasonable. It has also made it difficult to analyze changes and update valuations in future periods. Calibration requires a more detailed understanding of the underlying rationale of the premium paid or discount received on the initial transaction date, so that it is possible to assess the differences between the portfolio company and the guideline public companies at subsequent measurement dates and to update the valuation. Accordingly, a separate adjustment to reflect control (or a lack thereof) or illiquidity would not be appropriate because the effect would already be captured in the transaction price. The Valuation Guide covers this concept in much further detail in Chapter 9 – Control and Marketability.
A Simple Example Applying Calibration to an Equity Investment Using the Market Approach
One approach to estimating the value of a private equity investment is to compute the enterprise value of the target company using a multiple of EBITDA, revenues, or some other financial metric. These multiples are typically selected based on comparable public data or transaction data. Suppose a target company is acquired for $100M and is expected to outperform guideline public companies in the same industry. The target company has a trailing 12-month EBITDA of $10M, and therefore, the transaction price implies 10x EBITDA while the guideline public company multiple is 8x EBITDA (a 25% premium for the target company). At the end of one year, the target company performs as expected and has a trailing 12-month EBITDA of $12M. The guideline public company multiple is now 9x. The target company is still expected to outperform the guideline public companies by the same margin. If applying calibration, this would indicate that the fair value of the target company is now 9x *1.25x *$12M = $135M.
A Simple Example Applying Calibration to a Debt Investment using the Income Approach
The typical valuation technique used to estimate the fair value of a private debt instrument is to use a discounted cash flow analysis (“DCF”) estimating the most likely or expected cash flows for the instrument and then discounting them at a market yield. Suppose a debt instrument is issued with its original rate based on LIBOR + 200 basis points (“bps”) with a 5-year maturity. At issuance, the 200 bps credit spread corresponded to a B+ credit rating. LIBOR + 200bps would be the calibration input used for the market yield in the DCF at issuance. At the end of year 3, the issuer still maintains a B+ credit rating. If the credit spread for a B+ credit rating is now LIBOR + 300 bps, then the estimated market yield used in the DCF to value the investment at the end of year 3 would be LIBOR + 300bps.
Calibration is flexible and can be used with various valuation techniques across all asset classes. There are detailed examples included in the Valuation Guide in Chapter 10 – Calibration, as well as Appendix C – Valuation Case Studies.
Calibration promotes consistency in valuation techniques and assumptions used. It also helps remove some uncertainty and subjectivity in the valuation and creates a benchmark going forward. Although calibration may require some additional time to set up, most portfolio managers are already creating similar acquisition models to estimate the fair value and compute the required rate of return as part of the due diligence process and deal analysis. Further, COVID-19 has caused significant uncertainty throughout the industry, and calibration could be an important tool to ensure valuations reflect current market conditions. Investment managers are encouraged to proactively review and update their policies and procedures to incorporate the use of calibration in their valuation practices. For further discussion any of the points raised above, or those in the Valuation Guide itself, please contact a member of Marcum’s Alternative Investment Group.