The UK Financial Conduct Authority is set to probe the way asset managers value the private assets on their books. While the scope of the review has not yet been drawn, the review is expected to look at the following areas:
- disciplines and governance in valuations processes;
- scoping the accountability in valuation;
- the quality and flow of information; and,
- procedures that are in place.
Given private equity accounts for over 50% of the AUM within private markets[1], with the rest going to venture capital, private debt, real estate, and infrastructure, any review of private markets will have a bias to private equity. In this blog we will focus on what this review could mean for private equity.
Private equity valuations: the overlooked half
In our experience, valuation in a private equity context has two halves.
The first half of the valuation process is to determine the enterprise value of the portfolio companies held by the fund. Here there has been a lot of scrutiny and pressure from private market fund investors on GPs. Fund investors increasingly want to see GPs adopt standardisation, consistency, quality and depth of datapoints used, and robustness in valuation methodologies (for example a combination of discounted cashflows and market multiples). No doubt the review will focus on these aspects.
However, private equity, unlike their other private market counterparts, has an important second half in the valuation process. Here, private equity funds must go a step further in determining the portion of a portfolio’s enterprise value that belongs to the fund. This is because private equity portfolios have the following characteristics:
- significant non-fund shareholders in the form of portfolio management and co-investors; and,
- complex capital structures consisting of multiple instruments with varying terms, hurdles, and rights in a distribution waterfall.
Therefore, the value of a private equity fund’s holdings across its portfolio companies can only be determined by running the enterprise value of each portfolio company through the distribution waterfall using the capital structure data as at the valuation date.
Importance of portfolio capital table data in valuation
The document that summarises the portfolio company’s capital structure data is called the capital table. The capital table for any given date will show all the instruments in issue, who owns them, the invested amount by shareholder, and also have back up calculations (e.g. accrued interest on coupon bearing instruments, unallocated instruments, vested versus non-vested positions, economic ownership %s, voting or control %s etc). Portfolio capital tables change over time due to events at the portfolio company level such as additional drawdowns, leavers, joiners, issuances, buybacks, re-organisations. All changes need to be tracked and logged, and back-up calculations need to be maintained to have accurate capital table data that can be fed into the portfolio waterfall models.
Given the importance of capital structure data for the accuracy of portfolio waterfall models, we would expect this to be an important part of any review that focuses on disciplines & governance, procedures, information flow, and accountability in portfolio company valuation processes. Below, we explore the current state of affair and what a digitised future could look like for private equity capital table management and waterfall valuation.
The current state of affair:
- Excel is the tool of choice: Tracking the ownership data in private equity-backed businesses has primarily been done on spreadsheets, with Excel being the tool of choice. While Excel is a versatile tool for modelling and scenario analysis, it has severe limitations when handling tasks that are workflow and process intensive. In addition to being workflow and process intensive, portfolio capital tables also need to accurately capture the intricacies of portfolio investment and capital structure (e.g. instrument terms, legal entity structure, tax and legal aspects). Excel ends up being a poor tool in managing the workflows, processes, and in capturing all the key datapoints that make for a ‘single source of truth’ document.
- Poor record keeping:Across the industry, there is a lack of standardised, auditable record-keeping processes for capital tables and investment structures. This makes it difficult to ensure that the ownership data accurately reflects the actual position at the valuation or transaction date. The way forward has got to be digitised cap tables that support robust review and control processes, with each transaction being underpinned by verified and executed legal documents.
- Lack of a ‘single source of truth’: Private equity funds maintain individual excel cap tables for each portfolio company owned by the fund. Each file can look and behave differently due to a lack of standardisation and automation in the way capital structure events are logged and back up calculations are maintained. For example, there is no standardised way in which capital structure events such as additional issuance, buybacks, transfers, cancellations, and interest schedules are maintained. Furthermore, data is fragmented across multiple static sources – excel files, legal documents, and company share registers are all maintained separately by different teams. Errors can easily creep in and accumulate over the portfolio holding period, resulting in heavy time and cost during a liquidity event. A ‘single source of truth’ that captures all datapoints in one place ensures accuracy.
- Complex Calculations:Private equity portfolio capital structures are often financed with interest bearing instruments like preference shares and loans to a material extent. Valuing these instruments goes a long way in valuing the capital table. This requires detailed interest calculations and schedules tracking each shareholder, event, and interest periods. Managing these calculations manually is time-consuming and prone to error. Private equity deals also commonly use multi-layered investment structures that require separate calculations and schedules to be maintained to track the effective ownership of the fund entities in the portfolio. Furthermore, cap table data is often required for any historic or future dates (e.g. historic data is required for audits, and future projections for exits. This can be challenging to produce manually.
- Lack of Verification:The current way doesn’t lend itself to smart collaboration, review, and sign-off of ownership data across the key participants – e.g. portfolio management, private equity deal team, and fund’s finance and legal functions all need to work together in order to ensure accuracy of the data. Static files and manual processes don’t lend themselves to smart collaboration, review, and sign-off. Furthermore, as the legal documents underpinning capital structure events are maintained separately, it is not straightforward to verify and validate the data in cap table files.
Due to the reasons discussed above, errors and discrepancies often creep into portfolio capital tables which can have a cascading effect on portfolio and fund valuations.
Digitisation is the way forward
Amid these challenges, DealsPlus is transforming the way private equity funds manage their portfolio capital tables and investment structures. Here’s how:
- Standardisation & automation:DealsPlus’ intelligent workflows bring standardisation and automation in end-to-end capital table management processes. Role based access controls allow easy collaboration across all relevant functions in maintaining a ‘single source of truth’.
- Auditable processes:By providing a structured and auditable workflow, DealsPlus brings transparency and accountability to capital table data, aligning with regulatory expectations. The software maintains a comprehensive history of capital structure events with clear audit trail for reference and verification.
- Complex Calculations Made Easy:DealsPlus automates all relevant calculations and datapoints:
- Interest schedules and automatic valuation of all coupon bearing instruments (loan notes, preference shares, and debt);
- effective ownership workings for fund entities, tracing through multi-layered ownership structures; and,
- reports across multiple datapoints that are useful for valuations, tax, legal, compliance, and portfolio exits.
- Verification and sign-off:Each capital structure event is verified with underlying legal documentation, ensuring that the ownership records are not only accurate but also legally compliant. Automated sign-off processes ensure ongoing review and sign-off by all responsible persons (e.g. portfolio company management, deal team members, and external advisors).
- Cap table data synced with portfolio waterfall models: Cap table data can be synced with the fund’s own portfolio waterfall models, ensuring ease and accuracy when valuing the capital tables.
Digitisation with best-in-class solutions like DealsPlus helps build trust and confidence in private equity valuations, reporting, and transaction processes.
[1] McKinsey Global Private Markets Review 2023