With the March 31 date having just passed, many India-based or India-focused private equity (PE), venture capital (VC), and alternative investment funds (AIFs) are required to disclose the value of their investments as part of the reporting process to investors. Various accounting standards such as US Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS), or Indian Accounting Standards (Ind-AS) also require PE/VC/AIFs to compute the “fair value” of their investments. However, as there are several valuation methods to compute this, the funds may arrive at different fair values using different valuation methods. The various accounting standards fail to earmark the methodology of valuation to be adopted under different circumstances, leaving the choice of valuation method at the discretion of the valuer. However, these standards do hint that market-related inputs should be used to the maximum and subjective inputs should be used minimally.
To ensure consistency and advocate uniform practice adoption, the Alternative Investment Policy Advisory Committee (AIPAC) of the Securities and Exchange Board of India (Sebi) has endorsed the International Private Equity and Venture Capital Valuation Guidelines (IPEV Guidelines) for valuation. IPEV Guidelines set out recommendations intending to represent current best practice on the valuation of private capital investments, including privately held investments in private growth companies, early-stage ventures, management buyouts, credit investments, and investments in funds making such investments.
For unquoted investments, IPEV Guidelines provide specific valuation techniques or methods that can be considered by the valuer and mention that the key criterion in selecting a valuation technique is that it should be appropriate in light of the nature, facts, and circumstances of the investments and in the expected view of the market participants. The appropriate valuation technique should incorporate available information about all factors that are likely to materially affect the fair value of the investment. The key valuation technique being recommended is the multiples of earnings or revenue or other specific metrics used within the industry. This involves computing value by multiplying (market computed) earnings multiple or revenue multiple by the earnings or revenue of the business of the investee company (or considering another appropriate parameter of the investee company). This technique might be most appropriate in cases involving investment in an established business that has a track record of making profits or where maintainable profits can be computed without material uncertainty. However, in the case of businesses that are not earning adequate return on assets and for which a greater value can be realised by selling assets or for asset-intensive companies, IPEV Guidelines suggest the usage of the net assets valuation technique, which involves computing value by reference to the fair value of the underlying net assets of the business/investment.
Where the investment being valued is either made recently or there has been any recent investment/transaction in the investee company, IPEV Guidelines hint that the price of the recent investment can be considered as this may provide a good indication of the fair value. However, exceptions can arise if a significant unexpected value-sensitive event has occurred after the recent investment, if the market conditions have changed significantly, or if the recent investment has happened for a different share class. Also, where the price at which a third party has invested is being considered as an input for estimating fair value, the background to the transaction must be taken into account before applying the price of recent investment as a valuation technique. Inputs to valuation techniques should be calibrated to the price of a recent investment, to the extent appropriate.
IPEV Guidelines mention that the discounted cash flows (DCF) technique can be considered for valuation, especially for businesses going through a significant change such as turnaround, strategic repositioning, rescue refinancing, or when the business is in the start-up phase. DCF involves deriving the value of an asset by calculating the present value of expected future cash flows. There can be a high level of subjectivity involved in forecasting expected cash flows and in selecting inputs for computing value under the DCF technique. IPEV Guidelines also mention that several industries have industry-specific valuation benchmarks (such as ‘price per tonne’ for cement companies or ‘price per bed’ for nursing home operators or ‘price per key’ for hotel companies). These industry norms are often based on the assumption that investors are willing to pay for turnover or market share, and that the normal profitability of businesses in the industry does not vary much. However, both these methods should be used cautiously as primary valuation methods.
So far as debt instruments are concerned, IPEV Guidelines require that the fair value of a debt investment, in the absence of actively traded prices, be derived from a yield analysis taking into account credit quality, coupon, and term of the debt instrument. DCF technique can be considered to value debt instruments based on the present value of expected future cash flows to the debt instruments. Non-performing collateralised debt investments can be valued based on the value of the underlying collateral, the risk of converting the collateral into cash, and the time required to convert the collateral into cash. Uncollateralised non-performing debt investments can be valued based on the most likely cash flows discounted at a market participant appropriate discount rate.
To make the valuation reliable to the greatest degree, the valuer may cross-check the valuation as computed using the primary valuation technique with value outcomes using different valuation techniques. This will not only help the valuer to corroborate the valuation but will also help the valuer to understand the reasons for the difference in such value outcomes.
To further strengthen the valuation process and ensure impartiality in reporting the fair valuation, Sebi, vide notification dated June 15, 2023, has mandated that AIFs should appoint an independent valuer with specified criteria for valuing the investments made by AIFs. Further, Sebi’s circular dated June 21, 2023, requires that valuation be conducted based on audited data of investee companies as on March 31 and that AIFs should report such valuation to performance benchmarking agencies within the specified timeline of six months.
Such streamlining in the valuation process and emphasis on the independence of valuations being undertaken will likely improve investors’ confidence in private capital/AIFs and deepen the penetration of alternative investments in India’s capital market.
Dinesh Arora, Partner and Leader – Deals, PwC India and Mihir Gada, Partner – PwC Business Consulting Services LLP
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First Published: May 20 2024 | 6:27 PM IST