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March 26, 2024
Author: Shwetabh Sameer Co-Author: Syed Sharan Raza
In the dynamic world of the Private Capital industry, Portfolio Valuation is a critical process for accurate performance reporting and evaluation. However, unlike publicly traded stocks with readily available market data, valuing private investments requires more prudence, independence, and objectivity. For Private Equity and Venture Capital funds, ensuring accurate investment valuations is essential for informed decision-making, risk mitigation, and achieving long-term financial objectives.
The Perils of Inaccurate Valuations
Inaccurate valuations paint an incomplete picture of portfolio performance. Investors may be misled into believing their portfolio is performing better or worse than reality. This can lead to poor investment decisions, such as allocating additional capital to underperforming assets or missing out on lucrative opportunities. During the dotcom bubble, many online and tech companies faced bankruptcy and liquidation, such as Pets.co., Webvan, 360Networks, Boo.com, eToys, and others. These companies were given high valuations, leading to rapidly rising share prices driven by strong demand. The bubble eventually burst, resulting in a market crash. Numerous tech and internet firms that went public during this period were significantly overvalued due to high demand and a lack of reliable valuation methods. Their valuations were inflated with excessive multipliers, resulting in overly optimistic and unrealistic numbers. Analysts focused on metrics like website traffic instead of fundamental analysis and revenue potential, leading to inflated valuations.
An inaccurate valuation obscures the true risk profile of the portfolio. Investors may unknowingly expose themselves to excessive risk or underestimate the potential downside of an investment. This can jeopardize the overall portfolio’s health and potentially lead to significant financial losses, impacting all aspects of long-term success. On November 9, 2022, FTX filed for bankruptcy, while crypto exchange was growing exponentially in valuation. Various venture capital funds invested around $1.8 Billion in the venture which raised its valuation to $32 Billion in January 2022. On November 6, 2022, Binance announced that it would sell its entire position in FTT tokens — roughly 23 million FTT tokens valued at about $529 million resulting in a collapse of FTX. According to Forbes, FTX’s investors’ losses are limited to $1.8 billion. However, their paper losses are much, much higher. If any of these investors had cashed out in January 2022, when FTX peaked at the $32 billion valuation, they’d be tens or even hundreds of millions dollars richer.
Private Capital firms are obligated to report portfolio valuations to their Limited Partners (LPs). Inaccurate valuations can lead to misleading financial statements and a breach of trust with investors. This can damage the firm’s reputation and potentially lead to regulatory scrutiny, impacting compliance across the financial reporting of the fund. A prominent venture capital firm, faced scrutiny in 2019 for allegedly inflating the valuations of its portfolio companies. This implied misleading performance reporting for investors and potentially caused them to overestimate the value of their investments. Such allegations could have potentially damaged VC’s reputation and highlight the potential risks of inaccurate valuations in the private capital industry.
During exits like mergers, acquisitions, or secondary sales, an inaccurate valuation can significantly impact the negotiated price. Investors may end up accepting lower-than-fair value offers or missing opportunities to maximize returns on their investments in deals. The market has not been favorable to those investors as well who have waited to reap more returns on overvalued investments. An example of losing an opportunity to exit an investment is WeWork. It was valued at $47 billion in January 2019 after Softbank led a $1 billion round, totaling its investment to $10 billion in WeWork. After filing for IPO in August 2019, its filing showed huge losses of $1.9 billion on $1.8 billion revenue in 2018. In May 2020, Son – SoftBank’s CEO, who had invested over $10 billion in WeWork, said he was “foolish” for the firm’s investments, and valued WeWork at $2.9 billion as per a CNBC news story. In November 2023, WeWork filed for Chapter 11 bankruptcy and its stock fell to 84 cents a share, giving it a $44.5 million market capitalization.
IFRS and Private Capital Investments
The International Financial Reporting Standards (IFRS) provide a framework for accounting and financial reporting. While primarily focused on publicly traded companies, IFRS offers guidance relevant to private capital investments under certain circumstances. Below are some of the considerations:
Best Practices for Accurate Private Capital Valuations
While IFRS provides a framework, investors in Private Equity and Venture Capital can adopt additional best practices to enhance portfolio valuation accuracy:
Ready to ensure your portfolio is valued accurately based on global best practices? Contact our team of experienced professionals from the Private Equity and Venture Capital industry for a complimentary consultation on portfolio valuations.
Schedule a call: https://calendly.com/p01consulting/30min?month=2023-03
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