This interview was originally published in the April/May 2023 issue of Private Funds CFO.
How is the macroeconomic environment affecting current values for complex financial instruments, alternative assets, and portfolio valuations?
Jamie Spaman: Broadly speaking, the market conditions that we are experiencing, with rising interest rates due to a confluence of inflation, supply chain issues, and other factors, are all having the effect of lowering asset values. That is across the spectrum from debt through to equity. That said, investors are taking a more diligent approach to the evaluation of their investment choices, which means that quality companies may still be able to retain their value. Certainly, we are seeing greater differentiation in appetite for companies than would be the case in a looser monetary environment. There are also differences between individual assets as well as differences across sectors. Emerging technology, for example, where there simply aren't the earnings or cashflow to deliver or sustain required returns in a higher interest rate environment, is being viewed more conservatively than other more robust and resilient industries.
As funds become more sophisticated and investors place greater scrutiny on valuations, particularly given the macroeconomic context, how is the approach to performing complex security and mark-to-market valuations changing?
Brendan Smith: I am not sure that the approach is necessarily changing, but we are certainly seeing heightened focus on consistent rigor around the process when working with our clients to provide periodic mark-to-market valuations. When we talk about good process, we are talking about how information flows from portfolio managers to valuation providers. How key assumptions that feed into portfolio valuations are being documented, for example.
This is particularly important for more esoteric markets where there might be less liquidity. We try to understand what portfolio managers are seeing in their markets and whether these economic conditions are being appropriately reflected in valuations. Further to that, we look to see whether market conditions in less liquid markets are able to be found in some form of documentation, so all parties at the table are able to gain comfort in the valuations being put forward. So, if anything has changed, I would say it is that rigor around the process and increased focus on how macro conditions are being factored into valuations in less liquid markets and, ultimately, how that is being documented.
Is there a danger that we are going to see surprises at exit when it comes to write-downs? Or will GPs just hold fire on realizations until market conditions improve?
Jamie: I think managers are going to become more selective in their activities, both when it comes to entry and exit. Diligence is going to intensify as buyers investigate companies either for credit quality, equity growth potential, or whatever their strategy may entail. As a result, I think we have already seen deal processes slow down over the past 12 months as managers become more deliberate in their approach. There is less of a hurry to put money to work than we were witnessing a year or two ago.
Naturally, that is mirrored when it comes to exit because not only are potential buyers applying more scrutiny, but potential sellers are also taking the time to ensure their assets are ready to go to market and to withstand that extra diligence that potential buyers are applying right now.
What are some of the best practices that you have seen fund managers implement when it comes to valuation policy?
Jamie: As Brendan says, I think the best practices that we see involve the application of more thoroughness and more documentation around the different inputs and assumptions that go into a valuation. I would also add that consistency of approach is really important, and that is certainly something we are encouraging with our clients. It is critical to have consistent information flow, a consistent methodology, and consistent documentation around all the different inputs, and if things are going to change, you need to have well-reasoned, documented thoughts in terms of what is changing and why it is changing. Overall, it appears that consistent and well-documented processes are becoming increasingly prevalent across the market.
To what extent is an increased demand for investor liquidity in the private markets space leading to evolutions in private asset valuation methodologies, particularly given the increased focus of regulators?
Brendan: The overlay of liquidity demands from investors in asset classes that are fundamentally illiquid is one of the most significant trends that we have observed, and it’s something that we expect to see a lot more of. For example, we’ve recently seen investors and managers contemplating liquid fund strategies from the investor’s standpoint in relation to a portfolio of underlying investments involving illiquid venture capital assets. We have also seen open-ended credit funds that primarily hold illiquid private credit investments offering investor redemptions and purchases at more and more frequent intervals.
Inevitably, these strategies where asset managers are trying to give illiquid exposure, while at the same time offering liquidity, are receiving increased scrutiny when it comes to valuations. That’s because those valuations have real world impacts from a dollar-and-cents perspective for those investors who are coming in and out of the investment vehicles. Regulatory scrutiny is also having an impact here. Certainly, we don’t expect to see the regulatory environment loosen when it comes to private markets valuations, particularly given this trend towards private markets exposure with a greater demand for liquidity. That clearly means that valuations have become a pivotal issue for those investors and managers.
What role do you expect technology to play going forward, particularly as valuation frequencies increase?
Brendan: The trend where we are seeing asset managers try and provide more frequent liquidity opportunities to investors – and therefore more frequent valuations – will necessitate the use of enhanced technology in order to deliver those valuations both accurately and on time. At the extreme, a fund may offer daily liquidity for investors involving underlying assets that are fundamentally illiquid, and so valuations may need to be delivered daily as well. To do that efficiently and effectively, some degree of automation is essential, and that use of automation to deliver more frequent valuations is something that we are increasingly seeing in the market. In addition, automation can also help facilitate better reporting to asset managers from their valuation providers.