Unlisted valuations – potential issues and biases

Article highlights-

• Unlisted valuations are receiving increasing regulatory attention in Australia.
• Some outspoken market observers have labeled unlisted valuation practices as ‘dodgy’, while others continue to promote the methodology as superior to listed market valuations, which can be ‘irrational’.
• This article explores the key differences between listed and unlisted valuations, and the strengths and weaknesses of each methodology from the viewpoint of someone who has worked on both sides of the fence.
• Finally, several common issues and valuer biases in unlisted assets are highlighted and discussed. Important reading for anyone responsible for reviewing unlisted valuations-

1. Out of date assumptions
2. Sudden changes in valuation methodology
3. Inconsistent application of the valuation cross-check
4. Asymmetric treatment of good and bad news, valuation ‘smoothing’ and valuer independence
5. Disproportionately high focus on the discount rate and insufficient scrutiny of cash flow forecasts.

Unlisted asset valuations increasingly in the regulatory spotlight in Australia

In Australia superannuation fund members can transact daily in and out of investment options. Where these options hold daily priced listed securities, members putting contributions into, or redeeming funds out of their superannuation options will receive ‘current’ market valuations (ie. Yesterday’s closing share price), which is an equitable outcome for all members invested in, and transacting on that product.

Superannuation funds have been gradually increasing asset-allocations towards unlisted (private) investments, which is appropriate (in my view) given the potential for superior returns and aligning the duration of investments with members’ time horizons, which can be long-term.

However, a mis-match can arise as some unlisted assets are only valued quarterly, biannually, or annually. Therefore, members may be transacting on funds where underlying unlisted valuations are potentially up to 3-12 months ‘out of date’. Given the increasing materiality of unlisted assets in member options, this can lead to inequitable outcomes - an ‘over-valued’ unlisted investment option will favour the outgoing fund member at the expense of the incoming member, and vice-versa for under-valued investments.

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Common criticisms of unlisted and listed valuation methodologies

To add to the potential timing mis-match of transacting on outdated unlisted asset valuations, the valuation methodologies employed by valuers have also come under increased scrutiny, with certain outspoken market participants having bluntly labelled unlisted valuations as ‘dodgy’, while APRA, the regulator of banks and superannuation funds has taken an active interest in enhancing unlisted valuation practices.

Recent examples of unlisted valuation criticisms include superannuation funds being accused of being ‘too slow’ to re-value Australian tech darling Canva following last year’s ‘tech wreck’ and the criticism of funds being too slow to devalue unlisted property investments as listed trust valuations were falling.

A useful cross-check to gauge the ‘accuracy’ of unlisted valuations is to compare an asset’s transaction price to the valuer’s most recent valuation. Unfortunately, this can only be done when assets transact, which can be sporadic.

While there may be loud critics of unlisted asset valuations, there are promoters of the methodology, seeing unlisted valuations as being more detailed and considered, relative to the ‘whims’, ‘panics’ and other investor behavioral biases which can impact stock market valuations (recall the covid-19 ASX market crash in March 2020 followed by its rapid recovery). My (perhaps cynical) personal observation over the past five years is that concern over ‘market irrationality’ is louder when markets are falling.

Valuers of larger unlisted assets typically benefit from receiving far more detailed management budgets and cash flow forecasts relative to the rather limited information listed companies disclose to the public. Arguably, this should lead to a more precise valuation outcome for unlisted assets.

Best practice for unlisted valuations, according to accounting fair market value standards is to cross-check unlisted valuations with observable market transactions or market valuations of comparable peer companies. However, issues with the cross-check can arise given potential scarcity of peer companies, the inherent subjectivity of choosing the basket of comparable companies, and ensuring that the cross-check methodology is applied consistently.

For instance, if the share price of a listed peer company suddenly falls sharply close to the valuation report due date, the valuer may be faced with a choice of 1) significant re-work in a short amount of time or 2) reflecting the impact in a future valuation. This could give rise to a ‘status quo’ bias, or potentially motivated by cost savings, a valuer may therefore put forward a ‘no impact to valuation’ argument, something along the lines of “this share price drop is likely reflective of short-term investor panic, while we think longer-term like-minded unlisted asset investors will see past this short-term market reaction, and therefore, in our professional judgement we will not adjust our current valuation”.

Similar arguments against updating unlisted valuations for the sharp market drop in March 2020 were heard at the onset of the Covid-19 pandemic, where some valuers were of the initial opinion that the pandemic would be short-lived and valuations would rebound within 3-6 months, primarily based on analysis of previous market impacts of health-related events (eg. The SARS outbreak). ?Therefore some valuers were initially hesitant to reflect the sharp March 2020 listed market crash in their quarter-end valuations, arguing that it didn’t impact the long-term valuation outlook. These valuers may have been displaying the ‘anchoring’, ‘confirmation’ and/or ‘over-confidence’ biases. Or valuers may simply have been hesitant to make a material forecast judgement call on Covid-19 themselves, preferring to wait for updated management numbers which reflected the estimated Covid-19 impact.

I am not seeking to criticize valuers here, as it was a highly volatile period and hindsight is 20/20. However, it is important to remember that valuations often have a material subjectivity element, and are a mixture of ‘art’ and science’. It is therefore critical that reviewers of unlisted valuations should ensure that where possible, valuers reinforce their arguments with appropriate supporting data. ??

Insights from sitting on both sides of the valuation fence

I have been fortunate in my career to have sat on both sides of the fence, spending the last five years reviewing unlisted valuations of infrastructure, private equity and private debt, and the seven years prior to that performing intrinsic valuations of large publicly listed companies.

While the valuation methodology in both listed and unlisted cases was typically based on the income approach (eg. discounted cash flow - DCF, or earnings capitalisation), I observed the way new information was factored into listed and unlisted asset valuations differed significantly.

Over the past 12 years, I have developed a deeper understanding and appreciation of both listed and unlisted valuation methodologies, the nuances that exist, the strengths and weaknesses of each approach, and how these two methodologies can co-exist. As the preparation and review of unlisted valuation reports are an increasingly visible function at all ends of the market, below is a list of my five ‘front of mind’ issues when reviewing unlisted valuations.

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1.????? Out of date assumptions or forecasts

Cash flow forecasts prepared by listed stock analysts tend to be updated instantly (typically within 24 hours) to reflect new information, such as an earnings beat or miss, or an acquisition announced by a public company. Stock analysts may not always receive updated guidance from company management, and may need to make their own judgement calls ahead of the next market open. On the other hand, valuers of unlisted assets are typically furnished with highly detailed information from company management and may therefore be more hesitant to adjust company forecasts or make subjective judgement calls themselves, instead opting to wait for updated guidance from management. This can cause issues where updated management information is not ready by the valuation date.

At other times, key discount rate components may be highly volatile ahead of valuation date, such as the sharp drop in the 10-year Australian government bond yield we saw in ?December 2023. Some valuers may be reluctant to update their discount rate assumptions close to valuation date, particularly if their report is almost complete and this would cause a significant amount of re-work.

The risk here is that relative to listed valuations, unlisted valuations are more susceptible to being ‘out of date’ when significant events occur, and reviewers of unlisted valuations should undertake a close review of the dates of latest cash flow forecasts and discount rate assumptions.

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2.????? Sudden changes in valuation methodology

Whenever valuers change their valuation methodologies, this needs to be scrutinized carefully, given the potential valuation impact. For example, a valuer may suddenly change their risk-free rate assumption methodology from a spot rate, to a blend of spot and longer-term rates. Whenever this happens the valuation reviewer should ensure the valuer has appropriate supporting data for the methodology change to ensure that it is logical and defend-able.

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3.????? Inconsistent application of the valuation cross-check

When performing the valuation cross-check, a common problem can be the lack of transaction or listed peer comparable market data. However, where comparable data on listed peers is available, the reviewer of the unlisted valuation will need to ensure that sufficient detail has been provided in the following areas-

• Supporting data for the inclusion (or exclusion) of companies comprising the peer basket.
• The key outcome of performing the cross-check. For example, if listed peer multiples de-rate, a corresponding de-rating would be expected to impact the unlisted valuation, albeit possibly to a lesser extent.?
• Justifications for a significant premium or discount of the asset relative to the sector. Typically, we would only see such a significant premium where a company has a superior growth profile or significantly higher profitability levels vs peers (eg. higher net profit margins or return on equity).? In my experience, significant premiums for unlisted assets are not always adequately detailed in the valuer’s report.

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4.????? Asymmetric treatment of good vs. bad news, valuation smoothing and valuer independence

Treatment of good and bad news should be symmetrical and objectively applied in unlisted valuations, but oftentimes, I have observed that good news is reflected in unlisted valuations far more quickly relative to bad news (ie. kicking the bad news can down the road).

Bad news here is defined as a disappointing event for a company’s growth prospects, typically resulting in management making downwards revisions to cashflow forecasts, which, ceterus paribus, would result in a lower valuation – the share price reaction we typically see in listed markets when earnings disappoint.

Participants responsible for reviewing valuations need to ensure that valuations reflect all relevant and current information, both good and bad, at the valuation date, while there is consistent and symmetrical treatment of both good and bad news.

Downward valuation pressure for unlisted assets following a negative event is usually far more muted vs. a comparable event for a listed peer. This can be partially attributed to lower volatility of unlisted valuations, however, reviewers will need to be aware of any potential valuer bias.

In my experience, following a bad news event, valuers may elect to partially or fully offset the negative valuation impact from bad news by lowering the asset’s discount rate, typically arguing something along the lines that ‘cash flow forecasts are now de-risked following the downward forecast revisions, therefore it is also appropriate to lower the discount rate’.

The issue I have observed, is one of asymmetry – where valuers fully or mostly offset the bad news valuation impact via discount rate reductions, but immediately reflect 100% of good news into a valuation (ie. not raising the discount rate to account for ‘re-risked’ cash flow forecasts).

There can be several issues which arise from an asymmetric treatment of good vs bad news. Firstly, this can cause the valuation multiple of an unlisted company to diverge from listed peers ‘ie. multiple drift’. Secondly, by arguing that cash flow forecasts are ‘de-risked’ following a negative event, there is a significant implied assumption that there is unlikely to be a repeat of bad news in the near-future (which I have found to be a hazardous assumption, as in my experience, a company that disappoints once, may very well disappoint again).

Given potential biases of valuers and asset owners (detailed below), it is not a huge stretch to see that a more mutually acceptable outcome (of less resistance) for both valuers and their clients would be to keep a valuation flat for several periods (also referred to valuation ‘smoothing’), rather than reflect a sharp, immediate valuation drop in one period. However, valuation smoothing is not compatible with ‘fair value’, and is not an equitable outcome for someone transacting on a ‘smoothed’ valuation.

A related issue of upmost importance is that the ‘independent’ valuation process remains independent. At times, the valuer may require input or feedback from asset owners, given their deep understanding of the subject asset. For valuers, communicating bad news to their clients (eg. asset owners or managers who engage the valuers) can be challenging, as asset owners may be in a conflicted position regarding the valuation outcome. Asset owner’s remuneration may be tied to the valuation outcome, or they may be on the receiving end of uncomfortable questions from various stakeholders when valuations fall. Some asset owners simply may take negative valuation outcomes for their asset personally.

The valuer may be concerned that a negative valuation outcome which upsets their client may cost the valuer future work, which may compromise their independence – the risk here is positively correlated to the proportion of a valuer’s total fees tied to a single client. All valuers I have met hold themselves to very high ethical and professional standards, while most organisations have appropriate conflict management procedures in place for valuations. Nevertheless, valuer independence is a critical component of a ‘fair’ valuation, so sufficient diligence should be undertaken to ensure all potential conflicts are appropriately managed.

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5.????? Disproportionate high focus on discount rates and multiple, and insufficient consideration of earnings forecasts

There are usually two primary considerations in a valuation exercise (of equal importance in my view) –

1.?analysis and challenge of cash flow forecasts and

2. arriving at an appropriate discount rate. Valuations can be highly sensitive to changes in either of these two underlying factors.

In my experience, I have found that in a typical valuation exercise, at least 75% of the time clients spend discussing draft valuation reports with valuers focuses on the discount rate, with much less time spent scrutinizing management’s ability to accurate forecast cash flows. Scrutinizing management’s forecasting ability typically consists of reviewing management’s track record of meeting its historical budgets, and benchmarking management’s forecast growth against relevant peers (where data is available).

Valuers and their clients need to be acutely aware that if company management have a poor track record of cash flow forecasting, or where forecasts appear overly aggressive or conservative relative to peers, discount rates should be adjusted to account for this additional valuation risk.

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Conclusion

Over time, I have developed a deep appreciation of both listed and unlisted valuation approaches, and the nuances of each methodology. There are legitimate differences, which can be due in part to different time horizons of short-term vs. long-term investors, and how ‘value’ is assigned to short-term vs longer-term themes. There are however, potential biases within each methodology.

A reminder for critics of listed markets – while markets can be subject to investor greed and fear, the market is a diverse place, with many retail and institutional investors of different views, risk appetites, ?and investment horizons.

While neither valuation methodology is perfect, presently best practice is to align unlisted assets valuations as closely as possible to transaction dates. While in my view we are unlikely to see daily pricing of unlisted assets anytime soon, assets owners only valuing asset owners annually or biannually may need to increase valuation frequency to at least quarterly. I also expect that accounting standards and regulators will continue to place increasing emphasis and scrutiny on the valuation cross-check exercise, which may lead to increased volatility of unlisted valuations.

While the above list of issues common to unlisted valuations is not exhaustive, it highlights some of the key issues I consider when undertaking or reviewing an unlisted valuation to ensure that potential biases are mitigated, and the arguments underpinning an investment case are sufficient, logical and defend-able.?

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