We live in unprecedented times. Covid-19 has brought havoc to stock and bond markets around the world. Despite this, many Venture Capital Trusts (VCTs) have been relatively calm. With the end of the tax year approaching, investors may still be considering where to allocate their VCT investment. This calmness should affect this decision as it may be an illusion.
The art of private company valuation
To understand what is going on, investors need to know how VCTs value their investments. Everyone uses IPEV guidelines. These are a longer read than most investors would like, and are not as precise as many imagine. Some managers refer to these guidelines as if they give a magic answer. They don’t, but investors would need to beware of anyone who doesn’t use them!
In practice, managers use one of three methods:
- The price at which the last meaningful transaction took place, so long as there were independent third parties involved. These conditions help to avoid absurdities, where managers could buy a small number of shares to inflate the valuation.
- By using valuation metrics of comparable companies. Typically, this is a standard valuation multiple, such as EV/EBITDA, price/earnings or price/sales, with a discount for being unquoted.
- Where a share is AIM- or, rarely, main market- listed, using the latest price.
Obviously, each is used in particular circumstances. Managers can only use the third method, indeed have to use it, when a share is listed.
They apply the second method once a company has an income statement that is adequate to justify it: you can’t multiply no profits or no sales. However, this method requires the most subjective inputs. The choice of comparable companies and the illiquidity discount can have a big effect on the outcome.
When managers cannot justify either of the other methods, they fall back on the first one. So this usually gets applied to earlier stage companies than the other methods.
What are the implications of these valuation methods?
The subjective element raises some potential issues. Management fees are calculated as a proportion of net asset value (NAV). This gives managers an incentive to inflate valuations, though this is mitigated by the requirement for an audit. Nevertheless, there is a range of answers that may be considered “reasonable”.
Anecdotally, this analyst has heard, separately, comments that valuations are both conservative and aggressive. My suspicion is that the market is probably about right on average. But averages can hide a lot of variation and we don’t know if there are examples of large over- or under-valuations. Detailed analysis may bring this out, but I’m not aware of anyone doing it.
Most VCTs use a combination of these three methods, though the preponderance varies. AIM VCTs tend to hold very few unquoted investments and will rely on the third method. VCTs that used to specialise in later stage investment will use the second method more, while the new VCTs will almost exclusively use the first. Outside AIM VCTs, the first two methods are far and away the most common.
Smooth valuations
The aggregate effect is that there is an implicit smoothing of NAVs over time. For method 1, the valuation remains constant unless another transaction takes place. Given many companies go up to two years between funding rounds, changes to valuations will be infrequent.
Slightly different considerations apply to method 2, though the result is the same. The methodology uses annual financial data, with progress over shorter periods disregarded. Managers recognise the subjective element of valuation multiples and, so, only change these when there is significant change. Fine tuning would imply an unreasonable level of accuracy. Again, changes under this method will be infrequent.
These mean that, in most VCTs, individual company valuations tend to remain constant for an extended period. However, when changes happen they can be substantial.
Because of this, valuations at short intervals may give little new information but will bring additional costs. Therefore, most VCTs value their assets infrequently. The most common timing is every six months, in the annual and interim reports. The biggest exceptions tend to be AIM VCTs.
Why is this relevant now?
In most VCT offers, the issue price is based on the last NAV per share with an adjustment for expenses. Most of the time this is reasonable. It is unlikely that, in the short time since the last valuation, that there has been much valuation movement. And, in supportive markets, it may work slightly in the investor’s favour.
But these are not normal markets. The FTSE AIM index is down over 30% this year and 23% so far in March. The FTSE Fledgeling (ex IC) Index has fallen over 30% in March alone. Almost every asset market around the world has shown significant weakness.
Although valuations in private markets seem to be different from those in quoted markets (I touched on this here), they will not be immune to this disruption. Most private companies are now worth significantly less than they were a month ago. We can’t know how much less, but the figures above suggest it is meaningful.
This will not, and cannot, be reflected in many VCT valuations yet. And this means that anyone investing now in a VCT with a smoothed NAV is likely paying a premium.
What’s the solution?
The simple solution is to invest in VCTs where the NAV isn’t stale. AIM VCTs update their NAVs more regularly and may offer better relative value just now. Although I’m not a fan of VCTs carrying high proportions of cash, those that do will also be better protected. Some will do a valuation as of 31 March , but this may or may not be ready in time for share allocations. I’m not aware of the more general VCTs doing specific revaluations, but any that do would be good candidates too.
This is not to ignore the usual considerations for selecting a VCT. There may be circumstances, such as manager diversification, why a VCT with a stale NAV may still be the right choice. But any adviser or investor who doesn’t think about this may make a poor decision and over pay.