Amidst heightened regulatory scrutiny, Luxembourg’s private investment fund landscape experiences a transformative shift in valuation paradigms, a panel discussion on Wednesday made clear.
In public markets, financial products such as equities, bonds and funds listed on stock exchanges are subject to constant valuations, with prices being constantly updated for much of the day. However, for private, alternative market funds, of which some 14,000 are domiciled in Luxembourg, prices are available once a month at best, usually once per quarter, with transparency on how that price is determined often being murky. A coordinated push by European regulators now appears to be leading to significant improvements.
Valuation experts on Wednesday discussed the challenges, standards, and evolving practices in the valuation of private investment funds. Led by moderator Antoine Boggini, managing partner at BHB, the dialogue unfolded around regulation, market conditions and the evolution of practices, all key themes crucial for investors and asset owners seeking clarity on valuations of their assets.
Geopolitics matter
Rafaël Le Saux, corporate finance director at PwC Luxembourg and a co-founder of the Luxembourg Valuations Professionals Association LVPA, shed light on the impact of geopolitical events on valuation policies. The panel explored how events like the war in Ukraine or changes in political leadership could influence market dynamics.
“Many asset managers have learned from the Covid era, from the start of the war in Ukraine, and now incorporate this into their processes,” Le Saux said.
It’s not just in Luxembourg where valuations standards are undergoing a bit of a paradigm shift. Following a Europe-wide review initiated by the European Supervisory and Market Authority, Luxembourg regulator CSSF last July ordered management companies to conduct a major review of their valuation processes by the end of the year.
Continuity and consistency
That backdrop is reshaped the way valuation is approached. “It’s important to give more continuity and consistency to the valuation process,” said Daniele Arcidiaco, corporate finance partner in deal advisory at KPMG Luxembourg. “Many clients were asking us, ‘Can you view our valuation policy? Our valuation framework?’ In many cases these were not updated, did not consider changes in markt evolutions, or the stressed markets in recent years.”
The impact of market conditions on valuations has become increasingly complex. The conflict with interest rates, potential inflation, and the varying responses across different sectors have raised significant challenges. The valuation process must now account for inflation’s influence on discount rates, business plans, and the ability of companies to meet their financial obligations. The panel highlighted the importance of maintaining continuity and consistency in valuations, especially during stressed market conditions.
Discount rates need to be considered in their proper context, said Rafael Le Saux, partner at PwC Luxembourg. “You don’t see them running in the wild in nature. That leads us to the need to challenge the models we use. These can have practical shortcomings.”
Le Saux raised the theories of Professor Damodorian, a globally recognized expert on valuations who distils implied data from public markets, such as the S&P 500, to project for instance dividends, or the Equity Risk Premium, or ERP, which projects excess returns over the risk-free discount rate that investors expect for taking risks with their investments.
Blindly using a US benchmark rate of 4.5% could lead to misleading valuations in Europe, Le Saux said. Instead, doing the same ERP exercise in Europe deserves using a higher rate.
Discounted cash flow
“Consider the impact of inflation on the discount rate and on the impact on the business plan. If there’s a higher degree of inflation it comes to affect the discounted cash flow,” added Arcidiaco, referring to a key valuation benchmark that used cash flows to estimate the value of a company. ”That should be appropriately assessed. Is this company really capable of paying back the liabilities over the next 12 months? How much inflation can you pass to our customers? Debt is something that needs to be repaid. When profitability hits the rough, the valuation would be impacted.”
Fund liquidity emerged as another significant concern in an environment of high interest rates and stressed markets. The discussion touched upon the importance of liquidity stress testing, with both ESMA and CSSF emphasising its role in valuation. Externalised valuations, while providing a different perspective, were encouraged to undergo scrutiny and challenge even in stressed market conditions.
Elena Moisei, managing director at Kroll Alternative Asset Advisory, emphasised the need for more concrete and detailed analysis in valuation practices. “Liquidity is a big topic in environment of high interest rates and stressed markets,” she said, adding that while the market is not ignoring the need for liquidity stress testing, firms do need to consider the results of these tests in the valuation of funds, also as per guidance from CSSF and Esma
Retailisation accelerating the change
The rise of open-ended funds, coupled with the impact of technology on valuation processes, is reshaping the landscape. That surge is also inspired by the ‘retailisation’ of private markets. The discussion acknowledged the importance of adapting to market movements, incorporating data-driven insights, and ensuring a nuanced approach to valuation methodologies.
“Regulators are vigilant on what is to happen,” said Irina Ridel, the partner at Mazars Luxembourg who leads the firm’s valuation practice.
Emerging standards, such as those introduced by the International Valuation Standards Council (IVSC), were discussed, particularly in relation to environmental, social, and governance (ESG) criteria and the valuation of data as a separate asset class. “There’s a big question when it comes to data valuation,” said Ridel. “Currently there is limited guidance on how to value data. Now it is emerging as a separate asset class, as it should be the case.”
‘Tech and talent go together’
EY partner and LVPA co-founder Christophe Vandendorpe, in charge of his firm’s strategy and transaction department, made clear that the industry is still in the process of learning, adapting, and finding the right balance between formalism and flexibility. The evolving role of technology was acknowledged but tempered with the understanding that a well-trained valuation profession remains indispensable.
“Technology and talent need to be considered together,” Vandendorpe said. “It is good to have technology but you also need to have well trained professionals to use that technology. We need to embrace the technology evolution, to have more frequent valuations and at the same time, consider that it would be risky to let technology do the whole job.
“As LVPA we make sure that the training is there so that we can have the professionals that can use the right tools. If we can manage both at the same time it would enable us to address such demands,” he added, referring to the increasing importance of valuations when more retail investors are going to be active in private markets.
The panel was co-hosted by the Luxembourg Private Equity Association, LPEA, and the LVPA at the premises of PwC Luxembourg.