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Why software hasn’t solved valuations, yet

The amount of company data now available to private equity firms has revolutionized the valuation process, but the competitive advantage still lies with humans.

This article first appeared in the February 2023 Valuations Insights Report

The amount of company data now available to private equity firms has revolutionized the valuation process, but the competitive advantage still lies with humans.

The tale of fintech start-up Frank – the founder of which allegedly fabricated millions of customer emails before a sale to JPMorgan – is a lesson in the value of data, and in the data that can drive a valuation. 

It is sometimes said one of the reasons private equity managers have grown to love acquiring tech companies, particularly in the later-stage of growth, is the relatively high number of data points available to project a valuation. In the case of Frank, the data was there but according to reports it was not what it seemed. 

In almost all sectors of the economy, private equity firms are sucking up more and more company data points and using better tools to analyse them. In December data provider Preqin launched a new set of asset-level valuation benchmarks and large PE houses have been building out their internal data teams to crunch numbers and test different investment hypotheses for years. 

“The amount of data that clients want to have before they take a step towards an acquisition or joint venture is increasing all the time,” says Andrea Guerzoni, EY’s Global Vice Chair, Strategy and Transactions.

Value chained

At the end of last year, investor research firm Third Bridge launched new product ‘Maps’ which presents tens of thousands of company value chains to help investors fast-track early-stage research. Other fintech platforms are attempting to do something similar but third-party solutions to valuing these companies have been slower to emerge. 

Around 60% of valuations can be more than 15% off their verified value, wrote M&A banker David W. McCombie III in a recent Forbes article, adding: “In any other industry this performance would result in someone getting fired. Valuations are more art than science (can easily be manipulated) and results relative to market value or even between reputable firms can be significantly off (as in a 10x difference in value) for private businesses”.

So, what to do?

According to a survey by Private Equity Wire, not much: only one in 10 respondents say they have onboarded new software or technology to support their valuation process over the past 12 months. In some cases that capability may already exist, or it may have been outsourced, but according to people working on private company valuations, the finding also reveals how technology is only half of the solution. 

Human factor

Even with the advent of ChatGPT and a potential revolution in generative AI, private equity firms are looking to human experience when it comes to deal valuations.

“You can have data engineers who clean the data and come up with correlations or interesting perspectives, but, ultimately, what counts most in the valuation process is the questions you ask,” says Guerzoni. 

“You still need to have people deeply involved in the dynamics of a sector and you need to work more on the human factor – an ecosystem of different perspectives. Even for smaller deals, having the possibility to spend more time with the local management can add incredible value and it is still a model that should be followed.”

This is particularly true in venture capital where comparable public valuations often don’t exist for many nascent sectors (ChatGPT’s own $29bn valuation being a good example). 

Tomas Freyman, head of valuations at Grant Thornton UK, admits that with private equity funds amassing so much data, there has been a move away from spreadsheets towards more sophisticated tools but agrees that fundamental approaches to valuation have stayed the same. 

Data may help private equity funds build conviction on an acquisition target, he adds, but human insight and experience remain “just as important to ensuring a valuation is robust and can withstand scrutiny”. 

With increased regulatory pressure on private equity firms, it is also humans – rather than machines – that are being pulled in front of management teams to justify this valuation. For this reason and others, one private equity adviser, unnamed, says that some of the larger private equity funds are growing suspicious of new “black box” tech solutions because they want more subjectivity in the valuation process. “The kind of finger in the air, human interaction element of valuation is much more of a craft than a science – as opposed to pumping all this data and outcomes a number and it must be right. But, you know, as these robots get more and more sophisticated, who knows?”

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