The world and our country are in a state of uncertainty. The economic volatility resulting from the coronavirus is now being compounded by issues of social injustice. While the stock market appears to be normalizing, many small and medium private businesses continue to struggle. Private equity investment managers and the value of their investments are squarely in the crosshairs of such business issues. As we approach the end of the second quarter 2020, the impact of these events will have a significant impact on the portfolio valuation updates.
Private equity investment managers' primary focus is on value creation and the eventual realization of investments. Despite this, the valuation of investments between origination and realization are important for accurate reporting to investors. The investors, often limited partners, are reliant upon valuations for several reasons. One such reason can be making asset allocation decisions. For example, during the credit crisis, many pension funds appeared to be overweight in alternative assets, such as private equity, as a result of pre-credit crisis valuation policies that did not fully reflect fair value. As the value of publicly traded assets in their portfolios declined and private equity investments held relatively steady, the pension fund managers appeared to be overweight in private equity investments when the values were simply overstated.
With so much uncertainty, how does the private equity firm and its leadership execute the proper diligence in estimating the value of their investments? More now than ever, the valuation of an investment depends on the facts and circumstances of each individual investment. For example, a company in the discretionary retail or hospitality industry will experience a very different impact from the first two quarters of 2020 than a company in an essential retail industry. Additionally, merger and acquisition (M&A) activity has all but come to a halt, so understanding how the current situation is impacting private company multiples still requires guesswork.
This situation highlights the role of a fund's valuation policy. A well-designed valuation policy provides the flexibility for investment managers to handle unforeseen events like the COVID-19 pandemic. A poorly designed valuation policy can handcuff private equity managers into valuation processes that present an administrative burden and divert crucial management time away from building successful businesses and creating value for all stakeholders.
The key to valuation is flexibility. Funds with a well-designed valuation policy provide investment managers agility to focus on future cash flow methodologies in the absence of M&A data. Future cash flow valuation methodologies can capture the unique set of business circumstances that are currently being presented to small and medium businesses. Moreover, coming to the end of the second quarter, investment managers will have over two months of COVID-19 impacted financial data to better navigate the future of a business. This same data makes application of an M&A approach to valuation harder. Second quarter valuation will require changes to valuation models and assumptions while remaining true to fundamental valuation theory. Investment managers that can balance fundamental valuation theory, fund valuation policy and the diverse implications of the current social and economic situation will serve their investors well in this time of complexity and uncertainty.
DHG is positioned to help you embrace the challenges of today with a future-focused approach so you can work toward emerging strong. Please contact your DHG Private Equity team member and tell us more about your goals so we can help you thrive.