by Andrés Ramos, Content Marketing Specialist – eVestment Private Markets
The valuation bridge is a key tool for understanding the value creation of a private equity fund. But despite its valuable insights, the bridge is often categorized as an “LP-only” tool and not widely used by GPs.
In the ever evolving and competitive fundraising landscape, GPs who fail to understand their valuation bridge and proactively utilize it as an analytics tool are missing an opportunity to create compelling narratives about their strategy and risk being unprepared for questions from potential investors.
This blog post will dive into why the valuation bridge is such an important part of an LP’s analysis process and offer practical advice on how GPs can leverage it to empower their fundraising, ongoing reporting, and internal strategy decisions.
Valuation Bridge 101: What is it?
The valuation bridge, or value creation bridge, is a “waterfall” style chart that represents the value created in a fund or individual portfolio company across key equity growth areas. These generally include revenue growth, EBITDA margin improvement, and debt reduction. Moving from left to right the cascading bars clearly demonstrate how each equity growth area has contributed to (or detracted from) the overall multiple growth of fund or portfolio company from entry to exit.
The equity growth metrics measured by the valuation bridge are most applicable for private equity buyout funds.
Sample Valuation Bridge
Why it matters to institutional investors
In today’s private markets, data-driven institutional investors are laser-focused on gathering as much data as possible from GPs before making a commitment.
On their own, headline metrics like IRRs and multiples tell investors very little about a manager, their performance, or their ability to repeat it. In addition to recalculating these performance figures to ensure consistency and standardization in GP comparisons, LPs are using more granular analysis to determine what factors actually generated value in the fund and to validate a GP’s future strategy. All this helps them make truly informed investment decisions.
With its clear and detailed breakdown of value creation from entry to exit, the valuation bridge is one of the key tools for investors seeking to understand a GP’s strategy and skill during the diligence process.
Yet many GPs are failing to proactively use the valuation bridge or other forms of granular analysis to win trust, and in turn commitments, from LPs. A recent report from eVestment Private Markets found that only 23% and 12% of buyout fund manager pitch decks mentioned “multiple expansion” and “EBITDA margin” respectively.
How GPs can use the valuation bridge to their advantage
As LPs are using more data to scrutinize fund managers and justify investment decisions, GPs should embrace the valuation bridge as a tool for meeting investors’ data needs and supporting their fundraising efforts. When not fundraising, there are many other ways GPs can proactively use the valuation bridge and its insights both internally and externally.
1. Validate your narrative
Potential investors need to be completely confident in a fund manager’s investment thesis before making a commitment meaning that GPs must be able to effectively communicate their strategy in their pitch presentations. The valuation bridge can be integral part of these efforts by reinforcing a GP’s value creation story.
If driving returns through hands-on involvement with your portfolio companies is central to your value creation strategy, the valuation bridge can be a proof point of this. In a valuation bridge for a fund executing this strategy, you would expect to see revenue growth as the largest of the floating bars, highlighting it as the key performance driver.
For managers who are successfully executing on their investment strategy, there is no downside to sharing more data with investors via the valuation bridge, especially during the fundraising process.
2. Supporting portfolio company case studies
A case study is a powerful tool for showcasing the impact a GP had on a successful portfolio company. While the bulk of the value creation story will be expressed through the written component of the study, constructing a valuation bridge specifically for the single deal can be a useful visual supplement that demonstrates the GP’s impact.
If the case study and the accompanying valuation bridge demonstrate that the portfolio company’s value growth was consistent with the fund manager’s stated strategy, an investor can be confident in the GP’s value creation process.
3. Enhancing ongoing reporting
Investor data demands rarely end after the first capital call, and the uses of a valuation bridge can extend beyond fundraising for GPs. When fund managers think about how they are communicating with their LPs on a forward-looking basis, they should consider leveraging the valuation bridge in these efforts.
The impact of shutdowns on portfolio companies was top of mind for investors in 2020 and fund managers were hit by an influx of requests for updates. When worked into investor updates and quarterly reporting, the valuation bridge is an excellent tool for demonstrating portfolio activity or progress. The bridge can pinpoint exactly what part of a company’s value has been most affected by the pandemic and fund managers can speak to how they are addressing the situation.
4. Investment strategy review
Just as the bridge can be used for external updates with investors, it can also be valuable for internal deal teams as they work to assess how their deals are progressing. For example, if a team is working to improve the operational efficiency of a portfolio company, they can look to changes in EBITDA margin for insight on how those efforts are creating value.
Overcoming the key hurdles to implementing valuation bridges
While the output of the valuation bridge is a very clear, easy to understand chart, constructing it requires a large number of data points and calculations. It is not a one-off task either, but rather one that requires quarterly updates with the latest valuations alongside the rest of the fund performance.
The chart is not a conventional one and formatting a valuation bridge can be a challenge even for seasoned spreadsheet wizards. For GPs still relying on spreadsheet-based processes to calculate their investment-level metrics, the time and effort required to actually produce a valuation bridge is a key limitation to being able to use them regularly and across a wider range of applications. Let alone the potential data integrity issues that come with a spreadsheet-based process.
Simply put, spreadsheets are not built to accommodate a valuation bridge.
With TopQ, our portfolio intelligence tool, once a user has added their updated cash flows to the platform, the valuation bridge is calculated and plotted in a matter of seconds.
The platform’s robust calculation engine and an easy-to-use interface enable any team across the firm to access the insights they need – including valuation bridges – and use a single, centralized source of truth. And exporting the completed bridge for use in internal or external reports or presentations is as easy as the click of a mouse.
As LPs continue to demand more data, the GPs who embrace the valuation bridge as a crucial tool for communicating their value creation will be well-positioned to address those needs. Its insights will also inform internal decision-making at the strategy level and contribute to the overall success of a fund. The valuation bridge is a fundamental tool for your analytics toolkit that should not be overlooked.