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Calibration – An Introduction

To ensure that the valuation techniques used to value the portfolio company, investment on subsequent measurement dates begin with the same assumptions consistent with the initial observed transaction or a more recent observed transaction in the instruments issued by the portfolio company. Calibration is the process of using observed transactions in the portfolio company’s instruments, particularly the transaction in which the fund entered a position.

When is Calibration used?

When the initial transaction value is at fair value.

Observed transactions in the portfolio company’s instrument at later dates

Steps in Calibration:

Confirm whether the transaction is at fair value if it is being calibrated.

Calculate the essential factors that influence the transaction’s value.

The difference or delta between the market-level inputs and the transaction date inputs is then evaluated.

Calculate the market inputs as of the valuation date, which is the next measurement date.

Evaluate the stability of the differential between the transaction multiple and market multiples.

Understanding the difference between the company’s actual performance and the performance budgeted at the time of the investment supports such an evaluation.

One method of calculating the company’s value of the target firm using a multiple of EBITDA, revenues, or another financial statistic is to estimate the worth of a private equity investment.

By predicting the instrument’s most likely or anticipated future flows and then discounting them at a market yield, a discounted cash flow analysis (or “DCF”) is a standard valuation method used to determine a company’s fair value.

Calibration under the income approach can be used to support the subjective inputs used, which is a very beneficial application. Unfortunately, the firm-specific risk premium utilized in the weighted average cost of capital (“WACC”) calculation is one of the WACC’s most arbitrary variables.

Calibration is most useful when there is little time between the initial investment date and the subsequent measurement date. However, even when there is a significant time difference between the two dates, calibration can still be used as a reasonableness test to demonstrate that the value change is related to the company’s success.