Recalibrating the valuation process

The valuation of alternative assets defies hard-and-fast rules. There are too many different kinds of investments and structures and too many factors that play a role in that valuation. For years, there’s been a massive effort to apply some consistency to valuations, but best practices tend to be a wide range of acceptable practices and approaches.

The American Institute of Certified Public Accountants is trying to narrow that scope and in May, issued a draft 649-page tome of guidelines titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment
Companies that goes a long way to establishing a specific range of best practice. The group is taking comments until August 15 and will issue a final version in May 2019. However, in the near term, GPs should work with auditors and valuation experts to discover how their own practices align with the guidelines.

Even in draft form, these guidelines establish a consistent philosophy around valuations. One of the biggest themes to emerge is the idea of calibration, of using the fair value at the time of the initial investment and doing so in tandem with the company’s ongoing performance and the state of the overall market.

The effort began several years ago. “The reason we started developing this guide in 2013 is because, for lack of better guidance, some practitioners were applying the Valuation of Privately Held Company Equity Securities Issued as Compensation [Cheap Stock] guide to the private equity and venture capital industry,” says Yelena Mishkevich of the AICPA. “And while the Cheap Stock guide has some relevant concepts to private equity and venture capital, there are distinct differences that can’t be ignored.”

The guide, issued in May, suggests best practices for the valuation of portfolio companies of investment companies that fall within the scope of Financial Accounting Standards Board Accounting Standards Codification 946. Because of the inherent subjectivity in estimating the fair value of illiquid investments, preparers also have to go out of their way to stay in accordance with FASB ASC Topic 820, which concerns fair value.

The reality is that many firms haven’t had the chance to dive deep into the 649-page draft, but the overall industry response has been quite positive. “There’s been such a diversity in how assets are valued that there are real inefficiencies in the process, as people spend time debating over which approach to take,” says Noam Hirschberger of the accounting firm PKF O’Connor Davies.

“On first blush, this is a great first step,” says Steve Davis of Murray Devine Valuation Advisors. “It should provide some clarity and consistency and may increase the level of documentation required, and my sense is that everyone will be served well by adopting these methodologies.”

Rooted in reality

Market participants find the 15 case studies helpful. The guidelines are applied to specific real-life scenarios involving several different kinds of investments. “These case studies do a lot to tease out the nuances around exercising judgment in a difficult area,” says David Larsen of Duff & Phelps who was part of the task force that developed the draft.

While these guidelines are strictly non-authoritative, that doesn’t mean they can be ignored. “They provide interpretations and best practices, and because of the consensus building around AICPA guidance, the valuation guide is expected to be uniformly adopted,” says Larsen.

Many experts expect some version close to the current draft to be adopted as the final, which means GPs should start reviewing what the guidelines mean to their own particular valuations.

“I’m not sure many firms have their arms around this yet,” says Hirschberger. “There’s a lot to review here, and it would be best to start now, before busy season begins.” Most large asset managers are letting their auditors and valuation experts take the lead, looking to them to provide a summary of which guidelines matter.

But firms shouldn’t expect radical changes from their current practices. “Those with a rigorous valuation process already in place, or those that use a qualified third-party valuation expert, probably won’t see much change, if any,” says Larsen.

Calibrating for rigor

One of the key themes is the idea of “calibration,” a concept that appears throughout the guidelines. “Calibration encourages a more holistic approach to choosing inputs,” says Davis. This requires considering the metrics that were used to value the initial investment in tandem with other developments in the market and the company’s performance.

THE CRIB SHEET

The sections valuation experts have highlighted as the most useful

Chapter 4: Even if they’re familiar with industry valuation practices, this chapter can help GPs to think about the concept of the “unit of account”

Chapter 10: This will clarify the concept of calibration

FAQs: The closest to a summary of the key changes

Case studies: Skim to find which of the 15 are most applicable to the firm’s valuations and study

For example, a company’s guideline market comps multiple might expand, but if the company’s EBITDA has declined, the valuation needs to reflect the underwhelming performance, especially within the context of the initial fair value assessment. But the experts pfm has spoken with stress they already do such calibrations, though they might not document them as suggested in the guide.

Another practice the guide recommends is back-testing, whereby a firm will re-examine its valuation as it exits an investment to see how close its assessment was to the actual value. Some industry practitioners were wary of this, as if back-testing was a method that proved a given valuation was wrong. The guide clears this up: “[It] stresses that back-testing is a tool to add rigor to the valuation process. It’s not about labeling a valuation right or wrong, but finding ways to improve,” Larsen says.

In some cases, the guidelines afford even greater latitude in valuations than current industry standards. It suggests that the option pricing approach isn’t the only methodology for early stage investors. “Some niche providers of software and some audit firms, for example, may say the only way to think about early stage investments is the option pricing model,” says Larsen. “The guide explains that option pricing may be a tool, but not required, and actually, other methodologies might even be better.”

Cindy Ma of Houlihan Lokey suggests that as an early stage enterprise nears an IPO, other methodologies, such as current value and scenario-based, become more relevant. But the use of option pricing may still be appropriate if another type of exit event is possible, for example the sale of the company. “Often both the option price approach and the current value approach are used, and their respective values are probability weighted to derive an expected value,” says Ma.

Many GPs and valuation experts point to the treatment of transaction fees as something that might lead to challenges. Transaction fees are specifically excluded from fair value assessments. “This guidance is based on FASB ASC 820 and its international corollary, IFRS-13, which excludes transactions fees in assessing fair value,” says Larsen.

Time-sensitive

The problem is there are different accounting rules pertaining to the initial purchase of an asset and its subsequent fair value measurement. Under FASB ASC 946, transaction costs are capitalized at initial recognition. So, if a fund pays $95 for an asset and also incurs $5 of transaction costs in connection with that purchase, the fund would report a total cost of $100 on Day 1. However, for fair value reporting, under FASB ASC 820, the fund must exclude transaction costs. As a result, the fund has a Day 1 unrealized loss of $5. Valuation experts expect that real estate funds may be more sensitive to this than private equity as they tend to have higher transaction costs.

Some private equity GPs take issue with the treatment of transaction fees during the sale of an asset. “When we sell an investment, say a $30 million business for $90 million, some of those proceeds go to legal work, investment banking fees or other transaction costs,” says April Evans, chief financial officer of Monitor Clipper Partners.

“So, we, as a seller, have to peel out those costs from the $90 million, so we don’t receive that full amount. The generally accepted accounting principles don’t allow us to factor in those costs to a valuation performed just prior to the sale. On the flipside, when buying a business, the guide makes clear that valuation on the day after the transaction closes, the value is reduced by those very same costs that occur in the acquisition. The result is inconsistency of treatment for the same set of costs when buying versus selling a portfolio company.”

The other complication for private equity GPs may be the treatment of leverage in their investments. The guidelines stress the need for industry practitioners to factor in the “unit of account” and “the assumed transaction” into a valuation process. This means considering the nature and size of the investment, for example controlling or minority stakes, and adjusting the valuation accordingly. One of the factors is the debt involved.

“Say we invest $30 million in equity and the company takes on $20 million in debt at the time of our investment. When we prepare our year-end valuation for that company, this guide explains that we have to value the debt as if it was purchased by a third party,” says Evans.

“What would a willing buyer pay for that debt on December 31?” she adds. “But the reality is, a willing buyer of the business would assume that debt or the debt would be paid off, so there’s no reason to value how much the debt is worth on a standalone basis when it would never be sold to a third party alone. In fact, I would contend that doing so actually distorts the fair market value of the equity, which is what we are supposed to be fair valuing.”

For pure debt investors, the guide may mean more work as well. They will have to list their debt and warrant coverage as separate line items, valuing both individually.

“The reality is these warrants are typically just sweeteners to potentially boost future returns,” says Davis. “But now they have to perform additional valuations for these warrants, even if they only represent a very small percentage of the portfolio.”

But even considering these initial critiques, the response has been favorable. “The reason the guide is so long is that it paid attention to all the flavors of these investments – real estate, biotech, oil and gas exploration, to early stage, start-ups and the like. It’s trying to bring some consistency for valuation processes across the entire spectrum,” says Evans. “So long as it treated as a resource for the industry and not a rulebook, it should be a net positive.”