Finding fair(er) value

Kevin Vannucci does not have an easy job.

As a valuation expert working in the private equity industry, he and his team have to determine the value of unlisted portfolio companies – where the right answer can’t be found on a big board on the wall of a trading room. Now GPs have to assign a fair value to these illiquid assets on a quarterly basis – rather than holding them at cost as they used to – that’s an ongoing challenge.

Equally, as a partner at audit and accounting firm McGladrey, Vannucci also has to help audit teams determine whether CFOs’ valuation estimates are reasonable. That’s particularly challenging since auditors don’t actually have detailed guidance to go on when it comes to evaluating tricky mark-to-market valuations – unlike (for example) goodwill impairment.

According to Vannucci, the issues are more apparent now the US Securities and Exchange Commission (SEC) has oversight of the industry. As of March 2012, GPs managing more than $150 million in assets were forced to register with the SEC as part of the Dodd-Frank legislation. Since then, the regulator has repeatedly cited valuations as a top priority for its inspectors.

Clearly auditors have responded to that. “They’ll do whatever they can do to ensure that inspectors don’t find anything wrong under their watch – that GPs are being tested rigorously enough on valuations,” says Vannucci.

But with limited guidance, some auditors are struggling to capture a “by the book” feel when testing GPs’ valuation marks, he suggests. In the past, many have used a valuation guide created by the American Institute of CPAs (AICPA), the main professional body for US accountants, which focuses on securities issued by private companies. But the guide – known in industry parlance as the ‘Cheap Stock Guide’ – isn’t a perfect fit for the private equity model, says Vannucci.

“Some people have misinterpreted this guidance, which was really put out for valuing private company stock options, and have suggested that GPs use complex option pricing models that may actually not be required given the unit of account and how market participants would view the transaction in their economic best interest.”

To complicate matters further, private equity firms follow their own rules when valuing assets: the International Private Equity and Venture Capital Valuation Association (IPEV) guidelines, which were developed by a group of GPs and LPs.

But Vannucci says the IPEV guidelines “don’t necessarily dive deep enough” to address some inconsistencies that auditors are encountering in the field. And until they do, some auditors may continue using guidelines like the cheap stock guide; they may continue to press CFOs for more information around their marks; and they may continue to demand more models be run to support their audit work papers, in order to show oversight bodies that the marks are reasonable.

The end result of all this has been a gruelling audit season for private equity firms in 2013. And in the absence of a better solution, Vannucci believes future audit seasons “will continue to be difficult” for both auditors and their GP clients.

TASKFORCE OPTIMISM

Happily, there’s some good news. “Recently the AICPA formed a taskforce to develop a valuation guide specifically for private equity- and venture capital-backed companies,” says Vannucci. He expects the taskforce to release a draft of its work sometime in late 2015 or early 2016.

“What the taskforce can do is create very detailed examples. They can outline how to value investments in a portfolio company under specific circumstances – the kind that auditors are struggling with in practice.”

And once auditors and private equity firms are following the same set of ground rules, the hope is that audits will become a more predictable and efficient process.

The industry, which throws its weight behind IPEV’s guidelines, may also be glad to know that the taskforce “plans to create guidelines that address industry concerns as well,” according to Vannucci.

“In many areas, the taskforce may align itself with what IPEV has already done. But in other areas, they may take a deeper dive in scenarios where fair value is not being measured consistently in practice.”

Vannucci cites the principle of calibration as one item the taskforce specifically plans to review in the year ahead.

“Calibration is an important valuation step that is often overlooked by GPs. It ensures that proper adjustments are made throughout the lifespan of the fund’s investment in a particular equity or debt position.”

Put simply, calibration involves a GP tracking the multiples, growth rates, margins and other financial metrics of market participants relative to its portfolio company during the valuation process. The methods and assumptions used to value the position can then be calibrated in order to inform any future assessment of its fair value. “The process of calibration will help determine if the valuation of the subject investment in a portfolio company reflects current market conditions,” says Vannucci.

Often GPs will claim that there’s a reason why their company is progressing at a different rate than its peers – a particularly successful value creation exercise, for instance.

Unfortunately, according to Vannucci, they don’t always have sufficient documentation or evidence to support their claims.

“Some private equity firms do a great job around calibration, while others need more documentation to help the auditor feel comfortable that the mark is reasonable.” And with the SEC now looking over their shoulders, more and more auditors are going to start calling for calibration, he predicts.

“Say a group of market participants are all growing at double digit rates, but management projects [that] the subject portfolio company [will] only experience five percent growth. Well, with all other things being equal, then you know your multiple shouldn’t be going up as much as those public companies. And that’s where some GPs aren’t doing the deep dive. Calibration will help fix that.”

A second major issue on the taskforce’s agenda relates to the concept of ‘unit of account’, says Vannucci – basically, how GPs measure their assets (either as single shares, say, or an entire company) when determining fair value.

One of the big challenges here relates to how GPs value an investment where they hold a controlling versus a minority interest – which can be further complicated depending on whether they hold it in a single fund or across multiple funds.

“Would the value of 100 percent equity within a single fund have the same pro rata value as 30 percent equity held in three different funds managed by the same GP, [or] as a club deal in which 20 percent of equity is held in five different funds managed by different GPs?” asks Vannucci. “Or if a sponsor has 100 percent of a company’s equity in one fund, and 100 percent of debt in another managed by the same GP, how do you value that?”

It is these types of scenarios where fund managers have adopted different valuation approaches, Vannucci says – and auditors lack clear-cut guidance on how to evaluate them. “It’s something that auditors can lose sleep over,” he admits.

These are the sorts of problems the new guidelines will look to address, says Vannucci. The eventual outcome may be that CFOs end up doing more work on their marks – but at least they would have “upfront knowledge on what they have to do, instead of having to go back and forth with their audit firms.” For both auditors and GPs, that ought to make life a lot easier during future audit seasons.