New valuation guidance: the key takeaways

The working draft from the AICPA task force focuses on best practice for measuring the fair value of portfolio companies, writes Christopher LaDue, a principal at RSM.

This article was sponsored by RSM. It appeared in the pfm Yearbook 2018 with the December/January 2019 issue of pfm.


As record amounts of capital continue to be raised and deployed by private equity and venture capital funds, the level of scrutiny these investments have garnered among regulators, policymakers, investors and other stakeholders has forced these funds to place greater emphasis on their valuation processes and controls, particularly the methods used to account for their investments.

LaDue: there are trade-offs whichever method you choose

In an effort to provide a conclusive source of guidance to the industry, the AICPA’s PE/VC Task Force, along with the Financial Reporting Executive Committee (FinREC), have released a working draft of an accounting and valuation guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The official release of the guide is anticipated sometime in the spring of 2019.

Despite its nearly 650 pages, the guide’s key focus is on best practices for the valuation of, and accounting for, fund investments in portfolio companies, specifically accommodating the key concepts of fair value for financial reporting purposes.

Here is a summary of some of the key topics that may be of interest to private equity and venture capital fund executives. The topics include options for the allocation of equity values, and concepts that may not be widely known but are critical for the accurate reporting of fair value investments, such as backtesting and the treatment of transaction costs.

Equity interests in complex structures

Perhaps one of the most controversial subjects encountered is the choice of approach used by equity investors to allocate overall company equity value among its various equity or equity-linked securities.

When estimating the fair value of the fund’s investment, the fund should determine how each class of equity would participate in future distributions from a sale or other liquidity event, and the implications for the fair value of each class of equity. Estimating the value of the different classes of equity in a portfolio company requires an understanding of the rights associated with each class.

The guide outlines four valuation or allocation methodologies for estimating the fair value of an equity interest in a complex capital structure:

  • Scenario-based methods: A forward-looking method that considers one or more possible future scenarios. These methods include simplified scenario analysis and relative value scenario analysis, which tie to the fully-diluted (“post-money”) equity value, as well as full scenario analysis, also known as the probability-weighted expected return method.
  • Option Pricing Method (OPM): A forward-looking method that considers the current equity value and then allocates that value to the various classes of equity considering a continuous distribution of outcomes, rather than focusing on distinct future scenarios.
  • Current Value Method (CVM): Allocates the equity value to the various equity interests in a business as though the business were to be sold on the measurement date.
  • Hybrid method: A combination of scenario-based methods and OPM.

While no single method for valuing equity interests appears to be superior in all respects and circumstances over the others, each method has its own merits and challenges, and there are trade-offs in selecting one method over another. The level of complexity also differs from one method to another.

Ultimately, when selecting a method for the valuation of equity interests, the following criteria should be considered:

  • The method reflects the going-concern status of the portfolio company, and that the value of each class of instruments reflects the expectations that market participants investing in those instruments would make about future economic events and the amounts, timing and uncertainty of future cashflows to be received by the holders of each instrument.
  • The method assigns some value to the junior instruments, unless the portfolio company is being liquidated and no cash is being distributed to the junior instruments.
  • The results of the method can be either independently replicated or approximated by other valuation specialists using the same underlying data and assumptions.
  • The complexity of the method is appropriate to the portfolio company’s stage of development.

The benefits of backtesting:

Chapter 11 of the guide introduces a concept that is not entirely new, but that isn’t widely adopted by funds in the middle market. Simply stated, backtesting is the process of reviewing and comparing the results, methods and assumptions of recent or prior valuations conducted for a fund’s investments with the ultimate valuation realized when the fund sells or liquidates its investment. The primary purpose of backtesting is to “assess and improve” the fund’s or investment company’s process for developing its fair value estimates with the benefit of hindsight. It is not meant to highlight mistakes or to correct a prior valuation estimate.  Rather, backtesting provides ongoing feedback that should help to enhance the fund’s valuation processes and contribute to its system of internal control over financial reporting practices.

The important elements of the backtesting process include determining what information and factors were known or knowable as of the measurement date; assessing how well those factors were considered in developing the fair value measurement; and identifying whether there were factors that were relevant to the valuation as of the event date that were not considered or given weight as of the measurement date.

As the guide says: “Backtesting allows the fund to improve valuation processes by assessing whether the factors that appear to have contributed to the actual result were consistent with those previously identified in the valuation.”

Treatment of transaction costs

Actual transactions in a portfolio company’s securities (either recently completed or contemplated) typically provide the best indications of fair value from a market participant perspective, but certain adjustments may be necessary. In particular, transaction costs should be excluded from the fair value of the investment, meaning the fair value may not be equal to the total cost to purchase, or net proceeds received upon the sale of, the investment. Frequently, we observe the following errors in the derivation of fair value estimates:

  • Fair value = purchase price + transaction costs (typically observed upon acquisition of an interest in a portfolio company, where incremental costs, such as legal, due diligence and other costs, are often incurred in order to consummate the transaction).
  • Fair value = sale price – transaction costs (typically observed upon sale of an interest in a portfolio company, where sales transaction costs, such as investment bank fees, legal fees, third party valuation fees and other costs, are often incurred to close the transaction).

“Transaction costs are capitalized at initial recognition and, therefore, impact the unrealized and realized gains and losses from investments reported in the statement of operations of the investment company at each subsequent measurement date,” says the guide.

The PE/VC guide was developed to provide guidance, examples and case studies for preparers of financial statements, independent auditors, management and boards of directors of investment companies, professionals that prepare valuation analyses and other interested parties regarding the accounting for and valuation of portfolio company investments of VC and PE and other investment companies.


*The above examples are just a few of the topics relevant to middle market funds. For a more detailed overview of these and additional topics, download RSM’s white paper AICPA guidance focuses on measuring fair value of portfolio companies, at