Valuation Challenge: 'Does NAV Equal Fair Value? A ‘Limited’ Perspective'

This article originally appeared in the April 2010 Private Equity Manager Monthly, a monthly printer-friendly publication delivered to subscribers to Private Equity Manager.

THIS MONTH’S CHALLENGE: “Does NAV Equal Fair Value? A ‘Limited’ Perspective”

PJ Viscio

THE CONTESTANT:
PJ Viscio
Managing director
Duff & Phelps

THE CHALLENGE:  Limited Partner (LP) has an interest in a private equity fund (Fund) managed by General Partner (GP). LP is required to mark its interest at fair value as defined under FASB ASC 820 (formerly FAS 157) for its fiscal year ending 30 June 2010. LP has historically relied on Fund’s net asset value (NAV) as reported by GP. LP has relatively limited resources, as well as relatively limited information, to perform its own internal valuations of the Fund’s underlying portfolio investments. May LP continue to rely on NAV to estimate the fair value of its investment in Fund, or is another approach required?

PJ VISCIO’S ANSWER:  It depends. FASB ASC 820 defines Fair Value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. However, FASB ASC 820-10-35-60 provides for the use of NAV as a “practical expedient” should certain conditions be met. These conditions are as follows:
1. The fund meets the definition of an “investment company” (most funds do);
2. NAV has been calculated based on a rigorous estimate of the fair values of the underlying investments in accordance with FASB ASC 820, adjusted for impacts such as carried interest; and
3. NAV is as of the same date as measurement date (i.e. no reporting lag).

Should the facts and circumstances regarding LP’s investment in Fund allow for the conditions, as outlined above, to be met, an LP can use its proportionate share of Fund’s NAV, as reported by GP, as a practical expedient, to estimate Fair Value for its interest.  Should either or both the second and third conditions not be met, ASC allows the use reported  NAV as a starting point to estimate fair value so long as “appropriate adjustments” are made.

These are summarised below:

 

 

Because most limited partner agreements (LPAs) allow 90 to 120 days for the GP to provide quarterly financial reports, the potential reporting lag becomes extremely problematic for LPs . In cases where an LP does not have an “in phase” NAV, the LP must make an appropriate adjustment to the last reported NAV. Such an adjustment would reflect changes in value of underlying investments during the period. For example, the LP may use value changes in the public markets or value changes in specific comparable companies to estimate the adjustment. Overall, developing an adjustment factor to reflect changes in value for out-of-phase NAV, while not trivial and while increasing the workload of the LP, should be relatively straightforward.

Adjusting NAV for underlying investments that are not recorded at fair value is even more problematic. While theoretically possible, generally an LP would not have sufficient information to estimate the fair value of underlying investments. For practical purposes, other than readily identifiable and quantifiable factors requiring adjustment that were incorporated in the reported value of underlying investments and reflected in the calculation of NAV (e.g. blockage discount, transaction costs, etc.) that can be identified and reversed or otherwise adjusted for, the LP would need to go back to the GP and obtain fair value estimates for underlying investments. Without such information, LP would not be allowed to use NAV and would need to estimate the fair value of its interest Fund through other means, such as market transactions in interests in Fund and/or through discounting the expected cash flows of the interest in Fund. Both approaches would be expected to be, if feasible, much more difficult to apply relative to using NAV to estimate fair value.

Guidance from FASB and the AICPA in the fall of 2009 made it clear that LPs cannot blindly accept GP reported NAV to estimate fair value. With respect to LPs, key aspects of the new guidance are:
1. LPs are responsible for the valuation assertions in their own financial statements;
2. Determining that reported NAV is fair value-based and in phase requires an LP to independently evaluate the measurement process utilised by the GP to calculate the fair value of underlying investments; and
3. Such an evaluation is a matter of professional judgment and includes determining that the GP has an effective process and related internal controls in place to estimate the fair value of its investments that are included in the calculation of NAV.

The AICPA’s guidance further states that to conclude that the reported NAV is fair value-based, which allows NAV to be used as a practical expedient to estimate fair value of the LP interest, the LP would evaluate among other things:

1. The GP’s fair value estimation processes and control environment, any changes to those processes or the control environment;
2. GP’s policies and procedures for estimating fair value of underlying investments, and any changes to those policies or procedures;
3. The use of independent third party valuation experts to augment the GP’s valuation process and validate its fair value estimates;
4. Qualifications, if any, of the auditor’s report on the fund’s financial statements whether there is a history of significant adjustments to the NAV reported by the GP as a result of the annual financial statement audit or otherwise;  and
5. Comparison of historical realisations to last reported fair value.

In summary, LP may utilise NAV as a basis (either unadjusted or if necessary, adjusted to reflect the fair value of underlying investments and/or to bring into phase) for estimating the fair value of an interest in Fund, provided that it can demonstrate that the underlying portfolio investments are reported by the GP on a fair value basis compliant with FASB ASC Topic 820.