Roundtable: Meet your auditor

Valuing private equity funds has never been an exercise without its challenges – but in recent years the process has become much more complicated. That can largely be attributed to accounting rules that now require GPs to report their portfolio at fair value, meaning investors could no longer be handed stale valuation figures that were only updated following a major milestone. Instead GPs now use complex valuation policies to decipher the market value of their assets on a quarterly basis.

Indeed, it’s hard to imagine a roundtable comprised of an industry chief financial officer, controller and two auditors having so much to discuss compared to just five years ago. So when in early March PE Manager assembled its valuation roundtable in midtown Manhattan, we expected a lively dialogue on what types of best practices have emerged in the creation of valuation reports; how much transparency firms should provide in justifying their fair value estimates; and arguably most important, what firms can do to satisfy the expectations of auditors. We were not disappointed. 
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MEET THE ROUNDTABLE

Tom Angell is the principal in charge of Rothstein Kass’ national commercial services group and its private equity practice, as well as a member of the firm’s executive committee. Angell, a certified public accountant, advises private equity funds and investment advisors on all aspects of private equity transactions, such as raising financing, deal origination and structuring.

Marc Rappoport is a partner and CFO of New Venture Partners, a global venture capital firm dedicated to corporate technology spin-outs. Rappoport overseas finance and administration, compliance, human resources, tax and investor relations at the firm. Previously, Marc was the CFO of Lucent Venture Partners, where he established the financial and operational infrastructure for the firm.

Laurence Rukin is the controller for HSBC Capital (USA), having joined the group in 2007. Rukin began his career at Goldman Sachs where he worked on the GS Capital Partners and the Whitehall Street Real Estate Funds. After Goldman, he was a director in private equity fund administration, where his clients included Court Square Capital and Odyssey Investment Partners.

Kevin Vannucci is a partner for McGladrey and is in charge of the east coast valuation practice, having been with the firm since 1991. Vannucci, an accredited senior appraiser and certified public accountant, has prepared business valuation reports for clients in many different industries including manufacturing, distribution, technology, construction, consumer products, food and beverage and professional services
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PAGES OF POLICY

In late 2008 a large number of GPs had begun marking their assets to market in response to the US Financial Standards Accounting Board’s Statement 157 (now topic 820). Others had been reporting at fair value for years, based on guidelines put forth by groups like the Private Equity Industry Guidelines Group, but had adjusted their strategies to be in line with FAS 157.

But what really formalized the valuation process was registration with the Securities and Exchange Commission, says Kevin Vannucci, a valuation partner at assurance, tax and consulting firm McGladrey. As of last March, private funds managing north of $150 million were required to register with the agency, an oversight change which included an “informal inquiry” into how GPs value their investments and report performance.

“Registration really turned the screw on funds to get their policies documented and documented right,” says Vannucci.

The SEC has also made it a priority to visit the newest members of the registered investment adviser club. And it’s safe to assume those visits included a request for the firm’s valuation policy, cautions Tom Angell, head of private equity at accounting and audit services firm Rothstein Kass.

“When regulators come in, they’re going to read the valuation policy and see if it’s actually being followed in your quarterly reports,” elaborates Angell. “Even if your valuations are materially correct, you’ll get cited if they weren’t completed in accordance with the firm’s protocols.”

Laurence Rukin, controller for HSBC Capital, a private equity investor specializing in both direct and fund of fund investments, says his firm recently underwent registration, adding that the process has led to greater effort being taken to explain their valuation methods. “It’s not enough to say a discounted cash flow (DCF) analysis is the best method to value a company, you have to explain why.”

It’s that “explaining why” that has turned a couple pages of valuation guidelines generally used by firms prior to 2008 into formal 10-page plus packets clearly outlining the firm’s policies now used today, says New Venture Partners chief financial officer Marc Rappoport.

Rappoport adds that as best practice it makes sense for firms to annually review their valuation policies to keep pace with updates in valuation guidelines published by groups like the International Private Equity and Venture Capital Valuation Guidelines Board, which in late December tweaked their fair value guidelines to meet US and international accounting definitions of fair value.

PROVING YOUR ASSUMPTIONS

Often the roundtable’s four participants would refer to valuation as being “both art and science”.

However the enhanced valuation guidelines being used internally by chief financial officers speaks to the desire to eliminate as much room for interpretation as possible, preferring instead to show auditors and regulators a rigid and systematic methodology used in deriving fair value.

But valuation of course is not completely objective, say the roundtable’s two auditors, Vannucci and Angell. Some element of subjectivity will always be embedded in the numbers; however some private equity finance professionals have asked the firm’s auditor for feedback on their policies (or an “interpretation of their art”, so to speak).

“We can’t help them write their policies in any way,” says Angell. “But we can raise any red flags, or explain our issues, with what they present.”

Vannucci adds that each accounting firm is different in what type of feedback they’re willing to provide – some accounting firms may provide best practice examples that can be found online or in industry articles.

On the topic of best practice, Rukin notes that transparency is key to a well-crafted valuation report: “Every one of our investments comes with a two to three page summary explaining its valuation.”

Rukin says these summaries track an asset from time of purchase to its latest valuation measurement – with an explanation of all the calculations (typically delivered in Excel) that went behind each milestone moment throughout the investment history. Other details, including the investment’s auditors and legal advisors, are disclosed, as well as all the anecdotal elements that help explain why the firm feels a company is worth ‘X’, he explains.

With the topic of conversation turning towards what assumptions are made during the valuation process, the roundtable emphasized that private equity firms rely on a number of unobservable inputs in deriving fair value. Unlike “observable” public company share prices updated by the second on a stock exchange, projected cash flows for instance are relatively “unobservable” and therefore require greater explanation in the footnotes.

To meet disclosure rules, funds must additionally provide quantitative information about which unobservable inputs and techniques were used in a valuation. Angell says this can be satisfied with a table that includes for each portfolio company the aggregate fair value weighted by each valuation technique used (which implies that more than one technique should be used as best practice), and, for each technique, a listing of the significant unobservable inputs, the range of inputs used, and a weighted-average of the inputs. 

Rukin adds that any accompanying commentary explaining how the unobservable inputs and valuation techniques were weighted in deriving a fair value estimate should be well-reasoned. “For example, the SEC would probably question a chief financial officer that describes the discounted cashflow method as the most superior valuation technique in their commentary, but who didn’t weigh that method heaviest in their analysis. It all needs to jive.”

The SEC’s intent is to ensure fund managers are not cherry picking valuation techniques. A consistent methodology prevents GPs from switching one valuation technique for another in the hopes of finding a more desirable valuation estimate.  

The roundtable agrees no valuation technique is necessarily better than the other, and deciding which technique(s) to use depends on a company’s size, stage of growth and the availability of observable inputs.

And which unobservable inputs GPs select in the valuation process is precisely what auditors are trained to test, says Angell, who tells the roundtable his favorite word during an audit is “why”.

Vannucci responds to the point saying that chief financial officers able to comprehensively answer his questions are more likely than not to have fewer follow-up questions. “Have answers for why you’re using a growth rate of 15 percent this year when last year it was less than 10 percent. Or for example, last year you anticipated growth in 2012 to be 15 percent, but it turns out your actual growth in 2012 was only 5 percent. Well, why did you miss your forecast? That’s why you should have your assumptions documented and a retrospective analysis completed in order to increase the efficiency of the audit process.”

Angell adds to the point saying that another scenario likely to result in probing is when a company experiences steady and consistent growth but a GP assumes a more aggressive rate of growth in their five year forecast, or for example, when a GP shifts the discount rate used for a company from one year to the next.

INFORMATION-HUNGRY AUDITORS

Indeed audits have become so comprehensive that some auditors are now even beginning to speak with portfolio company-level executives for their own internal valuation estimates – a move some GPs may find thorny if not handled with sensitivity.

“Some audit firms are looking to see if the portfolio company’s own third-party valuation matches that of the GP’s,” says Vannucci. “Now they might not necessarily match due to issues surrounding majority as opposed to minority control as well as the standard of value and the purpose of the valuation, but accounting firms are under pressure to look at all relevant  information as they determine the reasonableness of the valuations provided to them by their clients.”

When comparing valuations by GPs and portfolio executives, another conundrum for auditors is the tendency for portfolio executives to be more aggressive in their growth and margin projections. “Management of the portfolio company may be trying to hit certain targets while the fund wants to use realistic assumptions and doesn’t want to disappoint LPs with overly optimistic estimates that may inflate the company’s value,” says Vannucci, elaborating that this adds to the complexity of finding the company’s true market value. 

Likewise auditors are conducting their own sensitivity testing to GPs’ fair value estimates, says Angell. “If we think the discount rate should be a little different, we’ll run those models to see if a material difference arises in the original estimate.”

Agreeing with the trend of more enhanced audits, Rappoport adds that firms must take care in finding suitable public company comparables when selecting certain valuation methods. “We’ll try to focus on companies not only in the same sector, but same sub-sector. Not only companies of the same size, but that are growing at the same pace.”

Rappoport adds that it’s important to gather what data is available from portfolio executives who better understand their sectors best and are more likely to come across industry data not available in the public domain. “It helps keep our internal database of comparable companies up to date.”

Sharing that information with auditors can also increase their confidence in your numbers, notes Rukin. “We have a meeting where we update our auditors with what’s going on in the fund where we can share some of our thinking behind a company’s implied multiples when it was bought and sold for example.”

Vannucci demonstrates agreement with the point by elaborating on his previous comments on what GPs can do to improve the efficiency of the audit process: “When meeting with GPs I might question why their valuation used or didn’t use a guideline public company multiple that seemed to be very high or low, and if they’re able to immediately explain to me what were the specific company factors that may have warranted such multiples than it goes a long way in providing me reassurance that they’re closely following what’s taking place in their target markets and the companies that they may or may not consider to be comparable.”

Ultimately, GPs unsure of their abilities as valuation scientists/artists should back-test their investments, notes Angell. Previous sales can be compared against what exit price the firm believed it would achieve prior to the realization. Likewise, valuation assumptions can be tested as the company passes various milestone moments.

With the roundtable drawing to a close, each of its four members agreed no valuation policy was perfect, a point the room’s two auditors acknowledged smiling. However, a number of trends including registration with the SEC, more challenging audits and transparency demands from investors have highlighted the need to follow best practices that have only emerged a short few years ago.