It may not feel like it, but the science (well, art really) of valuation may undergo some significant, irreversible changes in the private funds industry over the course of the next two years.
Private fund CFOs may find that unbelievable considering the amount of change that’s already taken place in the last eight years, and maybe even concerning after having finally achieved a sense of normalcy in the last two. Since the introduction of FAS 157 (now known as Topic 820) in 2006, they’ve learned to report portfolio company estimates at fair market value on a quarterly basis; something far more complicated than the old way of doing things: holding investments at cost until something major forced a valuation to be updated.
Then in 2012, registration with the US Securities and Exchange Commission (SEC) prompted US finance chiefs to write new chapters in their valuation manuals, appoint valuation committees and think more about what types of disclosures were included in performance reports. Those best practices inspired CFOs elsewhere around the world to do the same, but European CFOs could also speak more about what it means to be “independent” from dealmakers as well as all the other complicated valuation-related requirements of the Alternative Investment Fund Managers Directive (AIFMD).
Nevertheless, CFOs report meeting those challenges and even embracing some of the recent changes. A status quo is beginning to emerge about what it takes to complete the year-end audit without going completely gray and about the type of information investors expect to see in valuation reporting. But in the time ahead, diligent CFOs will monitor new valuation developments that may very well end up testing the firms’ middle office and finance teams just as much as Topic 820 or, at the very least, spark a change in thinking about how the valuation function should be managed. Below, we round-up the biggest four.
1. UK regulators clarify valuation rules
First the really big news: pfm has exclusively learned that the UK’s Financial Conduct Authority (FCA) plans to publish technical guidance on valuation rules contained in the AIFMD. Expect draft guidance to be released for consultation this month, possibly April at the latest.
Here’s why this is huge: If GPs had to point to a single section of the AIFMD that was most confusing, many would land their finger on the requirement that deal partners be kept separate from the valuation process. Stopping optimistic deal partners from overvaluing their pet companies is feasible for large firms with formal valuation committees and enough resources, but smaller shops heavily rely on deal partners – who know the portfolio company most intimately – to arrive at a reasonable valuation estimate.
The AIFMD is riddled with confusing requirements like this, many of them valuation-related. Similar to the effect that SEC registration had in the US, the directive is forcing GPs to write more detailed valuation policies, disclose more information about their valuation methodologies and document everything for inspection purposes. Best practices will develop over time, but the concern is that regulators won’t like what GPs come up with in the initial years of post-AIFMD supervision.
To be fair, regulators have released a trickle of technical guidance since the directive took force in 2013, but none of them have been very comprehensive on valuation, which leads to the positive development that the FCA, the UK’s chief private equity regulator, will address the problem in the coming weeks.
Happily, market sources expect the guidance to address the “deal team independence” question. Some firms are reaching the conclusion that an external valuer needs to be appointed to achieve that independence, but there’s a problem here too: valuation service providers tell us the directive is too ambiguous for them to feel comfortable about taking on the liability that comes with AIFMD-approved valuation work. Under the directive, third-party providers are liable for any losses suffered by the fund manager as a result of their negligence or intentional failure to perform the job. This could potentially prove very costly if a buyer, say, proves that it overpaid for an asset.
Admittedly, valuation service providers always take on a certain level of liability risk when valuing private equity assets (which are especially hard to price). But pre-AIFMD, at least liability costs were usually capped at a certain multiple of the fee. Post-AIFMD, liabilities can be as high as the level of damages arising from a negligently mispriced asset. And some valuation specialists say it’s not worth their while to take the risk. The guidance is expected to clear the air on the matter, allowing for a more efficient external valuation market to develop in the industry. The hope is the FCA’s work will act as a springboard for other EU national regulators to do something similar, or at least point to the FCA’s guidance as a source of inspiration for interpreting AIFMD valuation rules.
2. IPEV plays defense
Every three years, board members from the International Private Equity and Venture Capital Valuation Guidelines Board (or IPEV) come together to review their valuation guidelines. The IPEV valuation guidelines are of course the standard of choice for private equity CFOs, and 2015 happens to be a review year.
It’s not necessarily the case that the guidelines are changed each cycle, but in both 2009 and 2012 they underwent an update. It’s safe to assume 2015 won’t be any different in light of some recent trends.
Aware that audits have become more laborious and time-intensive, the American Institute of CPAs (AICPA), the main professional body for US accountants, recently assembled a taskforce to create bespoke guidelines for private equity and venture capital valuation estimates.
However, the industry is questioning the need for this taskforce, arguing that IPEV’s valuation guidelines offer everything auditors need to prove that CFOs are sending financial statements in accordance with official accounting standards.
For their part, auditors argue that IPEV’s guidelines don’t provide enough instruction on certain areas where they’ve encountered inconsistences in the field. Critics counter that the taskforce’s mission is really to push more valuation work on CFOs, regardless of its benefit, so that auditors can show their overseers that GPs’ valuations were adequately stress-tested.
It’s feasible that IPEV board members may play defense by reviewing their guidelines with the AICPA taskforce in mind. The AICPA board is expected to publish some draft work later this year (at the earliest) that addresses valuation concepts like unit of account and what it means to have the perspective of a market participant when determining fair value. It is understood the AICPA guidance will use more case studies and example valuation models to make its points. IPEV may tweak its wording in certain areas to signal the correct best practice that AICPA should be considering when writing those valuation case scenarios.
Early stage investments are a good example of where the guidelines may need review in light of auditor demands, says Duff & Phelps managing director and IPEV board member David Larsen, who also holds a seat on the AICPA taskforce. “With some careful wording IPEV could make it more clear that CFOs must document how they estimate fair value for all investments, but shouldn’t blindly use mathematical models that deviate from market participant assumptions when valuing an investment during its early stages of financings.”
Larsen says the guidelines could potentially stipulate more of a “weighted expected return model” that determines an early stage company’s value based on the probability of it achieving certain financial performance milestones.
The goal would be to preserve IPEV guidelines as high-level, principle-based recommendations, but written in a way that provides auditors a little more comfort around consistency in practice, especially for early stage investments.
3. GASB creates more needy LPs
The Governmental Accounting Standards Board (GASB) – which sets accounting standards for state pension plans and other public sector LPs – put out an exposure draft codifying how state and local governments should define and measure fair value. The rules (which, at the time of press, were expected to be finalized imminently) are relatively straightforward and largely mimic what the Financial Accounting Standards Board has done with Topic 820. But now that GASB has ended its silence on how exactly LPs should go about reporting the value of their private fund holdings, one consequence may be that public pension plans require more rigorous and timely reporting by GPs.
Here’s why it matters: an average pension plan investing in private equity or real estate will usually report their first quarter numbers sometime in May (though some are as early as April). Meanwhile, in the weeks after the quarter closes, their GPs are tallying up their own quarterly estimates for reporting purposes. Most limited partnership agreements give the manager 45 to 90 days to get that job done (or 90 to 120 days for the annual report). Often, the delivery of their respective reports won’t sync up. But with a few simple tweaks to account for any investments, divestments or wild market swings during the intervening period, LPs can always use whatever the latest report they received from the GP was to figure out the fund’s current fair value. In accounting lingo, it’s known as a practical expedient.
And for a long time that’s always worked, not least because LPs never really had hard and fast rules on fair value accounting to follow. But with the new GASB standard that may all change.
What makes the exposure draft so significant is that it ends GASB’s silence on how exactly LPs should go about reporting the value of their private fund holdings.
The exposure draft acknowledges that the practical expedient concept is useful, saying the fund’s NAV per share can be reported instead of having LPs run their own valuation models on LP interests (they would need to estimate fair value for direct and co-investments), of which GPs presumably have a better understanding. But GASB also states that as a safeguard, LPs should make additional disclosures when relying on the practical expedient – and it’s this second part that may force LPs to require more rigorous and timely reporting from managers.
If so, there’s already momentum behind the development. LP expectations around reporting and communication have been building over time, leading a growing fraction of investors to demand more timely reporting. A full 25 percent of hedge fund investors now require their managers to report on a daily or weekly basis and almost half of private equity and real estate managers are expected to send portfolio updates at least monthly, according to a 2014 Intralinks investor survey (see graph).
4. Outsiders lose trust in your estimates
It appears that regulators and investors are catching wind of the same academic studies as you are. In 2013, Oxford researchers released a study claiming that GPs have been prone to inflating their reported interim performance data when marketing follow-on funds. In the time since, SEC officials have regularly cited the study as justification for private equity registration, and used it as a rebuttal to the industry argument that there is no incentive to balloon interim valuation measures because any performance-based carry dollars paid out are ultimately based on final realizations (and subject to clawback if not).
In 2014, Drew Bowden, the SEC’s top inspector who delivered the now notorious “Spreading Sunshine” speech at a May PEI conference, cited the study when pinpointing trouble areas the commission found during a two-year sweep of newly registered advisers. He also included in the speech concerns around GPs using a valuation methodology different from the ones disclosed to investors, cherry-picking comparables and changing a valuation methodology from period to period without additional disclosure.
Accordingly, fund advisers who haven’t undergone a fundraising since then should brace themselves for tougher questions from investors conducting due diligence. LPs are reacting to the academic study and regulatory speeches by taking a closer look at managers’ valuation policies and procedures and performing back-testing on estimates to see how interim valuations matched up with final exit prices. In short, the paper and SEC speeches created a small, though noticeable level of distrust in valuation estimates that wasn’t there before.
CFOs shouldn’t expect the issue to go away anytime soon either. Soon-to-be-released research from George Washington University claims that GPs are misleadingly presenting their returns as less volatile than publicly traded companies’ returns. The International Business Times, which obtained a copy of the study ahead of its release, said the researchers believe the private equity industry is using its latitude to “self-value its own portfolios in order to make their returns look ‘smoother’ than they actually are.” Based on that premise, the researchers concluded that “investors may have been unfairly induced into placing monies into these investment vehicles,” according to the report. Ignoring the fact that GPs are very hesitant to mark wild swings in their quarterly valuations for legitimate reasons, the study will no doubt catch the attention of regulators and investors, leading to more headaches for CFOs who may have to explain the minutia of the private equity valuation process to the uninitiated.
More concerning is the possibility of examiners taking a tougher approach when reviewing GPs’ valuation function. Convinced the study may be on to something, examiners could feel more confident about second-guessing GPs’ actual estimates, which, as Bowden said during his speech, was never a goal. The more real possibility is inspectors pressing harder on CFOs to use calibration, questioning the inputs used for an estimate, or asking more questions about why a portfolio company’s accounting methods do not match those of the firm’s own report (say, for instance, different discount rates were used). And now that a special private equity inspection taskforce is turning its sights on other illiquid asset classes like real estate and infrastructure, other GPs in the private funds industry should anticipate similar levels of scrutiny.
There is wide agreement that the valuation function has undergone rapid advancement (and institutionalization) in recent years. All signs point to the trend continuing in the next few years too. CFOs, brace yourselves.