An uncertain decade

In the valuation world, 2016 is a watershed year. The turn of the calendar marked 10 years since the introduction of FAS 157 (now known as Topic 820), which ushered in the age of chief financial officers (CFOs) reporting portfolio company estimates at fair market value (rather than holding investments at cost) and permanently changed the way private equity firms approached valuations.

To take a look in the rearview mirror and reflect on how Topic 820 has shaped the past 10 years in valuations, pfm gathered a roundtable of CFOs, auditors and valuation experts.

In the past decade, firms have been met with an onslaught of guidance on precisely how best to value their assets using fair value accounting from the likes of the International Private Equity Valuation Board (IPEV), Financial Accounting Standards Board (FASB) and the American Institute of CPAs (AICPA). But despite all this, many private fund CFOs are still struggling to bring their valuation methodologies up to speed.

“Ten years after FAS 157, you might have thought there would no longer be a lot of noise regarding valuations,” says Tom Angell, audit partner and head of the private equity practice at WithumSmith+Brown.

“While progress has been made in terms of improving transparency and providing a general level of consistency, guidance specific to valuation methodologies for venture and private equity investments is still evolving. We have seen different valuation experts value businesses in the same industry using different methodologies. It increases the complexity of auditing valuations when you see that occur in practice.”

The CFO representative at the table, Jason Donner of Veritas Capital, agrees that while uncertainty remains, the biggest shift since the release of Topic 820 has been the integration of the finance team in the valuation process. At Veritas, a mid-market private equity firm, Donner has seen the valuation process mature in the past 10 years as the firm’s finance team has become an integral part of the process of determining final figures for the valuation of portfolio investments.

“Years ago, our finance group wasn’t really involved other than in connection with the reporting of the numbers to our investors,” he says. “Now the finance group members are not only the ones who have developed the process, but in a lot of scenarios, they are also the last line of defense.”

Indeed, much of the conversation revolves around the issues of independence when preparing valuations, the way the relationship between LPs and the valuation process has evolved, and the valuation impacts of the most critical change in the private funds industry in the past decade: regulation worldwide.

While Topic 820 may have been introduced in order to simplify and standardize valuations, the sentiment around the table is that uncertainty is only continuing to grow, agrees David Larsen, managing director at Duff & Phelps.

“One would have thought things would have calmed down, but it seems this valuation topic in the alternative investment space has more legs than one would have ever believed,” he says.

Regulatory pressure

Much of the uncertainty fund managers are feeling regarding the valuation process comes down to the most significant shift in the US funds universe since 2006: investment managers falling under the purview of the Advisers Act and the oversight of the US Securities and Exchange Commission (SEC).

“Prior to having the SEC potentially knocking at their door, funds would throw an unadjusted median EBITDA multiple at audit firms and say, ‘Prove me wrong,’” says Kevin Vannucci, valuation partner at assurance, tax and consulting firm RSM US.

“We still see that sometimes, but it’s come a long way because they’re registered investment advisors and they have to have a formal valuation policy. They know they should be following that policy and if they aren’t, that’s going to be subject to scrutiny when the SEC examines them.”

Although the focus of recent SEC enforcement action has been on fees and expenses rather than on valuations, examiners are certainly taking notice when something seems awry, adds Angell. Because much of the valuation-related enforcement action has been for inflated valuations near the time of new fundraising by the fund, his team is taking a close look at that type of activity.

Angell’s observation prompts Vannucci to ask what exactly the team at Withum is seeing when the SEC confronts valuation policies. Are private fund valuation policies, from the regulator’s perspective, too general or too detailed?

Actually, the SEC’s influence has played a part in the way funds have written their valuation policies, Angell notes. Angell also indicated that in certain cases, enforcement actions have been brought against funds in situations where the fund has not complied with its stated valuation policies and procedures.

“When the funds were documenting their valuation policies in anticipation of registration, one of the biggest problems they encountered was they attempted to incorporate all potential procedures into the document. They thought more was better. When the SEC came in to review the funds, they observed a number of funds were not performing all the procedures detailed in the valuation policy. This resulted in SEC comments on the funds’ formal review. Now, all funds have cleaned up their policies and perform their valuations exactly how it is detailed in their valuation policy.”

Veritas has not gone through an SEC presence exam yet, but Donner says that, when the time comes, documentation is key.

“From my perspective, we don’t know what the SEC will look at in terms of valuation or anything else, so our mindset is: have a robust policy, follow it consistently, document everything and have a file and make sure when the regulator comes in you can answer most or all of their questions,” says Donner.

Aside from firms following their valuation policies, Larsen notes that when a portfolio company’s own valuation differs from a firm’s valuation, that is also when the SEC will raise the question of valuations. “I’ve seen situations where they’ve said, ‘You valued it like this but the portfolio company did a valuation and how did you take that into account?’ And even if the portfolio company did a 409A for a different purpose on a different valuation basis,” says Larsen.

Of course, the impact of regulation on valuation policies is not only felt in the US. Across the pond, the EU’s mammoth Alternative Investment Fund Managers Directive (AIFMD) is rattling nerves, especially when it comes to questions of “functional independence” around valuation methodologies.

Under the directive, GPs are required to demonstrate that the valuation function is independent from the portfolio management team to prevent any conflicts of interest. GPs can either hire a third-party valuation services provider or value the portfolio in-house, provided that dealmakers are kept far enough from the process. This requirement, however, can be problematic.

“Bringing in someone independent for independence’s sake, without using the deal team, has the potential to eliminate the knowledge base of those that are closest to the investment, who know the nuances of the management of that fund,” says Larsen.

Declaring independence

Questions of how involved the deal team should be in the valuation process crept up around the table. Despite the AIFMD rules and the preferences of regulators that GPs introduce more independence into the process of valuing their assets, deal teams are still primarily responsible for valuations, according to a poll conducted at the 2016 PEI CFOs and COOs Forum. The poll said approximately 68 percent of private equity firms said that their deal team, with some help from the accounting and finance staff, is mainly responsible for valuation work.

“As long as you know what’s in the policy and if you deviate from the policy you indicate in your work papers why. There’s no clear-cut
answer, it’s very subjective and judgmental what we do but you need to document why. If you don’t you’re open to scrutiny which would delay an audit,” says Vannucci.

The question of the deal team’s involvement in valuations falls to Donner as the roundtable’s CFO. The deal team prepares the valuations, but the Veritas finance team has developed a series of checklists that the deal team is required to fill out, and which the senior investment professional in charge of monitoring the particular asset must approve, in addition to writing a summary memo that goes along with the valuation package.

“They’re the experts and they live and breathe with our portfolio companies, but there has to be someone who’s looking at the information they provide and asking them questions from a different vantage point,” he says.

Angell, too, has seen an evolution in the clients he audits, who are beginning to understand that valuations cannot be considered independent when prepared by the deal team with no oversight.

“More clients are acknowledging the need for an internal check and balance dynamic in the financial reporting process. There are now formal valuation committees which include others outside the deal team. There has been steady improvement in this area.”

Around the table, the valuation experts agree that deal teams generally err on the conservative, rather than aggressive, when conducting valuations.

“Part of that is an education process with deal teams, especially young deal teams. You can hurt yourself by holding value down in a way that’s not prudent. Not reporting volatility does not make volatility go away,” says Larsen.

“Many funds are demonstrating increased rigor in their valuation process, often demonstrating independence through the use of a third party as a way to differentiate themselves with investors. In addition, LPs are under new pressure to demonstrate the robustness of their own valuation process.”

Confronting LP interests 

Indeed, transparency is an issue being raised more and more by LPs in the private funds community, and valuations are not excluded from those discussions. The Institutional Limited Partners Association (ILPA) has been conducting training for LPs so that LPs are better educated to have fluent, competent discussions.

“When they go in to determine if they’re going to invest they’re armed with more ammunition to look at valuation policies to ask the general partners about different things and ultimately get comfortable about whether they want to put money into a fund or not,” says Vannucci.

And while the GP community is being met with guidelines from FASB and IPEV, public pension funds have been confronting the new Governmental Accounting Standards Board (GASB) fair value rules, which were updated last year. GASB allows users to estimate a fund’s fair value using its reported NAV per share. However, the measurement date must sync with the report date; a difficulty in the private equity industry where reports are only provided on a quarterly or semi-annual basis.

Now public pension fund LPs can’t blindly accept the valuations the GP gives them, notes Larsen, who is increasingly seeing LPs issuing RFPs to obtain assistance to reevaluate their own valuation policies and procedures.

“Are they doing enough to qualify NAV for use as their fair value estimate for a fund interest? And if they have direct investments, they have to effectively be just like a general partner with respect to their valuation process. So you have a lot of issues continuing to percolate on the LP side.”

Angell adds: “Then you typically have different year-ends for the funds and the government LPs. As a result, the recent regulatory guidance from GASB impacts the frequency and scope of valuations required by public pension fund LPs. The funds now need to prepare detailed valuations on a more frequent basis than they did before. Ten years ago when we started all this, the biggest issue the GP had was getting his K-1s out to his LPs.”

Donner has witnessed the effects of the GASB update firsthand. LPs are requesting “a lot more” information from Veritas on the valuations and about the performance of the portfolio because they are performing their own valuations, whether because they want to use NAV or because they have co-investments.

“Investors want more qualitative information on the portfolio as well – how the business is performing, in particular when we’ve informed them previously about a specific contract or business line that the portfolio company is pursuing, et cetera. This information also goes into some of the work they’re doing around their valuations, understanding how the business is performing, what are some of the milestones,” adds Donner.

What lies ahead

What with regulation, LP requests and reporting requirements, GPs clearly have a lot more on their plates when it comes to valuations than they could have imagined 10 years ago. This additional workload may explain why some funds are falling behind when it comes to the most current and accurate methodologies.

“Sometimes I wonder if they’re keeping up with the latest. Calibration has been around for a few years; I don’t know if a lot of funds have really explored that or even thought about it,” observes Vannucci.

Calibration is the idea that a GP should look at the market inputs or assumptions originally used to price a target company. Then during subsequent valuations (typically each quarter), the GP should consider how those original inputs and assumptions may have changed in light of changing market conditions.

“If I could evangelize anything, I’d say calibration is the strongest and least-used tool in the valuation tool box of a private equity fund,” says Larsen.

He adds that in a recent discussion with a real estate deal team, the GPs told him that value had accreted because they had “changed valuation methodology.” If that team had used calibration, they would have been able to articulate what happened to cause value to go up. Values shouldn’t change because of valuation methodologies, values change based on market conditions and investment performance, Larsen says.

Unfortunately, especially for smaller funds, calibration is “not something that they’ve adapted as a required practice in their valuation analyses just yet,” says Angell. “Valuations are viewed as a year-end process necessary to supply their LPs and auditors with the required documentation.”

There’s a similar issue at hand with unit of account.

“People should be thinking about it because it determines how you’re going to value different equity or debt positions, but I can guarantee you most of our clients aren’t thinking of unit of account when they go to value something,” notes Vannucci.

Luckily, resources are emerging to help funds grasp these concepts and integrate them into the valuation strategies of any firm, regardless of size. In December, IPEV released its updated guidelines, including further commentary on unit of account, new guidance on reporting across funds, clarification on how debt impacts equity valuations, new language on back-testing, and revised guidance on the DCF model. This was an especially important development for European funds, many of which mandate compliance with IPEV guidelines in fund documents.

But valuation experts are especially looking forward to the AICPA’s bespoke guidelines for private equity and venture capital valuation estimates, due for release in 2017.

“From the funds’ point of view, different accounting firms view things differently so there is frustration out there when we go and visit prospective clients. This firm says we have to do it this way, this firm says we have to do it that way, there is no guidance per se,” says Vannucci.

“So a lot of people are waiting for the AICPA to issue this guidance. It will still be gray but I think it will go a long way to help define unit of account, help define how you look at equity/debt positions and what you do if you’re a VC firm. Funds are waiting for it.”

While anticipating the release of the AICPA guidelines, Donner wonders whether the 700-page guide will only serve to further regulate a rather subjective process that can differ from firm to firm.

AICPA’s goal, Larsen responds, is to do exactly the opposite.

“It will take some of these judgmental areas and demonstrate why they are judgmental and why there can be more than one answer, and that that’s okay. That in and of itself would be a relief valve for an auditor or a regulator who thinks there can only be one answer,” he says.

Perhaps that will be the reassurance needed to make the next 10 years in fair value accounting more certain than the last.