Writing a valuation report is no easy task for private equity firms. Aside from the fact that marking to market isn’t always straightforward for privately held assets, GPs are expected to regularly update valuations with changes to assumptions, methodologies or new industry guidelines. And not all firms have the capabilities, time or expertise in-house to meet the complexities involved in reporting.
In Europe, the Alternative Investment Fund Managers Directive (AIFMD) requires managers to produce independent valuations for the funds they manage that are reviewed periodically, and at least once a year or before a fund engages with a new investment strategy or type of asset. This gives firms two options: to employ the services of an external valuer or to create procedures to ensure the internal valuations team is independent from the rest of the business.
However, by seeking advice of an external advisor with experience drafting valuation policies, “firms can gain insight into what is considered ‘best practice,’” says Ryan McNelley, managing director of the Alternative Asset Advisory group at Duff & Phelps.
Fund managers are required to value fund investments either annually, quarterly or every six months, depending on their accounting requirements – for example, US firms are also required to report valuations on a periodic basis, usually quarterly, under the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards FAS 157, Fair Value Measurement (now know as Topic 820) – and/or their investors’ requirements.
“For large, long-term assets such as those in infrastructure, quarterly valuations are sometimes too frequent because nothing has changed enough to provide the asset manager or valuer with much to address,” says Andrew Robinson, partner and head of Deloitte’s special valuations team. “Whereas with six-monthly valuations it is more likely that there will be more deferrable trends with respect to earnings, refinancing and/or changes in the market and regulations.”
The responsibility falls on the chief finance officer (CFO) to maintain that the valuation report is written independently and follows the obligations the fund manager has made to the investors. Many CFOs aim to adhere closely to both the International Private Equity and Venture Capital’s (IPEV) guidelines, as well as the “Quarterly Reporting Standards” encouraged by the Institutional Limited Partners Association (ILPA).
But the challenge for GPs is that these guidelines are regularly updated to reflect changing market practice and interpretation of relevant accounting standards. Here are five tips our sources suggest for staying on top of valuation reporting requirements.
1. Create a ‘trigger mechanism’
Alternative investment firms should have a “trigger mechanism” in place that prompts an update to valuation policy when there is a change to any relevant guidelines or the nature of the investments held within the portfolio, says Nick Rea, partner and head of PwC’s valuation practice. Another “trigger,” he says, should be any potentially significant market shift impacting portfolio companies.
In addition to having a built-in trigger mechanism, firms should review valuation policy at least annually to ensure it remains fit for purpose.
2. Demonstrate good governance
Valuation policies are all about governance and “good valuation policies demonstrate good governance,” says Deloitte’s Robinson
Regulators are increasingly investigating firms’ valuation methods and imposing fines if they are found inadequate, which has prompted investors to focus more on governance controls and the valuation process itself.
“Although the specific valuation methodologies, models, assumptions and techniques that will be used to value the specific assets of your fund are important to include in the valuation policy, the real focus is on governance, independence, and process,” says McNelley.
GPs should be including more information about the personnel involved in the valuation process, identifying who is responsible for sign-off at each stage and the level of involvement of the independent third party, including how many assets it is valuing. Firms should also clearly state whether the valuation is being done independently in-house or by an external third party.
3. Create an independent valuation committee
Larger firms can benefit from setting up an internal valuation committee to decide who will be involved in the valuation process, how frequently they will meet and who is responsible for sign-offs, says Mary Ann Travers, partner and national valuation services practice leader at US-based consultancy Crowe Horwath.
Robinson cautions, however, that smaller firms who take this step increase the risk of creating a bureaucracy.
When creating a valuation committee, firms should ensure that some of the executives involved are independent from the deal team; regulators and investors tend to think having the investment team as the primary voice on the valuation committee presents a conflict of interest. GPs argue, however, that investment professionals are best suited to value portfolio companies because they are closest to the assets; 68 percent of attendees polled at the 2016 PEI CFOs and COOs Forum in January said their deal team, with some help from the accounting and finance staff, was mainly responsible for valuation work. Getting the balance right is key.
4. Encourage communication
Communication is a key factor between managers and investors and also plays an important role between managers and valuers.
“A well-documented policy allows for transparency and consistency – GPs and LPs alike are searching for ways to better collaborate. This is a great place to start the conversation, communication is key and clear, well-articulated policies allow for trust-building in the investment process,” says Travers.
Managers responsible for determining valuations should be forthcoming to the valuer about how they have identified and addressed particular commercial issues relating to the asset(s), which in turn, says Robinson, can accelerate the speed at which the valuer can get to the root of any issues.
Improving communication practices can be achieved by mapping a communication plan (both internally and externally) around policies (and procedures), says Travers.
5. Ensure flexibility
Valuation policies require flexibility, which is especially important when hiring external valuers.
“It is important that a valuation policy retains enough flexibility to allow the valuer to make sensible judgements specific to the portfolio investment being valued,” says Rea. And be “wide enough to cover new types of investment or investments in industries not already held within the PE portfolio while remaining a robust framework that ensures consistency in approach and assumptions across the portfolio as appropriate.”
Valuation reporting is an important aspect of the limited partnership agreement and can mean the difference between an investor deciding whether or not to invest in fund. With LPs increasingly looking for transparency and consistency, it is in the interest of GPs to create strong valuation policies that allow for both.