Marking to market isn’t a new phenomenon. Private equity firms have been using fair value accounting for nearly a decade now, but it continues to present significant challenges to fund managers. And given valuations’ impact on everything from investor reporting to track records referenced when marketing – even secondaries sales or restructurings – it’s important to have the right frameworks in place.
Due to new and old pressures such as renewed regulatory scrutiny, recent public market volatility and the inherent complexities of valuing illiquid assets, fair value continues to be a challenging and much-discussed topic among chief financial officers (CFOs) and other financial professionals in the private equity world.
“Not challenging would be no fair value at all,” the CFO of a US-based private equity firm quipped at PEI’s CFOs and COOs Forum (see p. 14 for an overview of the event’s main themes).
Back in the spotlight
Fair value – or marking assets at the price they’d fetch if sold at that moment in time – was introduced to the world of private equity in 2006 with US accounting standard FAS 157, since renamed ASC Topic 820. Until then, private equity investments were typically valued at cost.
Though there was a good amount of industry grumbling around the introduction of FAS 157 – “but we don’t have to sell these assets today!” was a common complaint heard from CFOs – as years went by, it became an accepted part of back-office life, particularly at the larger firms.
“Fair value became a larger issue almost 10 years ago for many firms with the introduction of FAS 157,” agrees Jeremy Swan, a principal at CohnReznick in New York and national director for the firm’s Private Equity and Venture Capital Industry Practice. “It raised its head and then it faded away.” But it has been back in focus in recent years, thanks to US Securities and Exchange Commission’s (SEC) registration requirements that came into effect in 2012 and subjected firms to possible examination by the regulator. During an SEC exam, GPs are expected to detail valuation methodologies and techniques used and show they’ve remained consistent in their application.
“With the SEC exam process, it started becoming a focus again for investment firms and the SEC started paying close attention to how companies were being valued,” says Swan. “It’s becoming more of a concern for PE firms because of the SEC process.”
Marc Brown, a managing director at consulting and advisory firm AlixPartners, agrees. “Over the past six to 12 months, outside audit firms have ramped up efforts to ensure that assumptions are documented more so than in the past,” he says. “There hasn’t been a proclamation that confirms it, however it does seem that regulators are looking for additional documentation right now.”
It’s not just the SEC paying closer attention to valuation methods. Limited partners are increasingly scrutinizing data coming from GPs, whether as part of their due diligence process when considering new commitments, or as part of their ongoing monitoring of existing investments and performance assessment. It ties into a larger trend of LPs pushing for more transparency and information.
No easy answers
The challenge to firms then is two-fold: find the internal or external resources to measure fair value properly and then determine the best possible data to inform valuations.
The resourcing issue is one that’s costly for all firms, regardless of whether they outsource or hire/dedicate internal staff, but sources say it’s probably hardest for smaller fund managers with lean rosters and more modest operating budgets compared to large-cap peers.
But the biggest challenge, irrespective of firm size and structure, is simply finding the best and most accurate inputs to inform fair value.
It can be highly difficult to assess the price a private equity asset might sell for at a specific point in time since there’s no active market where private equity assets are traded. The fair value of an asset has to be estimated and inherently involves some kind of judgement on the part of a GP.
Although the private equity secondaries market has developed rapidly in the last couple of years, with about $40 billion-worth of secondaries transactions globally in 2015, according to data from Greenhill Cogent, it still remains vastly illiquid when compared to public markets where transaction prices are available on a daily basis.
“The challenge is for a fund manager to gather and accumulate all the information available in the marketplace, as well as from their portfolio companies, to perform their valuations,” says Jay Levy, partner and financial services industry practice leader at CohnReznick. “It’s gathering all the data you need to perform your valuation exercise.”
A firm can use comparable data from publicly traded companies and their trading multiples. They can also use multiples from recent mergers and acquisitions of similar companies. A third common technique is to use discounted cashflow analysis. In most cases, GPs use a combination of the three techniques. But regardless of what methodology they use, adjustments and interpretations are inevitable as each type of input has its own limits.
“If you’re doing a discounted cashflow analysis, it is important to document why there are differences in different sectors,” notes Brown. “If there’s a lot of publicly traded companies, it may be easier to do so, but it is safe to say that any comparable may be subject to further inspection.”
Comparable data from publicly traded companies may need to be adjusted if the companies are of different sizes, for example. And some industries may not have many publicly traded companies to observe – which leads in to so-called “Level 3” territory.
According to ASC Topic 820 and IFRS 13, its international counterpart implemented in 2013, if there’s no price in an active market for an identical asset or liability, fair value should be measured using a valuation technique that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. Level 1 assets are liquid and easy to price, while Level 3 assets are illiquid and their fair value measurement is calculated taking into account unobservable inputs and assumptions.
Investment strategies also play an important role in the valuation process.
Sector-specific funds will have to factor in any relevant cyclicality. Take the energy sector for example, which over the past year has experienced heightened volatility in oil prices and public companies’ stock prices. The unpredictability has affected companies in different ways and comparable data may change rapidly. “As an industry like energy becomes distressed, you get dislocation in value and in comps,” said Brown. “You get some multiples that are out of whack.”
Companies with emerging technologies can also be difficult to value because of the lack of comparable input, making it particularly challenging for venture capital firms to measure their portfolio companies using fair value. As these companies mature and enter the private equity space, more information is available to achieve a more accurate valuation.
Fair value of any liabilities is also an area CFOs and finance professionals are grappling with, as the credit arms many alternatives firms have set up come with their own set of challenges. Measuring the private debt of private equity-owned companies, often mezzanine tranches or leveraged loans, can be tricky since the debt is often not actively traded and a judgment on the ability of a borrower to pay that debt is necessary.
Nonperformance risk such as credit risk is usually required to be incorporated in the fair value measurement of a liability, but it can be difficult to assess, according to PwC’s Fair Value Measurements 2015 report published in December: “When measuring the fair value of private debt, a reporting entity may use prices available for its own existing public debt, or public debt of other similar reporting entities with the same credit standing, with the same key terms, as a starting point. However, it may be necessary to make adjustments for market participant assumptions about nonperformance or other risks.”
Measuring distressed debt using fair value is actually easier than non-distressed debt, Brown noted, since the focus is more on the underlying assets and less on credit risk.
As alternative investment firms – as well as regulatory bodies – continue to evolve, and investors’ focus on performance data becomes ever sharper, expect attention on valuation policies and methodologies to increase. The following pages detail how
leading firms and advisors are dealing with the related challenges and advancing best practice – but it’s a topic that pfm will be returning to throughout the year.
Refining best practice
Late last year, the International Private Equity and Venture Capital Valuation board (IPEV) updated its valuation guidelines, which many private equity CFOs consider their go-to for valuation best practices. Here’s an overview of some of the changes:
New guidance on reporting across funds (Section 1.6): Private equity firms that split an investment across multiple funds will sometimes use one fund as the basis for estimating the fair value of each fund’s interest in the company. Despite the convenience of this, IPEV is recommending a fund’s fair value estimate to be independent from other funds and reporting entities. Trouble can arise, for instance, if one fund holds a combination of both debt and equity in the same company partially owned by a second fund under management with only an equity interest.
Clarification on how debt impacts equity valuations (Section 2.4): CFOs sometimes question how debt holdings could impact the value of equity in a company. For instance, if debt carries a prepayment penalty, should a CFO subtract the amount of that penalty from the company’s enterprise value if the measurement date was before the penalty no longer applies? In this instance, IPEV argues that the reasonable assumption would be that GPs normally transact before the penalty applies, meaning the fair value estimate may not consider the penalty price.
New language on back-testing (Section 2.7): Under this proposal, IPEV is asking CFOs to better understand “the substantive differences that legitimately occur between the exit price and the previous fair value assessment.” Also known as back-testing, the principle requires GPs to review previous valuation estimates and determine if any improvements could be made for future valuation estimates. Following concerns that some GPs may have inflated valuation estimates ahead of a fundraise, back-testing
has become a focus area for regulators and investors alike.