Fair market valuations: the road to clarity and consistency

As private equity and venture capital funds continue to struggle on a daily, quarterly and annual basis with how to incorporate clarity and consistency into the fair valuation process, a high percentage of alternative investment players are taking a “watching and waiting” perspective, anticipating the roll-out of the American Institute of CPA’s updated valuation guidelines, expected within the next year. At a time when the SEC’s focus appears to be mostly concerned with transparency in the reporting of funds’ fees and expenses, funds need not worry about fair market valuations policies and procedures, right? Wrong.

SFAS No 157, now known as ASC Topic 820, was introduced 10 years ago as a means to promote transparency and reliability in the financial reporting process, by emphasizing a market-participant perspective, reliance on generally accepted valuation methodologies, and reliance on an exit price. Despite its decade-old existence, keeping current with valuation best practices and the related impact of regulatory scrutiny continues to confound many of today’s best and brightest private fund CFOs. As a result, progression toward transparency and consistency in the application of certain methodologies has been slow and evolutionary, rendering the auditing of funds’ fair value indications highly complex, and simultaneously heightening the interest of SEC examiners, whose presence within private equity and other areas of the alternative investment industry, has been – and continues to be – more and more entrenched.

As investment managers continue to experience regulatory scrutiny from the SEC, the commission continues to exercise a consistently increasing influence on how funds develop and enforce their valuation policies and procedures. In addition to conflicts of interest with co-investments and independence issues, regulatory enforcement actions have centered on management’s departures from a fund’s stated valuation policies and procedures, unsupported changes in selected valuation methodologies for given assets between reporting periods, and inflations in valuations at or near the time of a fund’s capital raises.

Documenting valuation policy

In addition to being well-documented, effective valuation policies and procedures must possess several key attributes and typically serve as the guide for the internal valuation team and/or third-party valuation specialists to follow in their assessments of value. Integral components generally include at least three elements:

Clear framework: Identify the basis of the necessary valuation requirements, such as the reporting entity’s governing documents (i.e., partnership agreement), and the documented directives regarding valuation methodology, valuation standards as they pertain to ASC 820 or other relevant standards (i.e., International Private Equity and Venture Capital Valuation Guidelines, which also have been recently updated by the IPEV Board), and other reporting requirements as put forth by the fund’s management and/or valuation committee.

• Detailed valuation process: Outline the process to be followed each reporting period, and clearly delineate the roles and responsibilities of all team members involved, including internal team members responsible for the valuation analyses and senior management or valuation committee members who review and approve indications. Final approval of the fair value indications should be independent of the investment team manager responsible for monitoring the investment. All interactions with external parties, such as auditors and third-party valuation advisors, should also be described and documented.

• Portfolio-wide investments: Clearly define and document how the different types of investments included in the fund will be valued (i.e how different types of securities held by the reporting entity will be valued) according to the most recent and relevant guidance. Consistency of valuation approaches should be maintained across similar securities, and the rationale for any departures or changes from previous methodologies or key inputs must be supported and documented.

The selected valuation approach and key inputs for each security type should be documented, and should be considered from a market-participant perspective. Documentation should also include the basic details of the nature of the subject investments, the supporting valuation models and detailed support related to the rationale for the selection of certain valuation methodologies, key assumptions, and the resultant conclusions.

Early in the valuation process, it is advantageous for management to take a proactive approach in establishing effective communication and resolution of potential issues among the internal valuation team, the fund’s auditors, and the third-party valuation specialist. It is imperative for the fund’s management team to understand the scope of the work and level of assurance to be provided by the third-party valuation specialist, and to build consensus between these teams with regard to both the selection of appropriate valuation methodologies, and the determination of what constitutes adequate documented support for key valuation inputs and assumptions. Of particular importance is for management to fully understand the terms and conditions under which the third-party valuation specialist performs and documents its work.

A key example of an area which requires a thorough understanding on the part of management is the representation made by the third-party valuation specialist regarding determination of the reasonableness of the key assumptions driving projected performance and forecasted cashflows of subject portfolio companies. Typically, valuation specialists do not represent that they will attest to the reasonableness of the assumptions and inputs which underlie projected cashflows, nor to the ability of a portfolio company to reasonably achieve the projected level of performance which impacts the final fair value indication of the fund’s investment. Given this, it is critical for management to work closely with the audit team to understand the cashflow- generating capacity of each portfolio company relative to cash required for continued operations and growth, and to reach a consensus as to which investments might require consideration of a valuation scenario which includes a liquidation approach. Resolution of potential issues as described above early in the financial reporting process will foster a more efficient and transparent valuation process.

Valuation analyses must consider and document a market-participant perspective, transparency in all aspects of the valuation process must exist for all categories of investors, and documented trends in reported fair value indications must be calibrated across reporting dates. Private equity and venture capital funds should possess a well-documented valuation policy with an inherent system of checks and balances relative to the valuation analyses and the review of its reported conclusions, follow it consistently, and document comprehensively. Then and only then will the SEC – and stakeholders – be satisfied that every effort has been undertaken to ensure clarity and consistency in the financial reporting process.


Tom Angell, CPA, is the leader of WithumSmith+Brown, PC’s Private Equity Practice. He serves a diverse roster of private equity clients, including domestic funds, funds of funds, private equity and commodity pools. From start-ups to long-established organizations, Angell spearheads a team of auditors, tax professionals and internal quality-control specialists who advance each entity’s strategies and objectives while ensuring reporting standards and tax compliance. His expertise also extends to raising financing, deal origination and organizational structure.