Valuation Challenge: Secondary opinion

THE CHALLENGE:
Limited Partner A (LPA), which is a fund of funds, owns a stake in Private Equity Fund I (PEF I). LPA's investment was made at the inception of PEF I. LPA holds its investment at a value based on the Net Asset Value (NAV) of PEF I as provided by the General Partner (GP) of PEF I. Three years into the life of PEF I, Limited Partner B sells its stake in PEF I to LPA in a secondary market transaction at a price equal to 65 percent of the most recently reported NAV of PEF I (i.e. 65 cents on the dollar).

How does LPA value its new stake in PEF I which was purchased on the secondary market? How does the secondary purchase impact the carrying value of LPA's original fund investment in PEF I?

TIM SMITH'S ANSWER:
A year ago, a discounted price of 65 percent on NAV would have been unrealistic and the response to the valuation question would have been straightforward: follow the historical practice of valuing both positions at NAV as reported by the GP of PEF I.

What a difference a year makes. Even though current distressed market conditions have made secondary market discounts of this magnitude a reality, there is a new wrinkle that prevents the solution from being straightforward – FAS 157 “Fair Value Measurements.” With the adoption of FAS 157, LPs cannot simply rely on GP valuations and are themselves accountable for the determination of fair value. The difficulties for LPA in this complicated scenario are magnified by the current inconsistent implementation of the new accounting guidance as evidenced by the diversity of opinions, non-authoritative literature and editorials on the definition and determination of fair value. Market conditions combined with the adoption of FAS 157 have dramatically changed how we analyse and respond to situations such as this one faced by LPA.

While there is no doubt the GP has access to the best information regarding the portfolio companies in PEF I and its valuation should carry a significant level of weight, LPA cannot ignore other data points at its disposal in determining fair value. Public company multiples, market conditions and other factors all need to be considered. The GP's value is clearly an obvious starting point, but it is just that, a starting point. The real question surrounds the determination of PEF I's fair value now that LPA has access to critical data points following its due diligence as a part of the purchase and the final price for the secondary exchange.

While a good secondary buyer will underwrite a deal at the portfolio company level, it is important to note that, for valuation purposes, an LP is required to value its fund interest and not the individual portfolio companies in the fund. As the FASB Valuation Resource Group pointed out in July 2008: “Even though NAV is based on fair value of the underlying assets in the fund, it may not necessarily represent the price that would be received to sell an ownership interest….”

Just as it is incorrect to automatically assume that NAV equals fair value, it is equally incorrect (probably more so in today's distressed market environment) to presume that a secondary market price reflects fair value, even though this would be deemed an “exit price” per FAS 157. The reality is that with such a wide spread between the purchase price and NAV it will be hard for LPA to justify picking either one of these data points as an accurate reflection of fair value.

The final determination of fair value will be subject to LPA's analysis of all the factors already discussed. The various data points, when taken in appropriate context, will assist LPA in determining a reasonable fair value, which given current market dynamics, probably lies somewhere between 65 percent and 100 percent of NAV (and no, LPA cannot simply take the midpoint).

In short, while there is no “correct” answer as to a specific valuation for this scenario, one fact is not debatable – LPA must value both its original interest and its new interest in PEF I at the same level.

As time passes, markets stabilise and secondary market prices return to more normalised levels, LPA's ability to adjust its value of PEF I in line with the GP's NAV will be more supportable.

All else being equal, a reported NAV by a GP is a better starting point for assessing fair value than the secondary prices being seen in today's distressed markets. There is no replacement for the judgment and experience of proven, top-tier GPs, and it is difficult for LPA to replicate these critical components in any valuation exercise. Thus, staying in close contact with the GP and having full confidence in its valuation controls and procedures are paramount in assessing the appropriateness of NAV as an indication of fair value.