Valuation: The GP's biggest challenge

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.

“Not challenging would be no fair value at all,” the CFO of a US-based private equity firm quipped at Private Equity International’s CFOs and COOs Forum in January. And given valuations’ impact on everything from investor reporting to track records referenced when marketing it’s important to have the right frameworks in place.

While it might not be a new topic, new and recurring pressures – including regulatory scrutiny, public market volatility and the complexities of valuing illiquid assets – have fair value once again front and centre.

Fair value – or marking assets at the price they would 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,” says 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 it then faded away.”

But it’s been back in focus in recent years, thanks to the US Securities and Exchange Commission’s (SEC) registration requirements that came into effect in 2012 which 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 have 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 scrutinising data 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.

The biggest challenge, irrespective of a firm’s size or resources, is simply finding the best and most accurate inputs to inform fair value.

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, but 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,” says 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 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 maximises the use of relevant observable inputs and minimises 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. Sector-specific funds will have to factor in any relevant cyclicality. Take the energy sector, which has experienced heightened volatility in oil and 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,” says 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.

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. Non-performance 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, while measuring distressed debt is said to be easier since the focus is more on underlying assets and less on credit risk.

Valuation might not be black and white, but as alternative investment firms – and regulatory bodies – evolve, and investors’ focus on performance data becomes ever sharper, expect attention on valuation policies and methodologies to increase.

REFINING BEST PRACTICE
An overview of changes to valuation guidelines made by the International Private Equity and Venture Capital Valuation Board

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 example, 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 affects equity valuations (Section 2.4): CFOs sometimes question how debt holdings could impact the value of equity in a company. For example, 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 their previous valuation estimates with a company’s actual exit price, and determine if any improvements could be made when conducting 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.