AICPA Issues Draft Accounting and Valuation Guide to Provide Best Practices for Portfolio Company Valuations for Private Equity and Venture Capital Firms
July 24, 2018
By Michael Aronow and Craig Ter Boss
The AICPA’s Private Equity and Venture Capital Task Force (the “Task Force”) recently released for public comment a working draft of its Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”). The Task Force was formed in early 2013 to address concerns of numerous parties (participants and industry groups, accountants, valuation specialists) regarding valuation processes and to reduce diversity in practice for fair value measurements.
The Guide, which is not authoritative, is not meant to change any existing guidance; rather it is designed to help interpret and apply existing fair value concepts consistent with FASB Accounting Standards Codification (“ASC”) 820, Fair Value Measurements, which emphasizes that fair value is a market-based measurement, not an entity-specific measurement; and provides investment companies with an overview of the valuation process, concepts and roles and responsibilities of the various parties involved in the process. The Guide includes chapters addressing fair value related concepts, including:
- Market participant assumptions,
- Overview of valuation approaches,
- Control and marketability factors, and
- Valuation of debt and equity securities.
Since the introduction of ASC 820, several accounting and related valuation issues have evolved and the Guide addresses and helps clarify these issues, including those related to:
- Complex capital structures,
- The unit of account and assumed transaction, and
Unit of Account and Assumed Transaction
Defining the unit of account for investment companies is challenging. FASB ASC 946, Financial Services - Investment Companies, does not provide explicit unit of account guidance. The topic contains specialized accounting and reporting requirements for investment companies. Under U.S. GAAP, investment companies generally measure their investments at fair value, including controlling financial interests in investees that are not investment companies.
Further complicating this issue is that many investment companies hold significant positions in their portfolio companies, giving them the ability to influence the direction of these companies, or may hold multiple types of investments within a portfolio company. The Guide provides considerations and assumptions that market participants might utilize to estimate the value expected to be realized from an investment, which helps define the unit of account.
The Guide addresses how to assess the unit of account and an assumed transaction for purposes of estimating fair value under ASC 820. This assessment focuses on three questions:
- Does the assumed transaction appropriately consider market participant perspectives on the sale of the specific investment held by the fund or the sale or transfer of a larger group of assets?
- If the funds hold equity and debt investments, how should they be grouped together considering their best economic interest?
- How does the estimate of fair value consider market participant assumptions relating to the fund’s investment strategy and how, and when, will that value be realized from the investment?
When estimating the fair value of a fund’s holdings in a portfolio company, the concept of “economic best interest” is important to consider when determining how debt and equity investments are grouped together. In situations in which the investors hold the investments and the investors’ interests aligned, it may be appropriate to value an equity investment based on its pro-rata interest in the company, and allocate the value to be received from the sale of the portfolio company and allocate to the various interests.
When a fund makes an investment into debt and/or equity, it considers the expected cash flows over an estimated time horizon and the risks associated with those cash flows. This is an important reason why calibration is so important to the process of evaluating and estimating fair value at the initial investment date. This calibration should consider the attributes, risks, and anticipated strategies to maximize value associated with these investments, as well as the inherent level of control and marketability of the investment. These factors should all be assessed based on market participant perspectives acting in their economic best interest as of the initial investment date and subsequent valuation dates.
When using a valuation technique that requires unobservable inputs, the Guide discusses the importance to calibrate these inputs to observed transactions in the investment itself, providing an initial set of assumptions that are consistent with the transaction price when the transaction price represents fair value. One of the key aspects of calibration involves monitoring the difference between the multiples and rates used in valuing the company in the initial transaction and the changing market multiples and rates for the comparable universe against which the initial transaction was benchmarked. For example, at subsequent measurement dates, these input assumptions such as financial metrics for the company (revenues and EBITDA or projected cash flows), specific operating key performance indicators (number of customers or volume) and market-related inputs (valuation multiples, cost of capital, or other factors) should then be updated to reflect changes in both the investment and changes in market conditions, maximizing the use of observable inputs.
Market Approach Under Calibration
In selecting a multiple in the market approach, it is important to consider not only the range of observable multiples, but also the differences between the portfolio company and the selected guideline companies or transactions, which might indicate that a higher or lower multiple is appropriate. Calibration provides an indication of the way that market participants would value the investment as of the transaction date given the differences between the portfolio company and the selected guideline public companies or transactions. These initial assumptions can then be adjusted to take into account changes in the portfolio company and the market between the transaction date and each subsequent measurement date.
It is important to distinguish if the differences between the portfolio company and the selected guideline companies or transactions relate to operational differences or issues with control and marketability. For example, consider a transaction where a portfolio company investment is acquired with a transaction price that would equate to a multiple of 7.0x last twelve months (“LTM”) EBITDA when the guideline public companies are trading at multiples of 10.0x LTM EBITDA. In this example, the transaction price reflects a 30% discount to the guideline public companies. One explanation might be to call this discount a “marketability discount” or “illiquidity discount” without further analysis. These terms may imply that the discount results solely from the illiquidity of the position, rather than focusing on the reasons that market participants would demand a higher rate of return than the valuation model might otherwise indicate. In updating the valuation inputs for subsequent measurement dates, it is necessary to understand the underlying rationale for the low price paid – that is, to describe the differences between the portfolio company and the guideline public companies that led to this lower valuation as of the transaction date, so that it is possible to assess to what extent these differences still apply as of subsequent measurement dates. It may be that a transaction price that reflects a discount to the guideline public companies when measured relative to LTM EBITDA might reflect a need to invest more capital in the business or to strengthen the management team in order to reach a normalized level of performance. In this example, after these improvements are made and reflected in the portfolio company’s expected performance, such a discount may be significantly reduced or no longer apply.
Valuation of Equity Interests in Complex Capital Structures
Estimating the value of the different classes of equity in a portfolio company requires an understanding of the rights, both economic and non-economic, associated with each class. The Guide describes possible methods for valuing equity interests within complex capital structures. A more comprehensive examination regarding complex capital structures will be addressed in the fourth quarter edition of EisnerAmper’s Asset Management Intelligence.
In addition to the concepts discussed above, the Guide also describes leading practices compiled by the Task Force in the following areas:
- Using backtesting to improve a fund’s valuation processes, and
- Evaluating the impact of events at or near a transaction date.
The proposed Guide also addresses frequently asked questions and includes appendices on best practices pertaining to the valuation process and case studies illustrating different investment scenarios and factors to consider in arriving at fair value.
When finalized, the Guide will be the first guidance on how to apply ASC 820 specifically targeted to the complexities experienced by investment companies in valuing portfolio investments in accordance with ASC 820. Comments on the working draft are due to the AICPA on August 15, 2018. A final version of the Guide is expected to be released in May 2019.
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