Managers Can Avoid the Danger of Sloppy Valuation Practices
February 26, 2016
By Craig Ter Boss and Michael Aronow
As originally published in FundFire
Michael Aronow is a partner and Craig Ter Boss is a principal in EisnerAmper’s Corporate Finance Group, specializing in valuation services for alternative asset managers.
The recent increase in regulatory scrutiny regarding how asset managers value investments, particularly illiquid or hard-to-value ones known as Level III assets, has created the need for a stronger valuation framework. Not only is the Securities and Exchange Commission looking at the specifics of the value of an investment, the agency is also looking at the processes surrounding such valuation determination.
Numerous recent SEC enforcement cases have homed in specifically on improper valuation practices and policies, and auditors and investors have followed suit, highlighting the need for most fund managers to revisit their internal processes. Managers should consider whether their internal systems can stand up to regulatory scrutiny.
Establish effective valuation policies and procedures. Managers should make sure that their policies and procedures are comprehensive, transparent and flexible, and that they include a methodology for estimating the fair value of Level III assets. The key elements involve defining a fair value reflecting an exit price between market participants, and outlining who prepares the valuations, how often they are performed, who reviews these marks and the role of the valuation committee. This process should also identify the valuation techniques that will be utilized for different types of investments and address how to support unobservable inputs for Level 3 investments. Managers should also make sure that they are consistently applying the policies and procedures, and documenting any divergence from them.
Give the valuation committee defined roles. This committee should have members overseeing the implementation and maintenance of the valuation policies and procedures, and monitoring that management is complying with such policies and procedures.
Prepare a valuation memorandum. Managers should provide sufficient supporting information about the investment and that also reflects application of the valuation policies. Consider utilizing multiple valuation approaches and explain the rational for the weighting of each approach. If an approach is not utilized, provide an explanation for the exclusion of that approach.
Document and explain the selection of key valuation assumptions. Managers should include both observable and unobservable assumptions and attempt to make all inputs into the model transparent. For the market approach, the selection of a valuation multiple for a portfolio company should be based on operating performance such as growth and EBITDA margin and other factors like projected growth, size, diversity of operations and stage of development when compared to comparable public companies. Managers often should not use the the median or average multiples because of the differences in attributes and/or performance of the subject company and set of comparable companies.
Reconcile multiple approaches. Asset managers should consider whether a control premium, discount for lack of control and/or a discount for lack of marketability are appropriate based on ownership status, rights and preferences and the approaches utilized. In many instances, a discount for lack of control may not be appropriate if minority investors will benefit from the changes to be made by a control investor.
Provide a risk assessment update. Managers should consider macroeconomic, industry and company specific factors that may impact the value of the investment. Managers also should provide key facts and observations about the risks that could affect valuation as they monitor the investment.
Evaluate performance against the original investment thesis. Consider the market inputs underlying the original deal price and utilized in the investment thesis and calibrate the valuation inputs in subsequent updates to the original deal metrics. Then start the process all over again – ensuring the manager can maintain a dedicated valuation function and ultimately mitigate regulatory scrutiny.