A new valuation guide exclusively focused on valuations associated with portfolio company investments has been released. After years of interpreting and applying the principal based framework of the industry standard IPEV Valuation Guidelines, investment fund managers and their boards of directors, valuation specialists and auditors can now reference a detailed set of views and diverse case studies from alternative industry participants across a wide range of investments.
The new guide, five years in the making, is the AICPA’s (American Institute of CPAs) working draft of an Accounting and Valuation Guide, suitably titled “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” (the “AICPA Guide”). The entire AICPA Guide includes example rich chapters on individual concepts, and extensive appendices which include a number of real-world case studies.
The AICPA Guide does not teach one how to value, rather it provides best practice recommendations and techniques in understanding and applying fair value principles to valuing portfolio company investments across both debt and equity. While developed for Investment Companies complying with US accounting standards (Accounting Standards Codification (ASC) Topics 946 and 820), it is equally applicable to Investment Entities reporting investments at fair value in accordance with IFRS 13 and Indian Accounting Standards 113.
While the AICPA Guide is technically “non-authoritative”, its application will be considered best practice given its thorough vetting by the AICPA, major accounting firms, and other industry participants. As the vast majority of money invested in the Indian alternative space is through foreign Limited Partners (LPs), general partners (GPs) in India just like their global counter-parts are increasingly asked to describe their valuation process, and what guidelines or best practices they follow. This is true both for GPs in fund-raising mode, as well as recurring compliance and checks on internal controls. Global LPs need reported Net Asset Values to represent the fair value, compliant with IFRS 13 / ASC topic 820, of each individual underlying investment.
As is evident in recent years, valuations are a critical and core issue for all stakeholders in the alternative funds space. Failure to properly report the fair value of the assets (starting with a roll-up at the investment level) at a fund clouds decision-making, undermines credibility and increases risk, while improper valuation practices may expose investors to losses through secondary trades or through misallocations of capital. Even if an insufficient valuation process and failing to adopt best practices does not have immediate impact, there may be repercussions when communicating with existing investors, potential incoming investors, and secondary buyers. Given the subjectivity involved in valuing private assets, LPs have become more demanding around GPs running a rigorous process relating to valuing their investments.
The exhaustive AICPA Guide is well over 600 pages., So where does one begin? To assist the readers of RIPE, we have highlighted certain key chapters that may be of interest to GPs:
Market Participant Assumptions (Chapter 3)
Fair value guidelines require the professional tasked with measuring value to look at the information they would need to evaluate an investment through the lens of a market participant, i.e. other investors willing to transaction in the investment being valued. One need not identify a specific market participant, however in keeping with the definition of a market participant this simply means buyers and sellers in the principal (or most advantageous) market for the asset or liability that are independent of each other, have a reasonable understanding about the asset or liability and the transaction, and are willing to enter into the transaction for the asset or liability.
Valuation of Debt (Chapter 6)
Chapter 6 focuses on the valuation of debt from two separate and distinct perspectives: valuing debt as an Investment and valuing debt for purposes of valuing equity. Historically, some GPs attempted to use various measures as proxies for estimating the fair value of illiquid debt investments, such as the par value (notional), face value (par plus accrued PIK), financial reporting book value, or then even an anticipated payoff amount owed upon repayment. Unfortunately, these measures may not necessarily reflect the fair value of debt, nor the value of debt for the purpose of valuing equity in a capital structure stack as neither scenario may reflect a current assessment of the credit quality of the borrower or the market conditions as of the measurement date, both of which require judgment. In keeping with the LP paradigm of fair value, this chapter gets into details of the yield method, a typical valuation technique for estimating the value of performing debt using a discounted cash flow analysis, estimating the expected (or contractual) cash flows and then discounting them at the market yield.
Valuation of Equity Interests in Simple Capital Structures (Chapter 7)
This chapter provides guidance regarding the valuation of equity interest for a portfolio company with a capital structure involving a single primary class of equity, highlighting the difference between enterprise value when looked at as a whole and when valuing the equity interest. The main differentiator is considering company-specific assumptions vs. portfolio-specific assumptions in each scenario.
Valuation of Equity Interests in Complex Capital Structures (Chapter 8)
Many venture capital backed and private equity backed portfolio companies are financed via a combination of different classes of equity, each of these providing its holders with unique rights, privileges and preferences. The key takeaway from this chapter is whether a fund is doing enough to recognize the rights associated with each class, and whether these have valuation implications when estimating the value of different classes of equity in a portfolio company.
Control and Marketability (Chapter 9)
Adjustments for control and marketability have been somewhat common in valuation analyses performed in India. What may come as a change for those who did not consider calibration (see following) or market participant perspectives is that the task force believes it is not appropriate to include any additional control or acquisition premium nor marketability discount in the enterprise value when valuing the fund’s interest in a portfolio company. Instead, the task force recommends that funds evaluate the instruments in each portfolio company considering the improvements to the business that an investor in the fund’s interest would expect under existing ownership, as modified given the degree of influence that the buyer would have over those plans considering the nature of the interest acquired. No further adjustment is required since this value would be directly incorporated into the cash flows and calibrated required rate of return assumptions and/or calibrated market multiples used in the analysis. The enterprise value and corresponding equity value should be measured from the perspective of the investors who in aggregate have control of the business. If the investors’ interests are not aligned, it would be appropriate to consider the impact of the lack of alignment on the valuation of the fund’s position.
Calibration (Chapter 10)
Calibration is a technique whereby an observed transaction price as of an investment date is used to back into certain identified but unobservable input assumptions, which are then updated and rolled-forward for subsequent measurement dates. This chapter provides a framework for calibrating debt or equity investments in a portfolio company using the income approach and market approach. Calibration is required by accounting standards. It is best practice to use the transaction price, if fair value, as a basis to calibrate inputs used in the valuation model such that at the transaction date the inputs to the model will generate the transaction price.
Backtesting (Chapter 11)
Backtesting, also called a “retrospective review”, refers to the process of using the observed value of the fund’s interests as implied by an ultimate sale or liquidity event as compared to the fair value estimated for an investment as of an earlier measurement date. Simply put, backtesting helps to gauge how good a fund’s existing valuation process is as a predictor of ultimate realizations. Is the GP’s process consistent and credible, are they overstating, or are they attempting to under-promise and over-deliver? The purpose of backtesting is to assess and improve the investment company’s process for developing fair value measurements with the benefit of hindsight. This chapter touches upon factors that can contribute to a difference in value for a particular investment between the measurement date and the event date as well as the relationship between backtesting and evaluating subsequent events as defined by various accounting standards. Additionally, backtesting is increasingly becoming part of the control environment that regulators, policy makers, investors and other stakeholders expect over an investment company’s valuation procedures.
There are several other chapters one can point GPs to, such as Determining the Unit of Account and the Assumed Transaction for Measuring the Fair Value of Investments (Chapter 4), Factors to Consider at or near a Transaction Date (Chapter 12), and Special Topics (Chapter 13), however ultimately the suggested areas of focus and case studies to reference will depend on the GPs investment strategy and style.
Best Practices Typically Tend to Set Standards for Expectations
The AICPA Guide may not change valuation estimates or practices if a GP’s process is robust and they have been appropriately applying judgment. The IPEV Valuation Guidelines too were refreshed in 2018, and they are congruent with the AICPA Guide. One of the salient features of the latter document is the deemphasis on the price of recent investment (i.e. cost) as a default when marking an investment, thereby emphasizing the need estimate fair value at each measurement date. The fact that additional procedures will be required to support the price of recent investment as the fair value has a significant impact on the valuation processes and documentation required.
Increasingly, external third parties with requisite valuation experience and knowledge are used by GPs (and some LPs) to demonstrate transparency, increase reliability and improve the valuation governance framework. While the GP has ultimate responsibility for their fair value estimates, by putting into place robust valuation processes, procedures and documentation often with the support of a qualified third party, they provide greater relevance and reliability for their LPs using reported Net Asset Values.