Authored by Sylvia Dyke and Lauren Hayes
Private equity funds are required to conform to FASB ASC 820 Fair Value Measurements and Disclosures, which establishes a hierarchy used to measure fair value. Investments with an absence of market activity for the investment and significant management judgements or estimations are required to develop valuation input to be classified as Level 3 investments. Level 3 investments must have a valuation completed to determine the fair value at each year-end.
A private equity fund’s balance sheet and income statement are typically minimal, and the vast majority of the entire set of financial statements revolves around the annual valuation. As a result, valuations are at the heart of most private equity audits. Whether the fund invests in privately held oil and gas, manufacturing, real estate or healthcare companies, or anything else, determining the fair value at each year-end is paramount to both the private equity fund and the auditor. Consequently, this is often the most difficult part of the audit of Level 3 investments for everyone involved, as key inputs – such as discount rates and multiples – are subjective and can result in large variances in fair value conclusions.
From a fund manager perspective, there are several things that can be done to help make the process easier. A few things to consider when moving into year-end valuations and the annual audit, including:
Starting with its June 1, 2019, issuance, the American Institute of Certified Public Accountants (AICPA) releases an annual “Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” (the Guide). This details out best practices for the valuation of investments in this space. Most firms, including Baker Tilly, have whitepapers summarizing some of the key components of this – many of which will be covered in this article. This is a resource and starting point when preparing valuations, as it will provide insight as to what auditors need or are expecting.
One of the most specific points from the Guide is the types of valuation methodologies utilized. Valuations will usually be based on the following methodologies: discounted cash flow method; comparable company analysis; comparable transaction method; asset-based valuation method; sum of parts valuation method; or prior transaction method. A well-performed valuation generally uses multiple approaches – at least two or three – and weights the values to come up with a final valuation. Should you currently only prepare your valuation with one methodology, try utilizing other approaches for a blended fair value.
Valuations are very subjective, and management estimates are just that – estimates. These estimates are typically the hardest area for auditors and their valuation teams to gain comfort with. Assumptions and projections become key to determining the value of the underlying portfolio company. Thus, it is of the utmost importance that the reasonableness of the assumptions along with the methods used in arriving at the assumptions are considered. A few things to consider when developing your estimates:
Due to the highly subjective nature of valuations, it is possible that inputs and estimates used will be challenged by the auditors or their valuation teams. Unobservable inputs, by their nature, include subjectivity, but with sufficient documentation and consideration over all reasonably available inputs, the fund manager should be in a position to support their conclusions sufficiently.
A private equity fund manager will either have an in-house valuation specialist prepare the valuation, or they will hire an accounting or consulting firm to prepare the valuation for them. If preparing a valuation in-house seems daunting or like an annual headache, consider hiring an outside firm with relevant experience. Hiring an outside firm to prepare the valuation can often save the company from issues in the long run. A conclusion of value report from an independent, reputable, third-party provider is one of the best ways to provide your auditor comfort over fair value. The auditor can typically place more reliance on this report, and the value determined. While there may be questions, they are generally much less given the nature of the report prepared. A movement has surged in recent years towards the use of third-party specialists in light of the Guide, increased auditor scrutiny and the need to reduce the appearance of bias in the determination of fair values for Level 3 investments.
All this said, valuation should be assessed periodically during the year. While it may only be prepared quarterly, semi-annually or annually, there are things that can and should be done throughout the year to facilitate the process that constitutes best practices. As you meet with the portfolio companies to discuss projections, forecasts and the business in general, maintain documentation of these meetings to show that discussions are occurring and the investment team is involved with management’s forecasting process. Prepare documentation regarding the controls over the valuation process (such as management’s methodology, valuation meetings and discussions). This documentation will help the auditors gain comfort over the process surrounding the valuation. Having good controls may help reduce the auditor’s risk.
Communicate throughout the year with your audit team. Let them know if you are considering changes to your valuation methodology or assumptions. The audit team can involve their valuation specialists to discuss these changes and take an initial review of the valuation for reasonableness before you communicate with your investors. The earlier that these discussions occur, the more you can minimize questions later.
The valuation process is inherently subjective, and no one has a crystal ball for fair value of their investments. Therefore, there will be questions and scrutiny from the auditor and their valuation team. When reviewing Level 3 investments, the auditors must be comfortable that the amount presented on the face of the financial statements is materially correct for the end-user. Questions will arise, but with proper preparation, some of the headaches of valuations can be mitigated.