How Hedge Fund and Private Equity Can Deal With Fair Value Accounting
The US GAAP requires that PE/VC investments must be stated at fair value.These funds (PE/VC) invest in private securities which are by definition iliquid.
- Securities include:
- Common stock
- Preferred stock with complex economic and control rights
- Compensation options
- Convertible or straight debt
- These securities which are not publicly traded, have no Level I pricing to use, almost no level 2 data hence most valuations require Level III inputs
- The complexity and the use of Level III inputs that require complex valuation models are very challenging for the PE/VC
- The diversity in practice that is the result of the above complexity causes fair value measurements that vary across reporting in investment companies as well as the valuation experts.
- This attracted special scrutiny from the S.E.C. reported the New York Times on 2/12/2012
- Accurate portfolio valuations help boards make better investment decisions and transparent and timely reporting can attract potential investors. It is therefore not only a compliance issue.
- Valuing assets based on an observable market can be very challenging when the same are not traded on a regular basis.
- For companies that do not have an observable market there may be wide discrepancies between the price a company calculates and the value a third party valuation expert considers fair value.
- In order to bridge this gap to assess true fair value private equity firms rely on models that are composed of multiple data sets and numerous assumptions that require judgment, hence it produces a wide range of valuations if any of the inputs are altered.
- Level I inputs: Quoted prices for identical assets traded in active markets
- Level II inputs: Quoted prices for comparable assets or liabilities that can be observed directly or indirectly in active markets
- Level III inputs: Assets without an outside market; derived by using data that is not observable and are used with valuation models that require assumptions
The AICPA Draft Accounting and Valuation Guide
- The guide was released by the AICPA PE/VC Task force on May 15th 2018
- The guide is non-authoritative but is as a rule considered as best-practice guides.
- It does not supersede any existing regulatory guidance but is intended to improve the current valuation process:
- Providing an overview and understanding of the valuation process
- Elaborates on roles and responsibilities
- Discussing best practices
Key areas Covered
- How to determine the assumptions of a market participant
- How important is time horizon of the investment
- Complex structures
- Adjustments for control and marketability
- Calibration of the model
- Back testing on realized investments
- Consideration of uncertainties and contingencies
- Treatment of transaction costs
Mandatory Performance Framework (MPF)
- Certified in Entity and Intangible Valuations (CEIV) credential
- MPF is required for holders of CEIV credentials
- MPF is considered best practice for non CEIV credential holders
- MPF describes the degree and purpose of documentation
- An experienced professional must be able to:
- Understand purpose, nature, extent and results
- An experienced professional must be able to:
- Understand all approaches and methods used
- Understand inputs, judgment and assumptions
- Support the conclusion of value with sufficient detail
- Requires detail surrounding appraiser qualifications, intended users, measurement date, citing sources and providing supporting data
Fair Value, Market Participants and Unit of Account
- When market participants value an interest in a given company they will consider the information specific to the company as modified by the degree of influence associated with the interest being acquired.
- When estimating the value of an interest in a business it is appropriate to consider the value of the business from the perspective of the investors of the business who in aggregate have control of the same
- This approach may reflect the benefits of control as well as the cost of liquidity
- Contrary to conventional wisdom, in the context of transactions in venture capital and private equity-backed companies, the value associated with control and the cost of illiquidity are both embedded in the price paid.
- The unit of account is defined in the context of the reporting entity’s financial statements
- Therefore it cannot include interests that are not owned by the reporting entity
- When the reporting entity holds multiple instruments within a given portfolio company, the assumed transaction may consider how fair value would be maximized.
- Hence, the assumed transaction might be a transaction that involves the aggregate position held by the reporting entity if this is how the market participants would transact when acting in their best economic interest.
Fair value Measurement Objective
- In order to estimate the price at which an orderly transaction to sell the asset or to transfer a liability would take place between market participants at the measurement date under market conditions the reporting entity must determine:
- The asset or liability
- Non-financial asset – highest and best use
- The principal and most advantageous market
- The valuation technique most appropriate for market participants
Wide Range of Value in Financial Reporting
- There is an inherent uncertainty in estimation
- IPO at 45× revenue and traded at 120× revenue
- Financial crisis debt instruments lost volume – bid in $20s asks in $70s
- Use calibration to reduce uncertainty
- The key is to combat biases by having reasonable and consistent process using available market data as of measurement date.
Buyers and sellers in the principal and most advantageous market:
- Transaction at market terms
- Knowledgeable about the asset, liability and the market
- Able to enter into a transaction
- Willing to enter into a transaction
Market participant Risk Assumption
- Risk inherent in a particular valuation technique
- Risk inherent in the inputs
- Inputs may be observable or not
Principle and Most Advantageous Market
- Reporting entity perspective
- Must have access
- Must be the one most likely to trade in
- Not optimal to actively market at interim date; consider a hypothetical sponsor to sponsor the market
- The principal market must be reevaluated at each measurement date
- There are some typical characteristics that prevent access:
- Transform asset or liability to match observation
- Restrictions unique to the reporting entity
- Marketability difference in observable market
- Fair value is a market based assumption
- It is irrelevant whether the entity plans to hold or sell or settle
- Fair value is based on a hypothetical transaction at measurement date
Unit of Account
- The degree to which the asset or liability is aggregated or disaggregated for recognition purposes
- The asset measured might be a single or a group of assets
- Fair value can be measured by considering multiple units together (debt & equity) or as a single unit as determined by how a market participant would transact
- Level 1 Securities
- On Condensed Schedule of Investment PE/VC may report total value in a portfolio company, then allocate to each instrument
- May not report smallest value of each instrument that could theoretically be sold as an unrelated investment
- Relevant as to how market participants would transact
Valuation Methods in Stages of Enterprise Development
- Stage One: No product revenue
- Recent round of financing
- Asset accumulation
- Stage Two – Income approach with higher discount rate
- Guideline public company/transaction methods may not be reliable
- Difficult to obtain a reliable financial metric for which to apply multiples
- Intangible assets may be hard to value
- Stage Three – Income approach and or multiple rounds of financing
- Stage Four/Five – Income and Market Approaches are typically used
- Discount rates are lower than Stages Two/Three
- Use market approach reflecting calibration of the multiple rounds of financing
- A process using observed transaction in the portfolio company’s own instrument to ensure that the valuation techniques used on subsequent measurement dates begin with the observed transaction as well as more recent transactions
- Required when initial transaction is at fair value and there are observable transactions at later dates
- Unobservable inputs are used to measure fair value at subsequent periods
- The valuation technique and key Level 3 inputs are fine-tuned (i.e. calibrated) so that the model fair value equals the transaction price.
- Helps determine if an adjustment to the valuation technique is required
- Ensures current market conditions are reflected in the fair value measurement, capturing differences between the company and the observable guideline public companies or transactions
- The calibrated input assumptions are revisited at each measurement date to determine how they should be updated for
- Changes in market conditions
- Performance of the portfolio company
- Performance of the portfolio company vis-à-vis the selected guideline public companies or transactions
Transaction Price May Not Reflect Fair Value
- Between related parties except arm’s length sales
- Under duress
- Unit of account is different
- Transaction market is not the principal market
- Fair value is an exit price, not entrance price
If not at fair value the best practice is to compare the estimated fair value with the transaction price and reconcile any differences
- Consider rights and preferences between the current financing round and the company’s other classes of equity
- Evaluate changes in the value of the company, or changes in risk with planned transaction, if not yet closed
- When the trade price is not available perform a DCF analysis – cash flows are discounted at a market yield
- Market yield can’t be measured relative to issuance date:
- Change of credit quality of the company
- Credit spread of comparable debt
- Seniority, strength of covenants, company performance, quality of security
- For fixed rate debt, change in reference rate matching maturity
Calibration Debt Example
Company A issued debt on June 30th 2015
- Interest = Libor + 300 bps (Roughly B+)
- In 3 years business operations expanded, revenue grew
- June 30th 2018, estimated rating BB+
- Market risk premium increased
- Credit spread for debt rated B+ increased to 900bps (up by 600bps)
- Spread for BB+ increased to 700bps (up by 500bps)
- Result: Fair value is lower
Calibration Equity – Market Approach
- Company A acquired for $500m, $200m equity and $300m debt
- Good management and rapid growth
- Transaction price is 10× LTM EBITDA $50m; 8.33×forward-looking EBITDA of $60m
- Comparative public company median 8×LTM EBITDA and 7× forward-looking EBITDA suggesting a premium of 25% (=10/8) and 20% (8.33/7)
- Six months later:
- LTM EBITDA is $55m and forward looking EBITDA is $64m
- Comparable LTM EBITDA 9× and forward –looking EBITDA is 7.5×
- Assuming the same premium relative to the comps the multiples are 10.35× (9×1.25) and 9× (7.5×1.2) suggesting a value range of $570m (10.35×55) to $576m (9×64m)
Calibration Equity Income Approach
- Company A’s $500m transaction price implies an IRR of 15.0%; including forecasted cash flows and modeled terminal value
- WACC suggests 7% CSRP based upon forecast risk
- Fast-forward six months:
- Good management and rapid growth
- CSRP of 6%, EV is $570m
|Risk Free Rate of Return||3.0%||3.0%|
|Market Risk Premium||6.3%||6.0%|
|Small Stock Premium||6.0%||6.0%|
|Company Specific Risk Premium (CSRP)||7.0%||6.0%|
|Cost of Equity||22.5%||21.3%|
|After tax Cost of Debt||4.2%||4.2%|
|Discount Rate (WACC)||15.0%||14.5%|
- Significant time lapsed and no recent transaction
- Company about to be sold – triangulation
- Bankruptcy or debt restructuring – recovery method
- Change in business model, stage of development, anticipated exit market
- Secondary markets are where non-public debt and equity instruments may be traded
- Consider proper weighing between value in secondary market and fund valuation
- Secondary Market may not represent and orderly transaction
Other weighting factors:
- Timing of transaction – delay of 30 to 60 days
- Sufficient sophisticated bidders – accredited investors
- Sufficient financial information – reporting requirements
- Pattern of trades – relationship with the exchange and nominal investor pool
- Other biases and costs
Q.14.19 Shelf Life of Value Related Information
QUESTION: Port Co. had a new investor for $20/share on 1/31/2011. Co product and price and demand are volatile. 30% projected sales growth. Would equity transaction on 1/31/2011 reflect FV at 3/31/2011?
ANSWER: General no. High growth and volatile experience relative to a mature company in inversely related to the shelf life of a valuation. Look at other objective and substantive evidence indicators.
Q.14.24 Valuation of Contingent Consideration
QUESTION: Fund contractually entitled to a future payout contingent on portco performance. Should the contingent consideration be fair value assessed?
ANSWER: Yes. A contractual right to future payment is a liability that should be fair valued and recorded.
Q.14.26 Earnings Normalization
QUESTION: Is it OK to normalize earnings to derive fair value indication?
ANSWER: Yes. Market participants frequently normalize earnings for one-off non-recurring items to reflect sustainable performance.
Q.14.32 Addressing The LAG in Available Financial Information
QUESTION: In estimating market multiples for guideline companies as of 12/31 the latest info is available as of 9/30. Is it reasonable to use the data?
ANSWER: Yes. Also consider industry news and analyst reports for Q4. If delay in release of financial statements and Q4 data becomes available – if major surprises only adjust for information that is known/knowable at measurement date.
Q.14.42 Offer To Purchase
QUESTION: Does an offer or non-binding letter of intent constitute fair value?
ANSWER: Probably not. Asses if the offer is realistic. A good data point, however consider adjustments for closing price. Consider weighting offer price and adjusted price. Consider factors such as financing contingencies, stage of due diligence, regulatory approval and so on.
Q.14.55 Treatment of Equity Interest With Different Liquidity Preferences
QUESTION: How should valuation capture higher and lower ranking classes of Equity?
ANSWER: If profit sharing is proportionate and with preference in a waterfall there will be no difference. But if contractual rights and preferences are different than use appropriate waterfall of methods to reflect such rights.
- Seniority will sometimes significantly impact the value of an equity interest, while sometimes it won’t
- The lowest impact will be at the beginning stages and at a very high exit value when the proceeds to senior and junior classes are expected to be proportional
- For situations in between the guide suggests using a valuation method that is designed to capture the contractual rights and liquidation preference differences between the classes of equity
Q.14.60 and 14.61 Control Considerations
QUESTION: When evaluating private company interests where there are no observed transactions should the enterprise value reflect a controlling on non-controlling interest?
ANSWER: Should consult with counsel. The fund should consider the information that is known or knowable at the valuation date. Find out whether it is permissible to disclose information to market participants prior to use.
Q.14.71 Post Evaluation Event Product Approval
QUESTION: Measurement date 12/31/2010; Valuation date 2/1/2011; FDA drug approval date 1/25/2011. Should you include drug approval in stock valuation at 12/31/2010?
ANSWER: No. Drug approval in January 2011 was not known or knowable at the December 31st 2010 valuation date.
Level 1 Securities
If a reporting entity holds a position in a single asset or liability (including a position comprising in a single asset or liability (including a portion comprising a large number of identical assets or liabilities such as holding financial instruments) and the asset or liability is traded in an active market the fair value of the asset or liability shall be measured with Level 1 observable inputs as the product of the quoted price (P) for the individual asset or liability and the quantity (Q) held by the reporting entity (P*Q).
EXCEPTION: Post market close events (does not pertain to non-public information). Blockage discounts for level 1 securities still not allowed.
Level 1 Securities With Restrictions
- Where there is legal or contractual restriction which is deemed a characteristic of the shares and not of the holder an adjustment to the P*Q fair value estimate may be necessary.
- The same would prevent the fund from accessing the public market
- Hence the principal market would be a transfer of the interest to another market participant who typically would also be subject to the restriction.
- A reporting entity holds an equity instrument for which the sale is legally or contractually restricted for a specified period. The restriction is a characteristic of the instrument and therefore would be transferred to market participants.
- When evaluating an assumed transfer of a position any buyer of the position typically would be subject to the same restrictions, via direct transfer of the restriction or because the counterparty would require that the buyer accept the same restrictions. In such cases the task force believes that it is appropriate to consider the restriction to be characteristic of the asset irrespective of the form of the restriction
- The adjustment would reflect the amount market participants would demand because of the risk relating to the inability to access a public market for the instrument for the specified period.
- The nature and duration of the restriction
- The extent the buyers are limited by the restriction
- Qualitative and quantitative factors specific to both the instrument and the issuer
Pipe Similar Vs. Identical Securities
- To the extent that the restriction price reflects fair value at initial recognition the fund should calibrate the valuation model to the transaction price.
- Usually these transactions will be priced at the discount to be traded public stock price reflecting the relative negotiating leverage between the company and the investors in situations where the company does not have access to less expensive forms of capital.
- The valuation must also consider the differences between the specific instruments held and the common stock given the unit of account and the market participants in the principle market for the instruments.
- Timing of the most recent transactions
- Differences in information available
- Degree of dilution
- Ability to exit via the public market
Pricing Services/Broker Quotes
- Management should understand how a quotation or a price provided by a third party was determined.
- It should understand what the source of the information was
- What the inputs and assumptions used were
- Whether the quote is binding or not
- Also, management should establish internal controls to determine that the pricing information received from a third-party source as used by management in the valuation process is relevant and reliable, including:
- Whether that reflects how an orderly transaction would take place between market participants
- Whether there are a number of price indicators for a single instrument and the price indicators are widely dispersed
- If so, management should consider which prices represent the price at which an orderly transaction would take place between market participants on the measurement date
- When determining the relevance and reliability of pricing provided by pricing services, the following should be considered
- Whether the price provided is based on recent information
- Whether the price provided is based on transactions of similar or identical instruments
- The extent and nature of the market information on which the price was based AND
- Whether the price provided by the pricing service is representative of a market to which the entity has access.
- When determining the relevance and reliability of pricing provided by broker quotes consider the following:
- Whether quote is contemporaneous and actionable
- Who at the broker or dealer provided the quote
- IS the broker or dealer active in assets of the type they provided the quote for
- What disclaimers from the broker or dealer accompany the quote?
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