The valuation of private equity and venture capital investments has recently been garnering greater marketplace attention, with investors demanding more transparency and information than ever before.
Regulatory bodies, standards-setting organizations, and independent auditors in recent years have been tightening up their scrutiny of such valuations.
Marc Wyatt, former acting director of the SEC’s Office of Compliance Inspections and Examinations, said in a May 2015 speech that valuation was one of several areas receiving heightened focus among SEC examiners in their review of private equity advisers.
In May 2017, Jina Choi, former director of the SEC’s San Francisco regional office, and Michele Wein Layne, director of the Los Angeles regional office, noted in a securities enforcement forum that private equity managers and advisers should expect that valuation practices would continue to be an SEC exam and enforcement priority.
In 2018, the American Institute of Certified Public Accountants (AICPA) issued draft guidance outlining best practices for preparing and documenting valuations of investments held by private equity and venture capital companies.
The International Private Equity and Venture Capital Valuation (IPEV) Board released guidelines in 2012, and an update in 2015, setting out best practice recommendations around valuation that were intended to conform with International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP).
Given all of that, private equity fund managers should develop processes and procedures to conduct fair value analyses in support of their investments that are based on supportable, market participant-derived assumptions. Developing a robust process will allow for a seamless review by their independent auditor and ensure that the funds’ financial statements are GAAP-compliant.
Private equity fund limited partners are increasingly scrutinizing valuation inputs and assumptions presented by general partners, both during their due diligence when analyzing new fund commitments and their ongoing monitoring of existing investment performance.
Within the framework of mark-to-market (MTM) accounting, private equity funds are required to report their investments on their GAAP financial statements at fair value. Accounting Standards Codification 820, Fair Value Measurements and Disclosures (ASC 820), specifies that fair value is not an entity-specific value; rather, it’s defined as a market participant-based measurement.
Additionally, in late 2019, the AICPA for the first time issued guidance around valuations of portfolio companies held by alternative investment companies. The guidance seeks to help investment companies address the challenges around estimating and documenting their fair value measurements of these investments.
With the increased attention that private equity valuations are receiving among regulators and auditors, PE fund managers should be familiar with valuation matters that are likely to be a focus of audit and regulatory review in 2020 and beyond.
The following are examples of matters that are commonly encountered in independent audit reviews of private equity valuations, and how these matters may be addressed. While this list is not exhaustive, PE fund managers should be ready to address these items and discuss them with their auditors before and during an independent audit.
Financial projections: Projections prepared by company or fund management for use in mark-to-market financial reporting will very likely come under scrutiny from independent auditors. Care should be taken to ensure that assumptions used in such projections are based on a market participant view, rather than solely a company-specific view.
Income taxes: The assumption of whether to apply corporate-level income taxes in a discounted cash flow analysis should be based on a market participant view, which might not necessarily align with the actual tax status of the entity being valued for financial reporting purposes.
Discount rate: Independent auditors expect to see a discount rate based on a market participant-based weighted average cost of capital calculation. The income tax assumption should be consistent between the discount rate calculation and the discounted cash flow analysis (as discussed above).
Trading Multiples: Such multiples (for example, enterprise value-to-EBITDA or enterprise value-to-revenue) should be obtained either from applicable guideline transactions or guideline publicly traded companies. The selection criteria for comparable transactions and companies, as well as the rationale for any adjustments to multiples, should be documented.
Private equity managers should also be familiar with Accounting Standards Update (ASU) 2011-04, which describes requirements for disclosures around fair value measurements. Related to ASU 2011-04, auditors commonly look for the following information:
- Descriptions of valuation methods and key assumptions utilized, including inputs for Level 2 and Level 3 measurements (as defined under ASC 820)
- Quantitative information about significant unobservable inputs used for Level 3 measurements, as well as sensitivity analyses around these unobservable inputs
- Descriptions of valuation processes utilized
These information requirements typically call for greater levels of documentation, which likely results in more private equity firms reviewing their internal processes and controls. These requirements, along with the commonly encountered valuation-related audit review matters noted above, have also led some firms to hire third-party advisers to assist in preparing their valuation analyses.
The preparation of a thorough, market participant-based valuation analysis may require greater up-front cost and effort. However, doing so will almost certainly lead to a smoother audit process and more transparency to regulators, investors, and stakeholders.