Valuation under the microscope

In 1989 the US National Venture Capital Association attempted to reach consensus on how to value venture-backed investments. Since then, the alternative asset industry has seen significant growth in the number of managers, funds, investors, strategies and the extent of regulatory scrutiny. With respect to valuation, there have been a number of defining moments for the funds industry over the past 30 years, but 2017 may end up in the history books as a watershed period in the history of fair value reporting.

The financial crisis of 2008/9 was a major catalyst in expanded regulation. One of the points of contention during the crisis was the applicability and implementation of fair value accounting principles. It is often forgotten that the alternative asset industry has been under a fair value regime since 1940, or before, and had been praised for its self-regulatory foresight in establishing guidelines such as the PEIGG Valuation Guidelines in 2003 and the IPEV Valuation Guidelines in 2005. Both guidelines having been updated since.

While the NVCA failed to reach consensus with respect to valuation in their deliberations some 30 years ago, today the global alternative assets industry has generally acknowledged that measuring and reporting investments at fair value provides the most useful information to investors. Yet questions persist about the methodology and its application ensuring that the valuation of alternative assets is under a progressively stronger microscope.

Why fair value?

Fair value is globally defined “as the amount that would be received in an orderly transaction to sell the investment in an orderly transaction using market participant assumptions at the measurement date”. Before addressing the increased magnification applied to valuation in 2017, it is important to be reminded as to why investors need fair value. Investors may not always “want” fair value, but they “need” it because fair value is:

The basis that limited partners use (and are often required to use under their relevant accounting standards) to report periodic (quarterly/yearly) performance to their own investors, beneficiaries, boards and other stakeholders.

The basis upon which limited partners make “apples to apples” asset allocation decisions.

An important data point in making interim investment (manager selection) decisions on a comparable basis.

Often part of incentive compensation decisions at the investor level.

Necessary as a consistent measurement basis to consider risk.

The type of consistent and transparent information that limited partners require to exercise their own fiduciary duties.

The only way to make fund financial statements meaningful to investors.

A fund that does not report Net Asset Value based on the fair value of underlying investments creates a major problem for their LPs who need fair value-based NAV to allow the investor to measure and report the value of their fund interest.

Magnifying fair value

As previously stated, the 2008/2009 financial crisis exacerbated the focus on fair value estimates. While many alternative investment managers had strong fair value estimation processes, they were caught up in the frenzy surrounding the judgment required to value illiquid investments. Over the past decade, the Public Company Accounting Oversight Board, or PCAOB, has consistently found exceptions in their inspection of fair value audit procedures. In addition, the US Securities and Exchange Commission has questioned the failure of the valuation profession to adopt a unified view. Regulators in Europe, Asia, and Central and South America are also putting fair value under increased scrutiny.

As 2017 draws to a close, it’s clear that fund managers worldwide are going to have to adopt more rigorous valuation procedures and documentation amid increased pressure from investors for global standards and tougher local regulations. While a number of countries have proposed or implemented new fair value oversight, these are some of the more significant developments:

Proposed PCAOB standards: The PCAOB has proposed new standards focused on the use of specialists by auditors, fair vale measurement and tougher scrutiny of accounting estimates to guard against bias. Some auditors are already applying the proposals which could increase both the scope and cost of audits unless the manager can demonstrate that their valuation process is robust.

New valuation credential: In response to SEC concerns with respect to estimating fair value, leading US accounting groups and valuation bodies have over the past three years teamed up to create a new valuation qualification called The Certified in Entity and Intangible Valuations credential, or CEIV for short. The American Society of Appraisers, the American Institute of Certified Public Accountants and the Royal Institution of Chartered Surveyors were all involved in the initiative along with major accounting and valuation firms.

In addition to the CEIV credential, a Mandatory Performance Framework was created to determine how much valuation work to do and how to document the work in estimating fair value. This was supported by application guidance – the MPF (Application) – to help provide a consistent framework. The framework and the Application are to be applied by CEIV credential holders and expected to be followed as best practice by non-CEIV valuation professionals, both those working internally and externally.

A rival framework: The Association of International Certified Professional Accountants has separately proposed its own credential and framework for valuing financial instruments. The Certified in the Valuation of Financial Instruments, or CVFI, credential and its associated Financial Instrument Performance Framework (FIPF) provide best practice guidance for valuing financial instruments including debt and equity. The CVFI overlaps with the CEIV, but there’s been no decision yet on how to resolve this duplication.

Great expectations

Over time, it is anticipated that compliance with the MPF and Application will be expected by investors, auditors and regulators. The supporting documents say the framework was “designed to be used by all valuation professionals who provide valuation services for financial reporting purposes”. It is possible that the rival CVFI may be used interchangeably with the CEIV framework, but it is too soon to tell.

As these new credentials become standard practice, it is possible that investors and regulators will expect a CEIV or CVFI-certified valuation professional to be involved in all valuation estimates prepared for financial reporting. The CEIV/CVFI may be an employee of the fund manager and/or an independent valuation specialist with the credential. Further, with the proposed changes to audit standards, it is possible that the auditor will deem it necessary to expand audit procedures if the Mandatory Performance Framework or FIPF and their Applications are not applied.

A more rigorous approach

More is to come. The American Institute of Certified Public Accountants established a taskforce in 2013 to create a new guide focused on valuing the portfolio investments of investment companies. The draft guide is expected to be published in the second quarter of 2018.

Such an approach is to be expected in the alternative asset industry which has been a leader in promulgating self-regulatory valuation best practices. But it’s worth also noting the wider regulatory landscape, which has encompassed both alternative asset managers and investors. As a result, the new and proposed standards and guidelines will likely require increased rigor and documentation to support fair value estimates. Over time, investors, auditors and regulators will come to expect the increased consistency, transparency, relevance and reliability provided by a more robust valuation framework. Alternative investment fund managers have a vested interest in meeting the expectations of investors, regulators and the public in general. Understanding and adopting the new valuation framework should assist in expanding public trust. n

 

David Larsen is a managing director and a leader of the alternative asset advisory practice in the San Francisco office of Duff & Phelps. He serves a wide variety of investors and managers in focusing on valuation and governance-related questions. He is also part of the AICPA PE/VC Valuation Guide Taskforce, a former vice chair of the International Private Equity and Venture Capital Valuations Board (IPEV) and led the team that drafted the US PEIGG Valuation Guidelines.