What have been some of the main accounting changes in private equity recently?
DT: In the past few years, there has been little new accounting guidance that would affect private equity funds directly. However, there are some new standards that may affect the portfolio companies in which they invest – namely the new revenue recognition standard: ASC 606. That was based on accounting standard update 2014-9 and some amendments.
It is effective for private companies, which most private equity firms invest in, starting January 1, 2019 for calendar year companies. This new standard has sweeping effects in terms of how companies measure revenue and so forth. It would impact a private equity fund in that the standard affects when private companies recognize revenue – and not just when, but how much. From a valuation perspective, if the private equity fund is valuing a company based on performance metrics – for example, revenue-based or EBITDA-based – I think the new standard may need to be looked at by the private equity firm because those measures are now going to be different. If they’re going to look at comparable public companies for valuation purposes, then how that company recognizes and measures revenue could impact the performance metrics used and/or considered by the private equity fund in estimating fair value of that company. That’s something to keep in mind when the standard becomes effective.
This would be applicable this year if the portfolio company adopted the standard early – because that’s always an option – or starting next year. When they start to value companies, firms have to really understand what the changes are and how the new standard impacts the underlying company that they invest in.
How does this new revenue recognition standard differ from the previous regime?
DT: The standard is very broad and principle-based. It goes into a five-step approach. You have to look at the contract between the vendor and the customer. You have to look at what the performance obligation is – for example, what the seller or the service provider is providing or obligated to provide. You have to look at the price for the contract and determine when you have to start to recognize the revenue, whether it’s all upfront, pro-rated or recorded at the end of the performance obligation. Under the current regime, in some industries you collect the revenue, and if it’s over a certain period, you have to amortize that revenue over time based on the contract terms.
The emphasis under the new standard is more a step-by-step approach as to when you record it and how much you record. It is more rigid than before.
The standard also changes several key tenets of revenue recognition, including: transfer of control as the basis for establishing the pattern for revenue recognition, as opposed to a risk reward model; uncertainty of the amount to be collected is now a measurement constraint as opposed to a recognition constraint; and the evaluation of promises made in contracts will be evaluated as performance obligations as opposed to deliverables.
What’s the level of awareness of this new standard among general partners at this point?
DT: GPs are aware of it. Some believe that it will not significantly impact the way they go about valuation, and some of that results from the fact that they invest in company A, and company A is in a particular industry. They believe that if all companies in a particular industry are applying the new standard in the same way, then the multiple you’re going to pick up is going to be valid.
From a multiple selection perspective, they think the market will take that into account over the next year or so. As far as the actual metric, whether it’s revenue-based or EBITDA-based, the market will probably determine what is a better multiple to look at. Also, because of how certain industries are affected by the standards, you may have some other EBITDA adjustments going on. Who knows – they may come up with another adjustment or add-back to EBITDA to come up with a multiple.
Which industries will be more affected by this new standard?
DT: While every industry will be affected by the new revenue standard, the impact will vary across industries. The industries most affected are the ones that enter into agreements with multiple promises satisfied over long periods of time.
For example traditional software companies that deliver a license at execution and provide support will likely see an acceleration in the revenue recognition pattern as revenue no longer requires Vender Specific Objective Evidence to allocate the transaction price between elements.
Also industries with intellectual property elements, for example licensing companies that sign long-term licenses may see revenue recognized up front even when payments are due in far in the future. Even retailers, which appear to have simple revenue models, need to consider loyalty points and how that affects revenue recognition for each sale.
Is there an advantage to adopting the new standard early?
DT: I don’t see one.
Are there other new standards or guidance that may also affect the way private equity firms are valuing portfolio companies?
DT: There’s the Association of International Certified Professional Accountants valuation guidance for VC and PE funds, which is only in the proposal stage. GPs are free to comment on the proposed draft.
Overall, it is aiming to provide some uniformity and consistency in the approach to valuation. Some private equity firms have trouble with how they approached valuation. Some are so small that they can’t afford to hire an external valuation firm. This guidance will put some framework on how you approach valuing the equity in a private company, its debt and different types of instruments. Based on the type of industry that the portfolio company is in, it gives some examples as to how a fund approaches valuation.
In the VC space, generally companies don’t have any operating results, or there may be an operating activity but it’s not at a sufficient level yet. That’s a challenge. If the private fund’s advisor is registered with the Securities and Exchange Commission, it has to make sure that the valuation of the fund’s investments is consistent with the valuation accounting guidance ASC 820. The AICPA valuation guidance is more for the preparers of financial statements – meaning the GPs of these private equity funds, but it’s also applicable to auditors. The main idea is to bring some consistency across the board.
To what extent is the SEC looking at accounting issues during its exams of private funds advisors?
DT: During exams of private equity funds, the common themes are around conflicts of interest, and valuation to some extent. Around conflicts of interest, they’re trying to make sure that GPs are providing proper disclosure as to how expenses are allocated. To the extent that a GP or an affiliate has an interest in services that are provided to the private equity fund, it has to make sure that relationship is disclosed. To the extent that a GP has multiple funds under management, it has to make sure that no fund is favored over the others in terms of expense allocation. They really want to make sure that there is proper disclosure and there is fair play in terms of how the expenses are allocated.
From a valuation perspective, the SEC is looking at ensuring that the methodology and principles are consistent with Generally Accepted Accounting Principles and consistent with how firms disclose to investors how their valuations are done.
Dale Thompson is an assurance partner at BDO in the asset management practise in New York.
This article was sponsored by BDO and first appeared in the September issue of pfm.