Valuation will probably never be an exact science, but the industry is striving for more rigor. Last year, three valuation professional organizations released an optional credential, Certified in Entity and Intangible Valuations. It includes a Mandatory Performance Framework, which attempts to standardize how fair value estimations are documented.
The credential grew out of regulatory concerns about valuations at publicly listed companies, but GPs will need to take a close look at how it will likely affect alternative assets firms.
The framework doesn’t offer a standardized valuation methodology. Instead, it details a roadmap that reports how someone arrived at a particular valuation, which auditors are likely to adopt to save time. And as the credential and the MPF become more widely used, regulators may start expecting valuations with the CEIV stamp of approval from private funds managers, too.
But the CEIV was born out of Securities and Exchange Commission concerns about the valuation industry, not hedge funds or buyout shops. In 2011, Paul Beswick, then chief accountant for the regulator, spoke at the American Institute of Certified Public Accountants conference, expressing concern about the valuation profession. The application of fair value and fair value-based measures included in the US GAAP was being more broadly applied, and Beswick argued the valuation industry’s lack of uniform education or experience requirements might lead to analytical inconsistency or a lack of objectivity.
Beswick suggested the industry devise a single set of qualifications, standards for practice and a code of conduct. He added, “One could also contemplate whether a comprehensive inspection program and a fair disciplinary mechanism should be established to encourage proper behavior and enforce the rules of the profession in the public interest.”
As a result, three valuation professional organizations, the AICPA, the American Society of Appraisers and the Royal Institution of Chartered Surveyors, devised the CEIV with the help of international valuation and audit firms. “The idea was to establish qualifications and standards in response to the concerns expressed by the SEC prior to any regulators imposing their own on us,” says Joan D’Uva of EisnerAmper.
The result was released last year and goes a long way toward addressing Beswick’s concerns. “The CEIV sets a minimum of education and experience requirements for valuation professionals,” says Mark Zyla of the valuation firm Acuitas. “It’s a framework for consistency.”
It may be too soon to tell how the industry will respond to the new process. “It’s only been out since last spring, so many professionals may not have had the time to get the certification,” says Travis Harms, who leads Mercer Capital’s financial reporting valuation group. “In my practice, no one’s explicitly inquired about the CEIV just yet.”
Ready, set, go, once we know
Market participants suggest many valuation professionals are ready for the training and the testing but are waiting until certain issues surrounding the quality control process and enforcement mechanism are clarified. “The primary reason for the slow adoption is people aren’t quite sure how they’ll be inspected,” says David Larsen of Duff & Phelps. “Nobody wants to do anything wrong, and they don’t know what’s wrong yet.”
At the moment, the credential can be obtained from any of the three sponsoring groups, so one firm may have professionals with certification from different groups. And this raises the question of which of those three bodies will review that work, and what happens if the multiple reviews reach different conclusions?
There is also a confidentiality concern with the certification: private equity firms may not want to grant unlimited access to a monitor from the VPO who is sent to review the valuation. “One way they may resolve that is to have the monitor review the process rather than a specific valuation,” says Larsen.
But the industry is more positive about the documentation standards laid out in the MPF. “The [framework] identifies how you think about the valuation work you’re doing and how you document the valuation analysis and conclusions. The MPF is considered best practice and it’s something that all fund managers should be implementing, and all valuation professionals should be following,” advises Larsen.
The core rationale for adopting MPF-grade processes may not come down to regulators in the end, but auditors. “The guidelines already closely mirror what many audit firms outline, so it may be seen less as a radical departure, and more of a roadmap to documentations that closely mirrors the one already used by auditors,” says Harms. “If I’m the fund CFO, what I really want is as little friction between the fair value process I’m overseeing internally or externally; I want to minimize the friction between that and the audit process.”
“[The MPF] is going to be the de facto level of requirements for documentation that auditors will expect from either outside valuation firms or internal valuation staff,” says Zyla.
Better safe than surprised
As a result, many valuation professionals serving the alternative asset industry are exploring the certification, or at very least, matching the MPF’s documentation standards.
“We’re incorporating the MPF into our processes and speaking with our clients and other market participants about their own internal valuation process and what needs to be tweaked so that they’re compliant with this new standard,” says Larsen. So how much longer of a paper trail will GPs need to produce to meet this new yardstick?
“Adherence to the MPF will involve formalizing a lot of documentation that’s already being produced in an informal manner,” says Harms. “The MPF requires the practitioner to document the process so that someone with reasonable knowledge could review the valuation materials and be able to ascertain that the conclusion is supportable,” Larsen adds. That involves sharing more details about the decisions and assumptions that go into the final valuation.
“Now under the MPF, they’ll have to indicate why they used the methodologies they did and why they didn’t use other methodologies,” says D’Uva. “There’s now a more robust process to expand upon citing those reasons including ones that may seem obvious.”
Don’t complain, just explain
The MPF also asks people to say why certain metrics were left out of the valuation. “In the case of contrary information, that is, information that disputes the current valuation, the MPF asks that we report how such information impacts the final conclusion of value,” says Larsen.
Financial forecasts may also require more documentation. “Forecasts can be a challenge to evaluate, and practically speaking it can be a challenge to gain an understanding of all the inputs used to support an acquisition price,” says Michael Aronow of EisnerAmper.
“There are many factors that make a particular acquisition attractive at a transaction price, and that includes a forecast developed based on assumptions such as growth rates, market share, margins, as well as other significant assumptions that need to be properly substantiated and documented.”
While the MPF doesn’t advocate any particular methodology, some approaches may create more work than others, especially for a traditional private equity firm. “When an income approach is being used as valuation technique, most people do a pretty good job in identifying the discount rate and how they calibrate the inputs and such,” says Larsen. “But in the case of alternative asset firms, the projections are a little less robust, or at least the documentation of projections beyond one or two years can be less robust than in the corporate environment.”
For example, if a buyout firm projects a 5 percent growth rate, they will need to explain what inputs are being used to support that and what changes will drive the performance. “In the corporate world, the projections are more rigorous, in that they know how many more widgets they’ll be making, to which customers they will be sold, at which price, in which year, whereas the buyout firm may not be as detailed when it comes to projections three or four years out.”
“Over time, I would expect the SEC would check that people are following the MPF and I’d expect LPs to begin asking whether their GPs are meeting that standard as well,” says Larsen. “Whether they are pushing for a CEIV certification to be obtained by someone in the firm or their outside valuation provider, that remains to be seen.”
Investors and regulators may not be demanding CEIV-grade valuations just yet, but auditors will be certainly want a process that makes their life easier. “I’ve seen it in practice now,” says Aronow. “On a call recently with a large national firm and their valuation group, they only had a single question on our valuation documentation and even then, the answer was readily available in our work papers, so we were able to respond quickly.”
A quick response may make auditors happy, but at the cost of valuation professionals’ time. That, however, is something firms may just have to tolerate.