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Private Investment Forum - Fall 2019

 

Final Version of AICPA's Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investments is Released

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Introduction

Valuations of privately held companies is an inherently subjective and complex process, which becomes ever more cumbersome as the capital structure of the portfolio company increases in complexity. The selection and implementation of the many available valuation processes, assessment of critical inputs and analysis of appropriate comparable company sets, among a myriad of other considerations, are issues that PE/VC industry stakeholders face on a daily basis. To address these issues and harmonize the diverse views and practices of industry participants, the American Institute of Certified Public Accountants (“AICPA”) has issued the much-anticipated valuation guide entitled “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investments” (herein, the “Valuation Guide”).

The Valuation Guide was developed by the AICPA PE/VC Task Force, representing a variety of perspectives in the PE/VC industry, including market participants, auditors, valuation specialists and members of the AICPA staff. The intention of the Valuation Guide is to provide guidance and clarification, highlight best practices, and address certain valuation issues that have arisen over time (such as unit of account, transaction costs, calibration, the impact of control and marketability, and back testing). It also provides working illustrations and examples of the accounting for and valuation of portfolio company investments. The main focus relates to the valuation of debt and equity investments in portfolio companies; however, in instances where top-down valuation methods are employed, it also addresses the calculations of enterprise value of portfolio companies as a whole.

It’s important to note that the Valuation Guide does not represent authoritative guidance in and of itself, which is relegated to the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”) and authoritative guidance issued by the Securities & Exchange Commission. Rather, it serves as a guide for the application of those standards (namely ASC 820, Fair Value Measurements & ASC 946, Financial Services – Investment Companies). The end result is a surprisingly easy-to-read, highly informational and voluminous document which touches on a variety of valuation-related topics.

Overview

The Valuation Guide is organized into four sections:

  • Chapters 1-4 provide an overview of fair valuation of portfolio company investments, including the definition of fair value, industry background, who the key industry participants are and the fundamental concept of ”unit of account.”
  • Chapters 5–10 discuss commonly utilized valuation approaches and methodologies, fair value considerations for equity interests versus debt interests, and fair value considerations for equity interests in simple versus complex capital structures. A key topic in these chapters is calibration, which involves using implied assumptions for an initial or observed market transaction as a starting point for subsequent valuations, assuming the initial or observed transaction is at fair value.
  • Chapters 11–14 provide discuss specific valuation topics, such as back testing and factors to consider at or near the transaction date, including U.S. GAAP requirements with respect to transaction costs. This section of the Valuation Guide also includes FAQs.
  • Appendices A, B & C provide additional information, including a discussion of documentation. Most notably, Appendix C includes 16 user-friendly case studies that can be utilized to reason through real valuation scenarios.

Key Topics

Unit of Account – Per the ASC Master Glossary, “unit of account” is defined as “the level at which an asset or liability is aggregated or disaggregated in a Topic for recognition purposes.” Unfortunately, the application of this definition, as it specifically pertains to investment companies, is not explicitly provided for in ASC 946. The Valuation Guide seeks to bridge this gap and define the unit of account as it applies to investment companies by answering a few critical questions:

  • Does the assumed transaction contemplate the sale/transfer of the specific asset held by the fund in the portfolio company in question, or the sale/transfer of a larger grouping of assets?
  • Is it appropriate for investment companies to group assets for the purposes of valuation, and if so, how?
  • How does the ASC 820 requirement to measure fair value based on an assumed sale/transfer of the fund’s investment consider market participant assumptions regarding the investment strategy and the way that value is expected to be realized from the investment?

The Valuation Guide addresses these questions, presents numerous quantitative examples and concludes that various criteria need to be considered in the determination of unit of account (such as one Preferred B share, the entire Preferred Class B, all of Preferred Stock classes, etc). Key considerations include defining the assets to be valued in a manner consistent with the specific investments held by the reporting entity, consideration of the way market participants would transact in these assets, asset groupings that consider the best economic interests of the reporting entity, and consideration of market participants’ time horizon expectations and expected rate of return.

Transaction Costs - Transaction costs are defined as “the costs to sell an asset or transfer a liability in the principal (or most advantageous) market for the asset or liability that are directly attributable to the disposal of the asset or transfer of the liability” (i.e., due diligence fees, legal fees, travel costs, etc.). The definition further stipulates that such costs i) are the direct result of and essential to the transaction, and ii) would not have been incurred had the decision to sell the asset or transfer the liability not been made. ASC 820-10-35-9B then states, “The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability should not be adjusted for transaction costs, which should be accounted for in accordance with the provisions of other accounting guidance.” ASC 946-320-35-1 states, “An investment company shall initially measure its investment in debt and equity securities at their transaction price. The transaction price shall include commission and other charges that are part of the purchase transaction.”

The Valuation Guide seeks to bridge the gap between this apparent divergence between ASC 946 and ASC 820 and addresses what constitutes transaction costs and discusses how those costs should be accounted for in the estimation of fair value in three different contexts: on Day 1, at interim measurement dates, and in proximity to the exit date. The Valuation Guide concludes that ASC 946 requires the transactions costs to be included as part of the initial measurement of the investment and excluded at subsequent measurement dates, meaning on Day 2 of the investment (assuming all other factors remain the same) there will be an unrealized loss equal to the transaction costs. The Valuation Guide further concludes that when an exit is imminent, the fair valuation estimate should exclude estimated transaction costs associated with the anticipated exit.

Calibration – As described in ASC 820-10-35-24C, where the valuation of a portfolio company in future periods will incorporate valuation techniques that utilize unobservable inputs, those same valuation techniques should be applied upon initial recognition, and the unobservable inputs should be adjusted, or “calibrated,” such that the output from the model upon initial recognition equates to the transaction price (assuming the transaction price is at fair value).

The concept of calibration extends beyond the initial transaction as well. Given the level of subjectivity inherent in unobservable inputs, those unobservable inputs should be further calibrated in the instances of observable transactions in the portfolio company’s instruments or when there are changes in market conditions. Essentially, calibration involves monitoring the difference between the unobservable input (such as an EBITDA multiple) at the initial transaction date and the comparable input as it relates to the comparable company set against which the initial transaction was benchmarked. The intention of calibration is to ensure the valuation techniques employed are reflective of market data at the measurement date. The Valuation Guide addresses some of the vagary and poses questions (and provides working examples) such as, but not limited to:

  • When is a transaction a reliable indication of fair value? (i.e., not a related party transaction, the unit of account represented by the transaction is not different than the asset being measured, the transaction was not consummated under duress, the transaction occurred in the principal/most adventurous market, etc.)
  • How would calibration be applied in valuing a debt or equity investment in a business using the income approach? Using the market approach?
  • How long should a transaction be considered relevant for calibration?

Control and Marketability – Consideration of control and marketability is an important factor in the estimation of the fair value of a portfolio company, as it can vary considerably based on the scale and scope of the investment. As control increases, the PE/VC entity has more ability to influence the operations and outcomes at the portfolio company, which carries with it a premium - the control premium. The Valuation Guide concludes that this premium would not be explicitly incorporated into the valuation itself, but rather reflected in the presumed upwards adjustments to expected future cash flows and potential amendments to anticipated exit dates (which the investee fund now has more control over). Conversely, the Valuation Guide also addresses the non-controlling interest aspect, noting essentially the same concept. Generally, it’s not appropriate to apply explicit discounts in the fair valuation process due to a lack of control; rather, the typical considerations in the valuation process should be made. However, the Valuation Guide does note discounts for lack of control may be appropriate in limited scenarios (such as where one share class has superior liquidation preferences or guaranteed returns over other classes, and market participants may not expect to be able to fully capitalize on those rights or preferences, as other share classes have the control which would effectuate the hypothetical transaction). On the marketability side, the Valuation Guide notes that discounts for lack of marketability, after the enterprise value has been run through the waterfall, are appropriate in some situations. Such scenarios could include, but are not limited to, instances where there are several financing rounds within a portfolio company, or where there are senior rounds that carry certain preferences and market participants may not expect to be able to effect an exit to fully capitalize on those preferences.

Conclusion

The AICPA’s “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investments,” is an expansive must-read for all market participants in the PE/VC space. The AICPA expertly provides readers with definitions, refreshers, clarifications, nuances and working examples in a surprisingly easy-to-read and understandable format. The AICPA addresses the varying viewpoints and approaches of a wide range of market participants on a wide range of topics. Therefore, the guide is recommended for portfolio managers, investors, auditors, valuation specialists, and others. For further discussion any of the points raised above, or those in the Valuation Guide itself, please contact Marcum’s Alternative Investment Group.

 
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