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The guide includes case studies that can be used to reason through real situations faced by investment fund managers, valuation specialists, and auditors.

Governance

Key Takeaways From New Private Equity and Venture Capital Valuation Guide

  • Craig Arends
  • 6/7/2018

For years, there has been a diverse range of methodologies employed to estimate the fair value of portfolio company investments. That inconsistency has been problematic in a field where precision weighs heavily. But newly drafted guidance from an American Institute of Certified Public Accountants (AICPA) task force changes that equation by harmonizing views and providing best practices.

The venture capital and private equity guidance is meant to encourage alignment of approaches used by investors, auditors, and valuation professionals on the accounting for and valuation of portfolio company investments held by investment companies. The valuation falls within the scope of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 946 Financial Services — Investment Companies. This includes private equity funds, venture capital funds, hedge funds, and business development companies.

Key takeaways for investors, auditors and valuation professionals

The draft guides the approach to the valuation of investments in equity and debt instruments and certain aspects of the accounting related to those investments. It is titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.

On page 311 of part one, the task force recommends the following approaches for certain key areas:

Industry topic rigor

Investment managers and other financial industry professionals should become familiar with its directions for key industry topics. More than ever, documentation of critical judgments will be key to supporting fair valuation estimates. Investment managers should remain focused on being able to demonstrate (to investors, auditors, and regulators) that fair valuations were subjected to appropriate rigor and are supportable.

Value of the company versus value of the interest

For venture capital and private equity investments, the purpose of the valuation is to value the investment, not the portfolio company itself. Therefore, it is appropriate to consider the assumptions that market participants investing in the interest would make, rather than the assumptions that market participants acquiring the entire portfolio company would make.

Factor in the time horizon for the valuation

While FASB ASC 820 determines the assumptions of a transaction at the measurement date, market participants would use different assumptions to value an investment on the measurement date. Specifically, include the time horizon that market participants would expect for the investment, the strategies available to maximize value for the investment, and liquidity considerations.

Calibration changes

The goal of calibration is to ensure that at subsequent periods, valuation techniques use assumptions that are consistent with the observed transaction, updated to take into account any changes in company-specific factors as well as current market conditions. Therefore, estimate value at dates subsequent to the initial measurement date by calibrating the selected valuation model(s) to any recent transactions that were at fair value, and then update the assumptions for changes between the transaction date and the measurement date.

Consider relevant rights and preferences of the interest

When estimating the fair value of the fund’s investment, the fund should determine how each class of equity would participate in future distributions from a sale or other liquidity event, and the implications for the fair value of each class of equity.

Control and marketability

The task force believes that when valuing a fund’s interest, it’s appropriate to consider the expected cash flows to the interest, given the portfolio company’s plans under existing ownership, as modified under the new guidance. This assumes the degree of influence the market participant transacting in the interest would have over those plans, considering the nature of the interest acquired.

In addition, for the purpose of valuing the fund’s interest in the portfolio company, the total enterprise value is measured using the required rate of return of the investors who have control of the business. The use of calibrated inputs, adjusted for any changes in the company and for then-current market conditions, generally would incorporate the value associated with control and marketability, and therefore no further adjustments would be needed.

Value of debt

The value of debt, for the purpose of valuing equity, reflects the cost that market participants transacting in the equity would assign to this liability, given the expected interest and principal payments over the expected time horizon for the debt.

Transaction costs

Exclude transaction costs from the fair value of investments on day two since the fair value immediately after the transaction close may be less than the capitalized cost.

Back-testing

The task force recommends that a fund performs back-testing to improve the fund’s valuation processes.

How we can help

CLA was involved in the drafting of this guide so we understand the intricacies of the new information, which is open for comment until August 15, 2018. We also perform valuations of privately owned companies in an array of different industries, and can help you with all of your transaction needs.

  • Craig Arends
  • Managing Principal of Industry
  • CLA Minneapolis