The valuation of private equity and venture capital investments has recently garnered greater marketplace attention. This comes as investors are demanding more transparency and information than ever before. The U.S. Securities and Exchange Commission (SEC) and independent auditors are more closely scrutinizing private equity valuation processes and procedures. The International Private Equity and Venture Capital Valuation (IPEV) Board released guidelines in 2012 and an update in 2015 to set out best practice recommendations around valuation that are intended to conform to IFRS and U.S. GAAP standards. The American Institute of Certified Public Accountants (AICPA) in early 2018 issued draft guidance outlining best practices for preparing and documenting valuations of investments held by private equity and venture capital companies.
Given the greater levels of scrutiny and the best practices recommendations from IPEV and the AICPA, energy-focused private equity fund managers should develop processes and procedures to conduct their fair value analyses in support of their upstream oil and gas investments that are based on supportable market participant-derived assumptions. Developing a robust process will allow for a seamless review by their independent auditor and ensure that the funds’ financial statements are GAAP compliant.
Greater Private Equity Valuation Scrutiny
In recent years, the U.S. Securities and Exchange Commission (SEC) has more closely scrutinized private equity valuation processes and procedures. Marc Wyatt, acting director of the SEC Office of Compliance Inspections and Examinations, noted in a May 2015 speech that valuation was one of several areas receiving heightened focus among SEC examiners in their review of private equity advisors. In May 2017, Jina L. Choi and Michele Wein Layne, directors of the SEC’s San Francisco and Los Angeles Regional Offices, respectively, noted in a securities enforcement forum that private equity managers and advisors should expect that valuation practices will continue to be an SEC exam and enforcement priority.
In addition to greater focus from the SEC and from independent auditors, private equity fund limited partners are reviewing valuation processes and procedures. Limited partners are increasingly scrutinizing the valuation inputs and assumptions presented by the general partners, both during their due diligence when analyzing new fund commitments, and their ongoing monitoring of existing investment performance.
Against this backdrop, the IPEV Board released guidelines in 2012, with an update in 2015, that set forth best practice recommendations around valuation that are intended to conform to IFRS and U.S. GAAP standards. These U.S. and international standards were amended in 2011, resulting in a common international definition of fair value. Within the framework of mark-to-market accounting, private equity funds are required to report their investments on their GAAP financial statements at fair value. Accounting Standards Codification 820, Fair Value Measurements and Disclosures (ASC 820), specifies that fair value is not an entity-specific value, rather it is a market participant-based measurement.
In early 2018, the AICPA issued draft guidance around the valuation of portfolio companies held by alternative investment companies. This guidance seeks to help investment companies address the challenges around estimating and documenting their fair value measurements of these investments.
With the increased attention that private equity valuations are receiving among regulators and auditors, private equity fund managers who deal with upstream oil and gas investments should be familiar with valuation matters that are likely to be a focus of audit and regulatory review.
Valuation-Based Matters Commonly Encountered in Audits
In practice, the following are examples of matters that are commonly encountered in independent audit reviews of private equity valuations in the upstream oil and gas sector, and how these matters may be addressed. Though this list is not exhaustive, private equity fund managers should be ready to address these items, and discuss them with their auditors, before and during an independent audit:
Commodity Pricing – Internally-prepared price decks are often utilized, which may represent a company-specific view. For financial reporting purposes, independent auditors may expect to instead see commodity pricing based on publicly available sources that reflects market participant assumptions, such as the NYMEX strip, or a forward-looking price deck based on independent analysts’ estimates.
Risking Adjustments – Internally developed risking estimates by reserve category are often utilized in private equity valuations. However, independent auditors may expect to see risking that conforms to market participant standards and reflects the inherent risk of producing the hydrocarbons for the reserve category being valued.
Income Taxes – The assumption of whether to apply corporate level income taxes in a discounted cash flow analysis of reserves should be based on a market participant view, and may depend on the following factors, among others: (1) the asset profile of the company in question; and (2) the profile of other companies involved in acquisition activity within the same area.
Discount Rate – Independent auditors expect to see a discount rate based on a market participant-based weighted average cost of capital calculation. The income tax assumption should be consistent between the discount rate calculation and the discounted cash flow analysis (as discussed above).
Trading Multiples Utilized – Such multiples (for example, enterprise value-to-daily production or enterprise value-to-proven reserves) should be obtained either from applicable guideline transactions or guideline publicly traded companies. The selection criteria for comparable transactions and companies, as well as the rationale for any adjustments to multiples, should be documented.
Exclusion of Certain Asset Classes – In some instances, undeveloped reserves are excluded from a company’s fair value analysis. However, this might not necessarily be reflective of a market participant view. For example, there may be upside value in PUDs and unproven reserves that a particular company might not recognize; however, it may be recognized by a market participant.
Private equity managers should also be familiar with Accounting Standards Update (ASU) 2011-04, which describes requirements for disclosures around fair value measurements. Related to ASU 2011-04, auditors commonly look for the following information:
Descriptions of valuation methods and key assumptions utilized, including inputs for Level 2 and Level 3 measurements (as defined under ASC 820);
Quantitative information about significant unobservable inputs used for Level 3 measurements, as well as sensitivity analyses around these unobservable inputs; and
Descriptions of valuation processes utilized.
These information requirements typically call for greater levels of documentation, which results in more private equity firms reviewing their internal processes and controls. These requirements, along with the commonly encountered valuation-related audit review matters noted above, have also led some firms to hire third-party advisors to assist in preparing their valuation analyses.
The preparation of a thorough, market participant-based valuation analysis may require greater up-front cost and effort. However, it will almost certainly lead to a smoother audit process and more transparency to regulators and investors.