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. In fact, 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’s intended to conform to International Financial Reporting Standards (IFRS) and U.S. GAAP standards. In 2018, the American Institute of Certified Public Accountants (AICPA) issued draft guidance outlining best practices for preparing and documenting valuations of investments held by private equity and venture capital companies.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 best practices recommendations from IPEV and the AICPA, private equity fund managers should develop processes and procedures to conduct their fair value analyses in support of their 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.
In recent years, the SEC has more closely scrutinized private equity valuation processes and procedures. Marc Wyatt, former 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, former director of the SEC’s San Francisco Regional Office, and Michele Wein Layne, director of the SEC’s Los Angeles Regional Offices, 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.
"With increased attention that private equity valuations are receiving among regulators and auditors, private equity fund managers should be familiar with valuation matters that are likely to be a focus of audit and regulatory review in 2020 and beyond."
In addition to greater focus from the SEC and from independent auditors, private equity fund limited partners are spending more time and resources reviewing valuation processes and procedures. Limited partners are increasingly scrutinizing valuation inputs and assumptions presented by 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 in 2012 guidelines, with an update in 2015, which 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 (“MtM”) 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’s defined as a market participant-based measurement.
Additionally, in late 2019, the AICPA for the first time issued guidance around the valuation of portfolio companies held by alternative investment companies. Their guide, titled “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies”, seeks to help investment companies address the challenges around estimating and documenting their fair value measurements of these investments.
With increased attention that private equity valuations are receiving among regulators and auditors, private equity fund managers should be familiar with valuation matters that are likely to be a focus of audit and regulatory review in 2020 and beyond.
"Limited partners are increasingly scrutinizing valuation inputs and assumptions presented by general partners, both during their due diligence when analyzing new fund commitments and their ongoing monitoring of existing investment performance."
In practice, the following are examples of matters that are commonly encountered in independent audit reviews of private equity valuations, 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:
1. Financial Projections – Projections prepared by company or fund management for use in mark-to-market financial reporting will very likely come under scrutiny from independent auditors. Care should be taken to ensure that assumptions utilized in such projections are based on a market participant view, rather than solely a company-specific view.
2. Income Taxes – The assumption of whether to apply corporate level income taxes in a discounted cash flow analysis should be based on a market participant view, which might not necessarily align with the actual tax status of the entity being valued for financial reporting purposes.
3. 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).
4. Trading Multiples Utilized – Such multiples (for example, enterprise value-to-EBITDA or enterprise value-to-revenue) 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.
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:
These information requirements typically call for greater levels of documentation, which likely 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, doing so will almost certainly lead to a smoother audit process and more transparency to regulators, investors and stakeholders.