Valuation Issues Play Critical Role for Private Equity Firms

Valuation issues play a critical role for private equity firms whose business model is focused on investments where an active market does not exist. The leadership of private equity firms is challenged with determining the value of the investments in their portfolio companies. These values are reported to investors through financial statements and other reports. The investors rely upon the values to make investments and to monitor the investments in the private equity firms.

Business Development Companies (BDCs) are publicly traded companies that invest in capital of private companies. The BDC's price relative to net asset value per share provides some valuable insight to private equity firms regarding the importance of estimating the value of investments. At the end of 2012 and 2013, the median price to net asset value for the BDCs was 1.02x and 1.01x, respectively. Therefore, the traded stock price was approximately net asset value per share. This suggests that investors rely upon the net asset value reported in the financial statements when purchasing or selling the shares.

Most private equity firms are privately held, so the valuations and valuation processes are not publically available. However, BDCs are public; therefore, insight can be gained from the process and methods utilized to value the investments. This article aims to provide an overview of the valuation process, address a risk private equity firms encounter in reporting the fair value of their investments and discuss the role of qualified third party valuation firms.

For financial reporting purposes, the standard for recording investments is fair value as defined below:
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The challenge is establishing and assessing the reasonableness of the fair value of investments in companies and financial instruments that are not publicly traded. This is especially complex when different methods and assumptions can result in significantly different results. In general, there are three approaches to estimating the fair value of an investment: 
  • Asset-Based Approach: Determining the value based on the value of the assets, net of liabilities.
  • Market Approach: Determining the value by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.
  • Income Approach: Determining the value by using one or more methods that convert anticipated economic benefits into a present single amount.
The valuation process should involve one or more of the above approaches that are appropriate and provide a reasonable indication of value. The objective is to estimate the fair value of the investments that incorporates the appropriate methods, complies with the above standard and reflects a reasonable value.

To meet that objective, the private equity firm should have a process that ensures the methods used are appropriate, the key assumptions are reasonable and the result is consistent with the standard and approximates fair value. The ultimate responsibility of the fair values selected is placed upon the leadership of the private equity firm.

The firm’s leadership is responsible for establishing the policy and process for estimating the fair values. The policy should establish the timing of when fair values are estimated and the parties involved in the process. The policy can also be as specific as outlining the specific methodologies and the source of key assumptions used in estimating the values. The policy should minimize the risk that the values are misstated due to the methods and assumptions utilized and mitigate potential conflicts of interest.

The individuals or groups involved in the valuation process are very important in the valuation process of the investments. A review of SEC filings revealed the following general groups that are involved in the investment process:
  • Investment Professionals: These individuals are often responsible for managing and monitoring the investment and may have been primarily responsible for the original investment. They are closest to the investment and may have the best insight related to the factors that affect the value of the investment. However, they also may be subject to conflicts of interest that may impede their ability to provide an impartial assessment of the fair value.
  • Third-Party Valuation Professionals: Most, if not all, BDCs will hire a third party to either perform an independent valuation of the investments or perform procedures to assess the reasonableness of the methods used, the key assumptions and the resulting values. The key is to hire a valuation professional that is qualified and willing and able to provide an independent assessment, even if it differs from the value prepared by management.
  • Upper Management/Internal Committee: This role may be served by the board of directors, investment committee, audit committee or another individual or group. The purpose of this group is to be the final step in the valuation process and to challenge and approve the resulting values based upon the work performed by the investment professionals and potentially the third-party valuation professional.

Many private equity groups may not have the internal roles performed by different groups (the investment professionals may also be upper management) or may not use a third-party valuation professional. In that case, participants in the financial reporting process should review in greater detail the methods used, key assumptions used and resulting values.

For investors in private equity funds, the fair value of the investments is critical in the investors’ abilities to monitor their investments. Also, the resulting net asset value is often reflected in the investors’ financial statements and other reports. Therefore, the process utilized by the private equity firm to estimate the fair value of individual investments should ensure conflicts of interest are mitigated, appropriate methods are utilized and reasonable assumptions are incorporated. The objective and end result should be a value that is a reasonable reflection of fair value.

 

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