Valuation Best Practices: Answering the ‘Frequency’ Question
AICPA’s draft version of its Accounting and Valuation Guide highlights the need for ongoing calibration around fair value methodologies and processes, underscoring the critical role of recurring independent valuations.
By Mark Emrich
This past August, when President Donald Trump conveyed via Twitter that he had asked the SEC to study the possibility of moving from a quarterly to bi-annual reporting schedule, the investment community at large took notice. While such a move ultimately seems unlikely – particularly given the transparency premium afforded to domestic stocks – it does bring to mind pressing questions around reporting frequency that are common among private-market participants. More specifically, while there is general agreement that a quarterly reporting cadence is usually appropriate, how private equity fund managers corroborate their internal assessments of fair value and the frequency at which they provide independent third-party validations can differ considerably across the GP universe.
To be sure, this is a fight that has already been fought on several fronts in the past. In fact, the transition from holding illiquid holdings at “cost” to adopting fair-value methodologies did not occur without a pitched and extended battle. But ever since the 2008 implementation of FAS 157 (later reclassified as ASC Topic 820), asset managers and their investors have largely coalesced around the reporting standards set forth by the Institutional Limited Partners Association (ILPA) and the American Institute of CPAs (AICPA). Given the level of transparency LPs have come to expect, it would be difficult to push the string back on anything that delivers less transparency, however incremental.
As long as fair value remains something of a subjective measure, however, the prevailing question for GPs will revolve around the amount of rigor that goes into third-party validations and when, exactly, these independent assessments should accompany portfolio-company reporting. The easy answer – that it depends on the strategy and structure of the specific fund – is typically less than satisfying. But what is appropriate for Blackstone or KKR very likely won’t apply to smaller partnerships or single strategy firms. As practitioners well know, particularly amid recent convergence trends as sponsors delve into private debt, there are also material differences distinguishing the way lenders and private equity firms utilize valuation firms. The common thread, however, that applies across the industry is that just as LPs are scrutinizing performance, they’re also evaluating the compliance, internal controls, and fund administration infrastructure of their GP relationships.
Structure Dictates Approach
Beyond just the size of the fund and total assets under management, the specific structure of the investment vehicle is often the primary determinant in how firms utilize third-party valuation services. For instance, BDCs, as registered investment companies, are more likely to regularly use independent valuation firms to corroborate fair-value disclosures and do so on a recurring and consistent basis. More traditional private equity funds, on the other hand, may only provide independent validations annually, if at all.
News that the Securities and Exchange Commission is exploring ways to provide retail investors access to private markets would also seem to increase the need for independent valuations. Carlyle’s recent joint venture with OppenheimerFunds to launch a private credit vehicle – OC Private Capital – offers one high-profile case study. Structured as an interval fund that features quarterly repurchase offerings, the advisor is required to calculate a weekly NAV, and stated in its prospectus that it would tap third-party valuation firms to analyze assets in which market prices are not readily available.
The other factor that often plays into the frequency discussion is the level of analysis and rigor fund managers are seeking from valuation specialists. While negative assurances can help inform valuation policies, limited scope positive assurance can support and add credibility to internally derived portfolio-company valuations. However, the more common and thorough alternative is a full valuation report in which the vendor provides in-depth analysis, incorporating the most up-to-date cash flows and discount rates and supporting analyses, to deliver a comprehensive conclusion of value report.
Again, there’s no one accepted approach, but most private equity firms tend to fall into one of three imprecise categories. At one end of the spectrum, a fund manager’s CFO may seek third-party oversight for each investment every quarter to assess the fund’s entire portfolio of holdings. In these cases, PE funds may utilize the less-intensive positive assurance reports to ensure they’re not overlooking any material issues in their assumptions or methodologies; or on the other end of the spectrum, funds will utilize independent third-parties to obtain conclusion-of-value reports for each of their portfolio companies.
A growing middle ground is comprised of firms who may tap third parties to validate a portion of their portfolio’s fair-value estimates throughout the year, either biannually or quarterly. This allows firms to spread out the costs over a 12-month period, while systematically utilizing independent valuations to help standardize and fine tune how they monitor and report on fair value over time.
The Calibration Equation
AICPA, in the draft of its Accounting and Valuation Guide for PE and VC Portfolio Companies, published in May, re-affirmed in the FAQ section of the 600-plus page document that funds are indeed expected to report fair value during every reporting period. The working draft specified that for most private equity and VC funds, this is typically done quarterly, although certain hedge funds or other vehicles may require monthly or even daily estimates of fair value. AICPA’s guidance, however, stopped short from offering specific direction around how often fund managers should utilize independent valuations.
That being said, a theme evident throughout the draft version of the guide was that private fund managers should be recalibrating their methodology to continually improve and refine their process. Upon a portfolio-company realization, for instance, the guide notes that fund managers should back-test earlier assumptions to assess the differences between earlier fair-value measurements and the ultimate sale price. AICPA is expected to publish a final version of the Accounting and Valuation Guide next spring.
This kind of rigor can also help mitigate some of the behavioral factors that tend to affect fair value assessments. Research has shown that better performing funds are likely to provide more conservative interim valuations than their underperforming peers. This isn’t lost on LPs, as further research highlights that close to a quarter of limited partners believe it’s necessary to perform their own calculations of fair value on unrealized investments as part of manager due diligence. The point is that not only are investors scrutinizing valuation practices, it’s both noticeable and telling when discrepancies exist.
The challenge for sponsors, though, is that clear-cut best practices have yet to be articulated specifying the frequency and rigor at which fund managers should validate and recalibrate internal estimates of fair value. And make no mistake, a one-size-fits-all approach does not apply. But given the attention and scrutiny on fair value – which ironically should grow in this era of deregulation – it’s beholden on fund managers to understand what’s appropriate given their specific circumstances and how they can leverage independent valuations to promote transparency, validate internal controls and processes, and implement best practices.
 Brown, Gregory W. and Gredil, Oleg and Kaplan, Steven N., Do Private Equity Funds Manipulate Reported Returns? (April 30, 2017). Journal of Financial Economics (JFE), Forthcoming; Fama-Miller Working Paper. Available at SSRN: https://ssrn.com/abstract=2271690 or http://dx.doi.org/10.2139/ssrn.2271690
 Da Rin, Marco and Phalippou, Ludovic, The Importance of Size in Private Equity: Evidence from a Survey of Limited Partners (July 2, 2016). Journal of Financial Intermediation, Forthcoming; ECGI – Finance Working Paper. Available at SSRN: https://ssrn.com/abstract=2379354 or http://dx.doi.org/10.2139/ssrn.2379354