When it comes to portfolio company fair value measurement and reporting, 2011 lacked the drama of 2008 and 2009. New procedures and policies spawned by SFAS 157 (now Topic 820) have hardened into established routines, the FASB did not offer any new crisis-related guidance, and (with the exception on a rather petulant August) financial markets were reasonably well-behaved. Nonetheless, private equity fund managers – and their limited partners – cannot take fair value measurement for granted. To help ensure that the upcoming year-end portfolio fair value measurement process is as uneventful as it should be, we have created the following checklist to help fund managers measure the fair value of portfolio company investments.

  1. Are you using the right valuation methods? In our experience, valuation methods under the market approach are most commonly used for portfolio company fair value measurement. However, the prolonged economic limbo we are experiencing may increase the relevance of other approaches. For example, a discrete cash flow forecast over the intermediate term may be appropriate for companies in cyclical industries. If a company’s earnings remain depressed, valuation methods under the asset-based approach may be worthy of consideration.
  2. Are you using the right guideline group? When using the guideline company method under the market approach, last year’s group is not necessarily the best group this year. Changes in the business model or strategy at the portfolio company may have rendered one or more of the legacy guideline companies insufficiently comparable, or may call for inclusion of certain companies previously excluded. In addition, guideline companies may have made acquisitions or divestitures during the year that limit their continued relevance to the portfolio company.
  3. Are you carefully vetting cash flow forecasts? The “auditability” of a fair value measurement under the income approach will be enhanced by a rigorous analysis of underlying cash flow forecasts. This is simply the basic blocking and tackling of sound financial analysis: What is projected unit volume and pricing? How do projected margins relate to the inherent operating leverage of the business? Are projected results achievable with existing corporate infrastructure? If not, what capital expenditures will be required? How do projected growth rates compare to the industry – is the portfolio company expected to lose, maintain, or capture market share?
  4. Are you reconciling to prior fair value measurements? Relying on the historical cost of the investment alone is no longer sufficient for fair value measurement. Is there a compelling narrative that relates the fair value measurement at December 31, 2010 with prior measurement dates, taking into account changes in portfolio company performance and expectations, changes in market multiples, recent transactions, and the like? Despite mid-year volatility, financial markets are basically flat year-over-year; how does the fair value of your portfolio company relate? Reconciling to prior fair value measurements is a critical element in enhancing the credibility of your analysis and conclusion.
  5. Are you double-checking your math? Excel will do a lot of great things, but it will not alert you to the missing or extraneous cell reference in your formula. Nothing is more embarrassing – or avoidable – than a computational error. Developing and implementing a consistent process for checking the arithmetic in your valuation worksheets is an essential internal control.

Mercer Capital provides a range of fair value measurement services to investment fund managers. We are always happy to discuss your valuation issues in confidence as you plan for the year-end fair value measurement cycle. Give us a call today.

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