On May 15, the AICPA’s Financial Reporting Executive Committee released a working draft of the AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The document provides guidance and illustrations for preparers of financial statements, independent auditors, and valuation specialists regarding the accounting for and valuation of portfolio company investments of venture capital and private equity funds and other investment companies.  The comment period ends August 15, 2018.

Weighing in at nearly 650 pages, the guide defies quick summary.  As noted in the preliminary “Guide to the Guide” section, different chapters in the working draft are likely to be of greater interest to some groups of intended users than others. In this introduction to the Guide, we provide a brief overview of the chapters and appendices with which PE and VC managers should develop familiarity.

  • Chapter 8, Valuation of Equity Interests in Complex Capital Structures.  For venture investments, valuation is often a two-step process.  First, analysts must focus on the attributes, opportunities, and risks of the business as a whole.  Second, analysts then need to assess how, amid the often staggeringly complex capital structures of venture-backed companies, to allocate the overall business value to the specific ownership interest held by the investor.  Chapter 8 focuses on the challenges and potential pitfalls of the second step.

The Guide distinguishes between the economic and non-economic rights typical of senior classes of preferred stock.  Analysts generally value the economic rights attached to different share classes using one of four methods: scenario-based methods, the option pricing method, the current value method, or the hybrid method.  The Guide provides a comprehensive overview of the relative strengths and weaknesses of these methods and describes which circumstances are most conducive to the use of each.

  • Chapter 10, Calibration. Valuing portfolio company investments typically requires the use of significant unobservable inputs and considerable judgment in selecting appropriate company and market-level inputs and valuation techniques.  Calibration is the process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the original observed transaction as well as any more recent observed transactions in the instruments issued by the portfolio company.

Chapter 10 of the Guide discusses the calibration framework and provides examples of how initial valuation assumptions used in valuing a debt or equity investment in a business can be calibrated with the original transaction price and subsequently adjusted to take into account changes in the subject investment and market conditions at the measurement date. When subsequent funding rounds take place, calibrating to the most recent transaction is typically most relevant, and the Guide outlines six different types of transactions and the process of potentially inferring value from these types of transactions.

  • Chapter 11, Backtesting.  The PE/VC task force believes it is best practice for investment companies to perform periodic backtesting.  Backtesting refers to the process of using the observed value of the fund’s interests as implied by the ultimate sale, liquidity event, or other significant change to assess the fair value estimated for an investment at an earlier date.

The primary purpose of backtesting is to assess and improve the valuation process going forward.  The Guide provides an overview of the backtesting process and advice on how to identify and evaluate factors that can contribute to a difference in value for a particular investment between the measurement date and event date.  The final section of Chapter 11 provides nine examples illustrating the backtesting process across different types of investments and under various scenarios.

  • Chapter 12, Factors to Consider at or near a Transaction Date. In accordance with FASB ASC 946, funds initially measure the investment as the capitalized cost including transaction costs.  At the first reporting date following the transaction, funds are required to measure the investment at fair value in accordance with FASB ASC 820.  Chapter 11 addresses fair value considerations at initial recognition and fair value considerations at or near exit in the context of these two apparently diverging requirements.
  • Appendix A, Valuation Process and Documentation Considerations.  Appendix A discusses considerations related to internal control over financial reporting and identifies a set of principles that are important to the establishment and maintenance of an effective valuation process.
  • Appendix C, Case Studies.  Appendix C includes fifteen case studies that are designed to illustrate how information would be evaluated and incorporated when estimating value.

In short, the new Guide is a welcome addition to the resources available for fund managers in developing reliable fair value measurements for portfolio investments.  We expect that having a common set of acknowledged best practices will promote efficiency in the preparation and auditing of fair value measurements.  We will provide more detailed comments on specific elements of the draft Guide in the coming weeks.  In the meantime, please do not hesitate to call us to discuss how any element of the new Guide may affect your portfolio valuation process.

This article originally appeared in Mercer Capital’s Portfolio Valuation Newsletter, Second Quarter 2018.

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