PARTNER CONTENT
By Muhammad Akram, CPA
Founder, Akram | Assurance, Advisory & Tax Firm
Why fair value is so important
Fair value impacts net assets/partners’ capital, potentially overstating performance and overcharging management and performance fees. Inflated values lead to overpayments and misrepresentation for investors, while understated valuations result in the opposite effects.
Primary valuation methodologies
Primary valuation methodologies include the market approach, income approach and cost approach. The market approach considers factors like comparable company market multiples, comparable transactions and previous transactions in the subject company’s stock. The income approach involves methods like discounted cash flow and capitalization of earnings. The cost approach encompasses investment cost, cost to build and replacement cost. Methodological considerations should encompass various factors such as sources of prices, their priority, and how they are utilized.
Documenting assumptions for estimates
In documenting assumptions for estimates, recognizing the inherent subjectivity of valuations is crucial. Management’s estimates, being subjective, pose challenges for auditors. Thus, ensuring the reasonableness of assumptions and methods used is paramount. Here are some considerations:
I. Strive to minimize bias and maintain a balanced outlook.
II. Provide support for projection estimates, incorporating tangible evidence like purchase orders or back-fill reports.
III. Justify the inclusion / exclusion of comparable companies and any adjustments made.
IV. Maintain documentation for all inputs, including growth rates and discount rates.
V. Update calibrated inputs to reflect changes since the transaction.
VI. Include relevant documents like recent financing rounds, broker quotes, or appraisals to support valuation assumptions.
VII. Anticipate potential challenges from auditors and ensure thorough documentation and consideration of all available inputs to support conclusions effectively.
Private funds must follow ASC 820
Private equity and venture capital funds must adhere to the FASB’s ASC 820 framework for fair value measurements and disclosures, utilizing a hierarchy to assess fair value. For private equity funds, financial statements predominantly focus on year-end (December 31) valuations. Regardless of the industry in which the fund invests, whether it be oil and gas, manufacturing, blockchain, real estate, technology, healthcare or others, determining fair value at year-end is crucial for both fund managers and the auditor. This aspect of the audit, particularly for Level 3 investments, is often challenging due to the subjective nature of key inputs, such as discount rates and multiples, which can lead to substantial variations in fair value determinations.
Policies and procedures (P&Ps)
Private equity and venture capital fund managers should comply with policies and procedures (P&Ps); these are essential for ensuring fairness and consistency in the valuation process. They should clearly outline the methods, principles, and models to be used, particularly for challenging-to-value investments. Fund managers should regularly review P&Ps and update as necessary, as they are dynamic documents. Establishing a pricing or valuation committee can help mitigate internal conflicts of interest. It’s important to note that valuation P&Ps are likely to be scrutinized by SEC examiners and should thus be
comprehensive and well-documented.
Internal valuation specialists vs third-party valuation firms
A conclusion of value report from an independent, reputable, third-party provider is one of
the best ways to provide your auditor comfort over fair value. The auditor can typically place
more reliance on this report, and the value determined.
Best practices to follow
Private equity and venture capital fund managers should follow the below best practices:
- Adoption of written/documented valuation policies and procedures
- Improving internal systems for retaining and monitoring Fund holdings data
- Establishing an internal pricing committee
- Maintaining an advisory board or committee
- Continuous investment monitoring
- Appointing an independent third-party valuation firm
Impact of higher interest rates on fair value of illiquid securities
A rise in interest rates during 2023 can have a significant impact on determining valuation of illiquid investments (Level 3) for private equity and venture capital funds. The cost of capital and discount rate are two critical factors that determine the overall value of a business, and both are impacted by changes in interest rates.
Conclusion
Fund managers should communicate throughout the year with the auditor and keep them in loop regarding any changes in valuation methodology or assumptions. The audit team can involve their valuation specialists to discuss these changes and take an initial review of the valuation for reasonableness before you communicate with your investors. The valuation process is an art not a science, and no one has a crystal ball for fair value of their investments. Therefore, there will be questions and scrutiny from the auditor. When reviewing Level 3 investments, the auditors must be comfortable that fair value presented on the financial statements is materially correct.
Muhammad Akram, CPA, Founder Akram | Assurance, Advisors & Tax Firm – Muhammad is a Certified Public Accountant in the states of California (License # 114908), New York (License # 122344), and North Carolina (Certificate # 37968) and leads the firm’s overall practice. Before founding his own firm, Muhammad worked with Big 4 and national CPA firms. His areas of focus included audit, tax and consulting engagements for onshore and offshore alternative investment funds. Because of his passion for alternative investments, Muhammad founded Akram | Assurance, Advisory & Tax as a boutique firm specializing in providing the highest quality service to this niche industry. Muhammad has worked with hedge fund and mutual fund administrators, and he has supervised all aspects of fund accounting and financial reporting assignments. Muhammad has also advised investment companies on structuring and compliance processes as well as consulted on regulatory and tax matters. Muhammad is instrumental in the firm’s marketing and business development activities and frequently speaks at industry events and conferences.
