2019’s new PE valuation rules: Key things to know
A number of new valuation guidelines emerged in 2019 that will have an impact on private equity (PE) and venture capital (VC) funds as well as their portfolio companies. The new rules provide clarity in several areas, offering best-practice valuation methodologies that PE firms should plan to adopt immediately. In this post, we share key points regarding this new valuation guidance. To learn more of Plante Moran’s perspective on the new rules and what they mean to PE firms, view our recent webcast.
AICPA finalizes PE/VC Valuation Guide
In August 2019, AICPA issued the final draft of the “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies — Accounting and Valuation Guide” (commonly known as the “PE/VC Valuation Guide”) — hereafter referred to as the “Guide”. The new 630-page guide addresses the lack of clarity and specificity in highly theoretical guidance (such as ASC 820, Fair Value Measurements) and provides companies with practical, industry-specific guidance on the valuation of actual portfolio company investments held by PE and VC funds and other investment companies. While the Guide is targeted to investment companies under ASC 946, its valuation principles, techniques, and best practices may also be useful for valuations performed under IFRS 13.
The new Guide doesn’t change the existing valuation methods listed in ASC 820, nor does it introduce any new techniques. Its value lies in the highly detailed discussion of how to interpret and apply those methods when performing a valuation of a PE- or VC-backed portfolio company, delivered through extensive case studies, examples, and an entire chapter devoted to questions and answers. Of particular interest is the Guide’s discussion and examples on key concepts such as calibration backtesting and the exit price notion.
The new Guide doesn’t change the existing valuation methods listed in ASC 820, nor does it introduce any new techniques. Its value lies in the highly detailed discussion of how to interpret and apply those methods when performing a valuation of a PE- or VC-backed portfolio company.
Calibration is the process of using observed transactions in the portfolio company’s own instruments, especially the initial acquisition transaction, as a fair value benchmark to utilize in subsequent valuations. The Guide states that calibration to the transaction price is required when the initial transaction represents fair value. We recommend that management perform a full valuation analysis at the time of the initial transaction, including comparing the multiple paid to guideline comparable companies’ multiples on the transaction date and correlating the implied internal rate of return to the discount rate. The valuation analysis should also include a review of management projections, the business plan, anticipated time to exit, key milestones, and short-term or long-term goals.
The Guide advises PE funds and other investment companies to take steps to consider whether any factors might indicate the initial transaction was not, in fact, a market transaction. Conditions that may indicate that the transaction price might not represent fair value are:
- Related party transactions.
- Distressed transactions.
- Transactions aren’t in the principal market for the asset or liability.
- Units of account in transactions are different from those being measured at fair value.
Even when the transaction price doesn’t reflect fair value, the Guide recommends reconciling the differences and quantifying and documenting the amount and reason for the discrepancy.
Further, the Guide recommends consideration of the investment’s marketability, nonmarketability, or illiquidity. Any lack of marketability discount should be calibrated based on the anticipated exit horizon and then continually recalibrated as that exit draws near or otherwise changes, or as the portfolio company itself improves or progresses.
Backtesting — also known as retrospective review — uses an investment’s ultimate sale or liquidity event as a means of evaluating earlier fair value estimates. Backtesting provides investment companies with feedback that can enhance the rigor of a fund’s valuation process and its internal controls over financial reporting.
Investment companies should expect differences between measurement date value and exit event date value, but these differences don’t necessarily imply an error in the valuation. Many factors can drive these differences: new developments in the market, new information, market-specific conditions, changing valuation techniques, and more. The Guide recommends that fund managers take the time to understand the factors behind differences that result from backtesting, and reconcile and document them.
Exit price notion
The Guide emphasizes that the valuation of an investment should focus on the unit of account and the security, as investment companies are looking at the value of the investment position in a portfolio company at the measurement date — not necessarily the sale of the portfolio company itself. This is the price that someone would pay to step into the fund’s position in the unit of account held. The Guide also clarifies that any discounts for lack of marketability should also be applied at the security level rather than the enterprise value level.
Appraisal Foundation unveils Valuation of Contingent Consideration
The Appraisal Foundation finalized its new guidance on the valuation of contingent consideration in February 2019, which takes much of the subjectivity out of the methodology selection process for valuing earnouts and is quickly being adopted as best practices.
Historically, a probability weighted methodology (also known as the scenario-based method (SBM)) was commonly used to value contingent consideration. Under the new guidance, this valuation approach is recommended in only a few instances: 1) a linear payout structure, and 2) when the payment is tied to an event or milestone. An example of such a milestone would be an earnout tied to FDA approval of a new pharmaceutical. In the PE space, we’ve seen few earnouts that would fit these two scenarios.
For the majority of earnouts — those involving thresholds, caps, catch-up or carryforward provisions, clawbacks, and similar provisions — the new Guide recommends using an option pricing method (OPM) such as Black-Scholes or a Monte Carlo analysis. The Appraisal Foundation also specifically recommends using a Monte Carlo analysis for earnouts that span multiple years, where the payout is impacted by performance in prior years and situations where the payment amount is based on multiple underlying metrics (e.g., revenue growth and EBITDA) during a measurement period.
The Appraisal Foundation’s preference for OPM analysis is driven by its greater transparency around key inputs and the assessment of risk. The Guide provides detailed advice on the many considerations to factor into your analysis when building up appropriate discount rates.
The new guidance is likely to change the way things were done in the past and introduce new complexities to the measurement of earnouts, especially for those that have relied on SBM analysis in the past. Proper planning and communication will help ensure auditors have the information they need to achieve GAAP or IFRS compliance.
Profits interests: ASC 718 springs a surprise
ASC 718, Compensation—Stock Compensation, isn’t technically new. But in 2019, we’ve encountered many PE firms running into issues related to ASC 718 and to profits interests, a form of equity compensation commonly used in the PE space.
Profits interests represent a share in the future profits of the portfolio company and can take the form of income or capital distributions. Defined by contract and typically subject to vesting requirements, profits interests are usually structured to obtain favorable tax treatment. And because they’re at risk — with no payout guaranteed — PE firms often determine that profits interests have no value and thus record nothing on the financial statements.
Auditors often come to a different conclusion because, under ASC 718, profits interests are classified as share-based payments — just like options, restricted stock, and phantom shares. Under GAAP, the fair value of profits interests is rarely zero when they’re granted because they have the potential for value in the future. The units have an implied value because, otherwise, there would be no reason to grant them. Thus, profits interests have value, and a related compensation expense must be established and recorded for those units. This value can be determined using option methods to determine a range of future value that can be recognized for financial reporting and used to support the tax position as well.
Talk to your auditor to gain greater clarity on the value and meaning of the new guidelines
The new rules and guidance briefly described above should bring clarity to many issues surrounding the valuation of portfolio investments made by PE and VC firms and other investment companies. PE and VC funds should discuss these rules with their auditors to understand the impact and ensure the latest guidance is reflected in their 2019 financial statements moving forward. Doing so will help avoid problems and make sure the audit process goes more smoothly.
To learn more about these rules and what they mean to your business, view our recent webcast or contact your local Plante Moran advisor.