Author: Alex Hocking
On August 19, 2019, the American Institute of Certified Public Accountants (AICPA) issued valuation guidance for investment companies on how to value their portfolio company investments. The guide, titled “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies,” provides a nonauthoritative practical approach to valuations and is intended to harmonize the views of industry participants, auditors and valuation specialists.
This guidance helps address diversity in practice that contributes to inconsistent fair value measurements year-over-year or those that are incomparable between investment companies. While many sophisticated investment companies already implement the best practices noted in the guide, the 16 case studies provided will help all industry participants navigate through real situations they may encounter. In addition, corporate venture capital groups or pension funds might benefit from the guide’s insight.
The guide addresses a variety of accounting and valuation issues, including:
- Unit of account,
- Transaction costs,
- Market participant assumptions,
- The impact of control and marketability,
- Use of pricing services and broker quotes,
- Backtesting and
- Complex capital structures.
However, investment companies should take note of two primary topics covered: calibration and identification of the most effective valuation techniques.
Calibration
Calibration is required when the initial transaction is at fair value and subsequent valuations are performed using unobservable inputs. At initial recognition, the valuation technique and inputs should be calibrated so that the result of the valuation technique equals the transaction price. Calibration ensures the valuation technique and initial set of assumptions reflect current market conditions. It is also helpful for the entity to determine whether an adjustment to the valuation technique is necessary at future measurement dates. This can be especially challenging with investments in early stage, pre-revenue companies; therefore, the investment thesis often plays a key role in the calibration process.
Identification of Valuation Techniques
The guide also discusses the limitations of the various valuation techniques. This should help industry participants understand the fact patterns where their method is effective at estimating fair value, as well as instances where it may not be as effective as other methods available. This may be the case when the selected method is highly sensitive to certain key assumptions. For example, an option pricing model (OPM) may not be ideal for estimating the relative value of senior and junior preferred classes, since preferred classes often have influence of the company’s operations and exit timing. An OPM model also assumes future outcomes can be modeled using a lognormal distribution and is highly sensitive to the volatility input, which often requires substantial professional judgement and subjectivity.
