AICPA Task Force to Issue Working Guide on Fair Valuation of Investments: What is on the Horizon?

Introduction

The AICPA recently assembled a Task Force to develop additional guidance on the fair valuation of investments. The guidance is intended to address a diversity of practices with respect to estimating the fair value of investments, with a focus on private and thinly traded investments. The working title of the new guide is “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.”

Background

Financial industry professionals employ diverse methodologies to estimate the fair value of portfolio company investments. The AICPA Task Force will look to address the lack of consistency among the views and approaches of various industry participants and provide guidance of a “user friendly” nature. While the anticipated guidance will be non-authoritative, it is intended to further the goal of achieving more standardization and convergence of fair valuation estimation techniques.

An objective of the guidance is to encourage alignment of approaches used by investors, auditors and valuation specialists. To that end, the task force includes representatives of audit firms, appraisers and other industry participants.

This initiative coincides with a period in which regulators, accounting standard-setters, industry leadership groups and investors are demanding greater risk management and transparency in the alternative fund space, particularly with respect to fair valuation of investments. The Securities and Exchange Commission (“SEC”), Public Company Accounting Oversight Board (“PCAOB”), Financial Accounting Standards Board (“FASB”), auditors and investors view valuation oversight as a focus area.

• The SEC’s Presence Examination Initiative targeting registered investment advisors and recent prosecutions brought by the SEC related to improper valuations shine a spotlight on the importance of appropriate and robust valuation practices in the current environment. Current SEC examination priorities include the identification of firms that demonstrate material weaknesses in controls, including controls surrounding valuations. Registered investment advisors that fail to implement sufficient valuation procedures assume substantial business, regulatory and reputational risks.
• Audit firms are responding to the PCAOB’s emphasis on valuations in the SEC-registered fund space by increasing the scrutiny applied to valuations on all audits, including audits of non-public investment companies. Valuations must be supportable, objective and well documented. In addition, financial statement disclosures should deliver transparency into the valuation techniques, significant inputs of the valuation models and methods, and liquidity of fund investments.
• Fund investors depend on fund management to employ procedures that ensure investment valuations are not overstated. Investors are increasingly factoring control considerations, including valuation controls, into the investment decision-making process.

The guidance is will promulgate a principles-based (not rules-based) approach to fair valuation of portfolio company investments. It is intended to address the hands-on application of valuation concepts by providing numerous examples that will cover many industries, investment types and exit strategies. The AICPA’s goal is to arm users with reasoning skills that can be applied to various valuation scenarios.

What This Could Mean for Financial Industry Professionals

The guidance is expected to be extensive. A few of the topics likely to be considered are discussed below.

Valuation of Non-Publicly Traded Companies

The valuation of non-publicly traded companies involves a high degree of subjectivity and estimation. The determination of enterprise value often requires the use of complex valuation techniques in the absence of observable market transaction data. In the new guidance, it is believed that the AICPA will address market participant assumptions including pricing, risk, illiquidity, holding period and exit strategies. It is probable the guidance will discuss unit of account, control considerations, marketability discounts, calibration, valuation approaches (e.g., market, income approaches), and both simple and complex capital structures. The guidance should also take on the question of when does the latest round of financing become stale for valuation purposes.

It is believed the new guidance will emphasize independence, sufficiency of support and documentation.

• Valuations should be determined without bias. This may be accomplished by use of independent, third party valuation experts to review fund management’s appraisals. This goal may also be served by segregating the valuation function or by subjecting the valuations to review by a Valuation Committee or other governing body comprised of members that are independent from fund management.
• Valuations should be based on demonstrable reasoning. Significant judgments should be articulated and supported. Key inputs should be verifiable. When possible and appropriate, multiple valuation techniques (e.g., income approach, market approach) should be utilized to demonstrate and crosscheck the reasonableness of the valuation conclusion.
• The valuation rationale should be memorialized. Documentation is an essential aspect of strong valuation controls. The valuation reasoning should not reside “in the head” of the portfolio manager. Documentation is fundamental to the encouragement of review and, as necessary, challenge of the fair valuation conclusion.

Valuation of Investments Using the Practical Expedient

US GAAP permits the use of net asset value (“NAV”) per share (or its equivalent) as a practical expedient for measuring the fair value of an alternative investment that does not have a readily determinable fair value, if certain criteria are met. Applicable accounting standards stipulate that use of the practical expedient is permissible if the NAV (or its equivalent) is calculated in a manner consistent with the measurement principles of FASB ASC 946, Financial Services – Investment Companies.

It is anticipated that, in the new guidance, the AICPA will take up the subject of which procedures should be employed to determine whether the NAV reported by an investee fund is based on fair value. The guidance is expected to discuss:

The Investment Manager’s:

• Initial due diligence procedures (procedures undertaken prior to making the investment).
• Ongoing due diligence procedures (monitoring procedures carried out after the investment is made).

The Appropriate Consideration of:

• Financial reporting controls (the controls in place at the investee fund surrounding financial reporting and determination of NAV or its equivalent), including:

– The investee fund’s fair value estimation processes and whether independent third party appraisers are utilized.
– The investee fund’s use of back testing as a validation technique for the valuations.
– Any adverse findings in the internal control reports of the investee fund’s advisor and/or administrator.


• The annual financial statement audit of the investee fund, including:

– Qualifications, if any, of the auditor’s report.
– Any history of adjustments to the investee fund’s reported NAV arising from the annual financial statement audit.

It is foreseeable that the guidance will underscore fund management’s responsibilities related to use of the practical expedient for valuation purposes.

Use of Pricing Services

The release of ASC 820, Fair Value Measurements and Disclosures, ushered in an era of heightened focus on the use of third-party pricing services to value securities, particularly as it relates to investments that are not exchange-traded, which are typically classified as Level 2 or Level 3 under the fair value hierarchy. These securities may include corporate, sovereign and municipal bonds, asset and mortgage-backed securities, and collateralized debt and collateralized mortgage obligations. Special focus is placed on securities that trade infrequently and are priced by reference to trades prior to the valuation date or trades of similar (but not identical) securities.

Fund management retains ultimate responsibility for the valuation of investments. Investment managers are, therefore, charged with obtaining a sufficient understanding of the valuation methods and assumptions used by any third party pricing vendors.

The AICPA plans to further address the use of third party pricing services in the new guidance and is liable to emphasize the duty of fund managers to understand the techniques and assumptions underlying valuations that are distributed by pricing vendors.

Effective Date

The new guidance will be subjected to extensive due process and must clear the AICPA Financial Reporting Executive Committee (“FinREC”).

The first public release of a working draft is presently scheduled for July/August 2017, with an expected comment due date of November 2017. The publication of the final guide is currently targeted for end of 2018.

Conclusion

Investment managers and other financial industry professionals should be aware of the AICPA Task Force project to develop a working guide for valuation of investments and the valuation topics under discussion. While the finalization of the new guidance will require a lengthy vetting period, it is expected to provide needed direction on a key industry topic.

While the industry awaits the new guidance, investment advisors should review existing valuation policies and procedures for the presence of the following attributes:

• Independence and segregation of duties.
• Substantiation of pricing sources, including:

– Reviewing methodologies used by third party pricing vendors.
– Employing appropriate procedures to ascertain whether the net asset value reported by an investee fund is based on fair value.


• Valuation oversight and governance.
• Adequacy of documentation.

More than ever, documentation of critical judgments will be key to supporting fair valuation estimates. Investment managers should remain focused on being able to demonstrate (to investors, auditors and regulators) that fair valuations were subjected to appropriate rigor and are supportable.