PE and VC valuations and the AICPA Private Securities Valuation Guide
By Paul Balynsky and John Czapla
An upcoming guide from the AICPA weighed heavily, both figuratively and literally, during a recent forum.
A group of private debt management professionals gathered for an Accounting and Valuation for Credit Funds Forum, and the topic of the guide came up for discussion. The AICPA’s forthcoming Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies Guide, currently running over 650 pages, is expected to be released in its final format in May. A panel discussion, “A Guide to the Guide,” moderated by Valuation Research Corporation, included market participants from the audit space and the buy-side. They managed to allay some of the concerns of the attendees at the event.
The panel presenters agreed that the guide essentially represents a clarification of how sophisticated fund managers are already approaching private securities valuations. The comment period on an exposure draft of the guide closed in August 2018, with most of the more than two-dozen letters focused on the treatment of debt instruments. The guide is currently in the hands of the AICPA’s Financial Reporting Executive Committee, or FinREC, which is expected to release a final version around May of this year, after the addition of a pair of new case studies — one focused on real estate assets and the other on distressed debt that is being equitized — to the 15 already in the draft.
While the document could change, the panelists agreed the guidance — as presented in the exposure draft — should generally be embraced by market participants to the extent it represents documentation and clarification of what most sophisticated fund managers are already doing.
What the guide does not do
Don’t expect any drastic changes in the guide when it’s finally released. “The guide doesn’t really change anything for those of you already using GAAP accounting,” said one panelist. “It’s really just a tool to help you refine your valuation process and make sure you are following best practices as represented by the major accounting firms, third-party valuation providers and buy-side industry participants.”
The panelists noted that, while the final document may top 700 pages, only about one-third of it is formal guidance, while the balance is devoted to examples and case studies.
Moreover, not every chapter or appendix applies to credit investors: “Unless you manage a venture capital fund, you can practically ignore half the guide,” said another panelist.
While the remark was partly tongue-in-cheek, the panelist suggested that credit investors would do well to spend most of their time familiarizing themselves with:
Chapter 4, Determining the Unit of Account and the Assumed Transaction for Measuring the Fair Value of Investments;
Chapter 6, Valuation of Debt Instruments;
Chapter 13, Special Topics (including pricing services and dealer quotes; options, warrants and convertibles and; contractual rights/contingent consideration) and;
Appendix C, a collection of helpful valuation case studies, especially No. 13, a look at a business development company holding a variety of debt securities.
Refining yield assumptions
For credit managers, the most directly relevant section of the guide is Chapter 6, which covers yield assumptions that go into calculating a discounted cash flow rate on debt instruments. One panelist walked through some examples.
Example 1 illustrates the importance of considering both market- and issuer-specific developments when calculating an updated “concluded yield.” In this hypothetical instance, the fund owns an unrated, five-year middle-market loan that was originated at LIBOR + 300 basis points at a time when the fund considered the issuer to be comparable to a B+ credit.
Fast forward three years and spreads on an index of B+ credit have widened by 600 basis points. However, at the same time, the issuer’s fundamentals have improved markedly, and the fund now assigns the issuer a synthetic BB+ rating.
In this instance, the fund might value the loan at LIBOR + 700, 400 basis points wider, to reflect the 600 basis points widening in market spreads, offset to some extent by 200 basis points worth of improvement in the issuer’s fundamentals.
While indices are a helpful input, the panelist added a more general warning about using indices that are generally comprised of large, liquid syndicated loans for private credit:
“Be mindful that the middle-market leveraged loan space doesn’t quite move the way the corporate par loan space moves,” said the panelist. “It’s not necessarily 1-for-1, so you need to use professional judgment when you look at changes in the indices.”
Example 2 illustrates a five-year middle-market loan originally issued at LIBOR + 700, where three years later the issuer’s synthetic credit rating improves from B+ to BB+ as the company re-emerges from bankruptcy and the relevant indices are unchanged.
In this case, if there are no significant penalties for prepayment, the fund might calculate a new concluded yield of LIBOR +300, placing the fair value of the loan well above par on a price basis.
Example 3 looked at equity/enterprise valuation (which even funds that invest exclusively in credit sometimes engage in to determine debt coverage) and made the point that investors need to adjust their earnings assumptions as companies mature.
An investor might purchase a privately held company at a higher multiple to EBITDA than its more mature publicly traded peers based on projections of faster growth as performance improves. The guide suggests that while the approach is sound, a fund needs to revisit those projections over time. As the performance improvements are realized, it may make sense to recalibrate to a multiple that is more in line with its peer group.
Other key concepts
Panelists highlighted many other important concepts covered in the guide and provided direction on where in the document they are addressed.
Time horizon: One panelist cautioned against moving too quickly to mark a loan up to its prepayment level. While a middle-market loan might technically be eligible for prepayment at 103, marking it up to that level only a month or two after origination is unrealistic because rational market participants are extremely unlikely to refinance a loan a mere month or two after they borrowed the funds.
Change of control: Alternatively, if it becomes evident there is a high likelihood of a change in control that will trigger prepayment above par, the guide encourages participants to mark the asset up to or near the prepayment level rather than waiting until the change of control transpires.
Unit of account: If a fund holds both debt and a controlling stake in the equity of the borrower, it is highly unlikely it would exit one position and not the other, so no yield analysis of the debt is required. In such a case the guide recommends holding the debt at par so long as the company has adequate cash flow to cover it and focusing the analysis on valuing the residual equity position.
Traded debt: One panelist observed that some of the most animated conversations they have with auditors are not about illiquid positions whose valuations are entirely modeled, but instead are around securities whose valuations are based on dealer quotes and/or pricing services. The guide is clear that market prices for debt anywhere in the capital structure should be considered in valuation, even if, for example, only the first lien loans are quoted, and a fund owns the second lien (in that particular case, it’s important to factor in not just the subordination, but differences in covenants between the respective loan agreements).
Dealer quotes are tricky: One panelist cautioned that a fund’s management must make sure it understands whether dealer quotes are binding or indicative, and whether quoting dealers are prepared to trade in a size that is meaningful vis-à-vis the size of their position.
However, another panelist suggested that even small trades of $1 million to $2 million that are sometimes dismissed by funds as “retail” should be considered in the valuation process, especially if the paper trades regularly in that size. “Nowhere in fair value guidance does it discuss ‘retail’ versus 'institutional,'” said the panelist.
Most private credit fund managers have evolved their valuation practices and are generally employing the policies and procedures outlined in the guide. Nonetheless, the panel agreed it will be a helpful reference point for existing funds to test their policies and procedures against best practices and an invaluable resource for anyone contemplating the launch of a new fund who wants to do valuation right.