Complex Capital Structures, Complex Valuations: Critical Implications Of The AICPA’s New Valuation Practice Aid
In May, the American Institute of Certified Public Accountants released a working draft of an accounting and valuation guide for portfolio company investments. The draft, titled “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investments,” and also known as the “Practice Aid," provides guidance on best practices relative to the valuation of investment interests for financial reporting. As the latest and most comprehensive valuation guidance from the AICPA, it also has application to many other valuation contexts.
“The Practice Aid calls for a more robust application of valuation methodologies than — based on our experience — is often applied by many private equity and venture capital funds in practice," Baker Tilly Director Paul Daddio said. "It also calls for more thorough support for key inputs and assumptions. While the methodologies covered generally are not new and have been covered by prior guidance, the fact that the Practice Aid explicitly recommends these as best practices should be seen as an emphatic reminder that valuation practitioners and funds need to adopt these practices."
The Practice Aid also provides enhanced detail and clarification on the proper application of each of the major methodologies and expands on certain techniques like calibration, which involves the use of prior transactions to support key valuation inputs and assumptions, Daddio said. The challenge is that many PE and VC funds may not have the time or qualified staff to implement these changes.
“As an asset class, private equity and venture capital are enormous," Baker Tilly partner Ken Fleming said. "Given that fair value analyses and the financial reporting they are incorporated into are relied upon by a wide spectrum of investors and stakeholders — including institutional investors, pension funds, public markets, limited partners, government regulators and college/university endowments — it should come as no surprise that the AICPA is focused on improving the consistency and accuracy of valuation analyses applied in their preparation.”
In order to achieve conformity with the Practice Aid’s prescriptions, PE and VC funds will likely need to obtain specialized training for their staff or engage an external valuation specialist with the proper training and experience.
Because the Practice Aid requires significantly greater rigor and imposes more complexity on valuation analysis, many funds will find it makes sense to outsource the valuation function to experts in the field to ensure consistency with the Practice Aid.
“In the event that scrutiny is imposed on valuation analyses, having had the analysis performed by highly trained and credentialed specialists may prove tremendously valuable," Daddio said. "And better yet, advisers can ease some of the burden of working with the auditors in an often difficult area.”
Existing regulations like FASB Accounting Standards Codification 820 Fair Value Measurement provide standard definitions for determining the value of a company based on its market value at the measurement date. The standard requires that assets are recorded at fair value and encourages disclosure and consistency in reporting these values. But estimating the value of these investments can be challenging due to the complexity of capital structures that is often characteristic of portfolio companies.
A complex capital structure might include, for example, multiple rounds of preferred equity that have liquidation preferences, conversion features, participation caps or other features. These cannot always be valued using traditional techniques. In many cases, advanced methodologies like the Option Pricing Method or the Probability-Weighted Expected Return Method may be required.
The Practice Aid aims to provide funds with best practice guidance to help them navigate these complexities. But understanding and appropriately applying the Practice Aid is no easy task.
“This is a highly technical, 650-plus-page document that speaks in great detail about complex methodologies and techniques," Fleming said. "Further, much of the document is open to interpretation. So even with the benefit of a careful reading, extensive experience performing valuation in a fair value context is necessary to properly apply the Practice Aid’s prescriptions. The old cliché that valuation is as much an art as a science is very true. But the Practice Aid seeks to guide practitioners to the right brush, colors and painting techniques.”
This feature was produced in collaboration between Bisnow Branded Content and Baker Tilly. Bisnow news staff was not involved in the production of this content.
