In February and March of 2020, uncertainty associated with the global COVID-19 pandemic and the related government and public health officials’ actions to reduce the spread of the COVID-19 disease have resulted in a dramatic public market volatility and significant economic uncertainty. During this time of crisis, with unemployment skyrocketing, vast segments of the global populace sheltering in place, and an unknown end to the pandemic, Investment Companies are faced with the need to exercise significant informed judgment as they estimate and report to investors the fair value of non-traded and infrequently traded investments at March 31, 2020.
Investment company managers (General Partners or GPs) and their investors (Limited Partners or LPs) consisting of sovereign funds, fund of funds, public and corporate pension plans, endowments, family offices, insurance companies, etc. have a fiduciary duty, financial reporting requirements, and internal management needs (asset allocation, incentive compensation, portfolio construction, beneficiary transactions, etc.), to measure and report investments at “fair value”. Fair value is defined by FASB ASC Topic 820 as the “amount that would be received in an orderly transaction using market participant assumptions at the measurement date.”
Public market volatility and the expanding uncertainty and the unknown duration and ultimate impact of the COVID-19 pandemic create a situation where it is more difficult to apply judgment in determining fair value, especially in the throes of the crisis at March 31, 2020. Yet fair value must be determined and determined consistently and objectively even in a highly subjective and rapidly changing environment. Fortuitously, in August of 2019, the AICPA published an Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (AICPA PE/VC Guide or Guide). The Guide provides through guidance, copious examples and answers to numerous questions which assist in exercising judgment when estimating the fair value of private investments.
Fair Value Framework
While market perceptions, government actions, and the behavior of individuals is changing and changing rapidly with the current spread of COVID-19, the framework for determining fair value remains consistent. In general, fair value is determined taking into account key factors, including, but not limited to:
- What is “known and knowable” as of the measurement date?
- What is an “orderly” transaction?
- How would market participants transact (especially in times of increased uncertainty)?
- What are the drivers of value; revenue/customers, cost, growth, competition, market conditions, supply chain, operations etc.?
- How much weight, if any, should be placed on recent or observable market transactions?
- What are the short-term, medium-term, and long-term impacts of a market disruption on the business and operations of an investee company?
- How should the potential for extended economic dislocation and potential recession be considered?
- How should potential or actual government and central bank fiscal and monetary actions be reflected?
There are numerous other factors and judgments required in estimating fair value, but for purposes of this discussion, the above highlight many of the key considerations.
It should be noted that historically private investments are generally less volatile than actively traded public market investments. During a rapid public market upswing, private investments tend to lag and increase in value less steeply. During periods of rapid market downturns, private investments have a tendency to decrease in value less steeply. This is because the drivers of value for non-traded or infrequently traded investments are not specifically or uniquely tied to the second by second trading vagaries of the public markets.
Estimating Fair Value in the Current Environment
When estimating the fair value of private investments March 31, 2020, it is important to thoughtfully and objectively consider the impact of the significant uncertainty created by the rapidly spreading COVID-19 disease and the ancillary impacts on the global economy and public markets. More importantly, when estimating fair value for a specific investment, both the macro environment and investment specific value drivers should be considered. These include, but are not limited to, the following:
- At a macro level, the current crisis is no different than any other external impact (e.g.,. significant public market volatility, Brexit, political events, natural disasters, etc.). Yet in many ways this crisis is unique in modern history. Curtailing travel, sheltering in place, and other actions are dramatically impacting employment, certain industries and economic growth. The potential for a recession is growing. The impact on the value of a specific investment should reflect a market participants consideration of uncertainty in the macro environment. It is clear that uncertainty has increased, and therefore a market participant would take the increased uncertainty and greater risk into account when determining the amount, they would pay for an investment. The increased risk generally translates into an increased required rate of return and thereby lower asset prices.
- February/March 2020 public market volatility and significant decline in value provides an indication of the increased uncertainty but may or may not be useable as a benchmark for the increased uncertainty with respect to a specific non-traded or infrequently traded investment. Uncertainty may differ by geographic region, industry, and other factors.
- On the individual investment level consideration should be given to the short-term, medium-term, and long-term impacts of the pandemic on the investee company’s performance compared to prior and future expectations. What is the impact on customers (revenue), supply chain (costs, delivery times), employees (productivity and availability) and growth? In most cases, if not all, it would be expected that projections should be updated to take into account, to the extent knowable, the impact of the pandemic and economic decline. A market participant would expect to see updated projections. If updated protections are not available, value drivers may need to be adjusted to account for increased risk and uncertainty.
- Up-to-date projections should be used with appropriate value drivers to estimate fair value. Care should be taken not to double count the impact of uncertainty. For example, if projections have been updated it may not be necessary to reflect an increased company specific risk premium (alpha) at the same magnitude as would be required if projections have not been updated. Similarly, if projections have been updated it may not be necessary to reflect a change in market multiples, or credit spreads, at the same magnitude as that indicated by changes in comparable public companies or actively traded investments. Value drivers will also need to be updated, but need to be congruent with projections to which they are applied.
- In all cases, a market participant viewpoint should also be considered – how would a market participant think about increased risk and uncertainty?
- All judgments, supported by objective data and subjective considerations, should be clearly documented to support the ultimate fair value conclusion.
Of critical importance, especially in this crisis environment is for Limited Partners to receive timely fair value information (estimated for underlying investments as described above) from their General Partners. LPs generally use last reported Net Asset Value (NAV) as the starting point for estimating the fair value of their limited partnership interests. As of March 31, 2020, last reported NAV is likely as of September 30 or December 31, 2019 given normal GP reporting cycles. For LPs to prepare their own March 31, 2020 financial statements, to exercise their fiduciary duty and to make critical real time decisions in a crisis environment, the LP must have relevant and reliable fair valued based NAV as of March 31,2020 as quickly as possible after quarter end.
Estimating fair value requires significant informed judgment in the best of times. The current environment requires enhanced consideration of individual facts and circumstances with a rapidly changing macro overlay. Some will second guess what was known and knowable at March 31, 2020;however, following robust established valuation processes, exercising informed judgment, and following the concepts outlined in the AICPA PE/VC Guide will help demonstrate the rigor applied and the reasonableness of the judgments used in estimating fair value at March 31, 2020. In the current environment with increased risk and uncertainty, investors need more than ever for fair value judgments to be sound.
For more information contact David Larsen, 415-693-5330; firstname.lastname@example.org.
David L. Larsen, CPA/CEIV/ABV is a Managing Director with the Alternative Asset Advisory practice at Duff & Phelps and serves as a member of the Standards Review Board of the International Valuation Standards Council, an advisor to International Private Equity and Venture Capital Valuations Board, a member of the AICPA PE/VC Valuation guide taskforce, and former member of FASB’s Valuation Resource Group.
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