New Guide Addresses Valuation Challenges

In August 2019, the American Institute of CPAs (AICPA) issued a guide that addresses valuation challenges associated with ASC 820, part of the Financial Accounting Standards Board’s Generally Accepted Accounting Principles.

ASC 820 requires private equity and venture capital investments to be stated at fair value, even though such investments are illiquid by nature and structure.

The AICPA’s “Accounting and Valuation Guide” highlights relevant areas for auditors and valuation specialists working with private equity and venture capital funds, with helpful insight and examples. It covers topics such as complex structures, including those with multiple securities or those held across multiple related entities; adjustments for control and marketability; performance of back testing on realized investments; consideration of uncertainties and contingencies; and treatment of transaction costs.

One example from the guide that can be used to more accurately measure investments is calibration— a framework that assumes that at the initial recognition date, the valuation technique equals the transaction price. Then at the subsequent measurement date, unobservable inputs are used to measure fair value. Calibration helps in adjusting the valuation technique, which would reflect observable market data at the measurement date or adjust for the characteristic of the asset or liability that isn’t captured. The key is to combat biases by having reasonable, consistent processes using available market data as of the measurement date.

Another important consideration from the guide concerns company control. ASC 820 raises an important question: When valuing private company interest where there are no observed transactions, should the enterprise value reflect a controlling or noncontrolling interest? The guide suggests the value of an enterprise should reflect assumptions that are consistent with the company’s plans under the current ownership. It wouldn’t be appropriate to add a control premium; if investor interest is aligned and the fund has information rights, adjustments for minority interest may not be necessary. If such information isn’t available and the minority investor internal rate of return is higher, then a discount may be necessary.

An appendix in the guide illustrates various case studies with topics including equity investments in leveraged buyouts, initial transaction and calibration, value accretion in a real estate project, value fluctuation in real estate investment financed debt, effect of the value of senior equity interests when junior interests have control, reliability of information for an emerging market investment and subsequent rounds of financing.

The guide, which doesn’t supersede any existing guidance, is nonauthoritative and is meant to be considered a best practice. Through case studies and illustrations, it serves as an important tool for addressing challenges when estimating fair value of private capital investments.