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Mercer Capital | Best Practices: Fair Value Management


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Topics include: Best Practices for Valuing Illiquid Portfolio Assets, Fair Value Measurement, Valuation Methods, Valuing Fund Interests, Mezzanine Loans, GIPS Valuation Hierarchy, International …

Topics include: Best Practices for Valuing Illiquid Portfolio Assets, Fair Value Measurement, Valuation Methods, Valuing Fund Interests, Mezzanine Loans, GIPS Valuation Hierarchy, International Private Equity and Venture Capital Valuation Guidelines (December 2012), CFA Institute Global Investment Performance Standards (2010)

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  • 1. 1Fair ValueMeasurementBest Practicesfor Firms Subject to the Investment Company Act of 1940
  • 2. 2PresentationOutline01.International Private Equity andVenture Capital ValuationGuidelines (December 2012)02.CFA Institute Global InvestmentPerformance Standards (2010)03.Key Takeaways
  • 3. 301.International Private Equityand Venture CapitalValuation Guidelines
  • 4. 4Determining theUnit of AccountMultiple Tranches• Unit of Account determined on same basis thatMarket Participants would transact (singleinstrument or bundle)Debt Only• Unit of Account likely individual debt instrument;fair value based on yield analysisDebt and Equity• Depends on transaction structure of marketparticipants. In general, private equity investorsoften invest in concert with one another andrealize value only when entire business is sold.Unit of account should be assessed accordingly
  • 5. 5Fair ValueMeasurement:ConceptualConsiderationsTo measure fair value of unquoted investments,assume the underlying business is realized orsold at the measurement date, appropriatelyallocated to various interests, regardless ofreadiness for sale or intent to sell• If multiple investment tranches owned by fundwould be transacted simultaneously, theyshould be valued in aggregate• Assume that necessary marketing activitieshave been completed to allow for hypotheticalexchange on measurement date
  • 6. 6Fair ValueMeasurement:ApportioningAttributableEnterprise Valueto FinancialInstrumentsIncorporate effect of ratchets or othercontractual rights in fair value measurement• Assume that in-the-money options and warrantsare exercised (adjusting for both share countand exercise proceeds)• Significant option and warrant positions may needto be valued separately using an appropriateoption pricing model• When debt must be repaid upon sale of theunderlying business, assume FV equal toamount to be repaid• If debt would not be repaid, fair value of debt,amount deducted from enterprise value may differfrom par value
  • 7. 7ValuationMethods:SelectionFactors to consider:• Nature of industry and current market conditions• Quality and reliability of data used• Comparability of enterprise or transaction data• Development stage of enterprise• Profitability and cash flow attributes of enterprise• Unique facts and circumstances• Results of calibration analysis• Maximize use of techniques that draw heavilyon observable market-based measures of riskand return• DCF and industry benchmarks should rarely beused in isolation from market-based measures
  • 8. 8ValuationMethods:Price of RecentInvestmentGenerally most appropriate for early stagecompanies subject to frequent funding rounds• Quality of valuation indication will erode overtime• Evaluate whether price represented fair value atthe time• Difference in economic and governance rights• Disproportionate dilution of existing investors• Strategic motivations of new investor• Forced sale or ‘rescue package’
  • 9. 9ValuationMethods:MultiplesMost applicable for investments inestablished businesses with identifiablestream of maintainable earningsSteps in applying technique:1. Apply appropriate and reasonable multiple tomaintainable earnings to derive Enterprise Value2. Adjust Enterprise Value for surplus or non-operatingitems, contingencies, and other relevant factors toderive Adjusted Enterprise Value3. Deduct value attributable to senior financialinstruments, taking into account potentially dilutivefeatures to derive Attributable Enterprise Value4. Apportion Attributable Enterprise Value to relevantinstruments using market participant perspective
  • 10. 10ValuationMethods:MultiplesMultiples of total invested capital generallymost appropriate because of role of financialstructuring in private equity• Multiples at acquisition should be calibrated torelevant set of comparable companies• Presumption is that multiples based on publiccompany stock prices are indicative of thevalue of the company as a whole• Multiples may be expressed in terms of‘current’, ‘forecast’, or ‘historical’ earnings,and should be matched to character ofmaintainable earnings
  • 11. 11ValuationMethods:Net AssetsLikely appropriate for business whose valuederives mainly from underlying fair value ofassets rather than earningsPotentially appropriate for unprofitable ormarginally profitable businessesSteps in applying technique:1. Derive Enterprise Value by measuring value ofassets and liabilities2. Deduct value attributable to senior financialinstruments, taking into account potentially dilutivefeatures to derive Attributable Enterprise Value3. Apportion Attributable Enterprise Value to relevantinstruments using market participant perspective
  • 12. 12ValuationMethods:DiscountedCash Flows(Enterprise)Flexible, but risky, valuation technique• Required inputs (detailed cash flowforecasts, terminal value, discount rate)require substantial subjective judgment• Indicated value often sensitive to smallchanges in inputs• Generally perceived to be more useful as across-check of values estimated undermarket-based techniques
  • 13. 13ValuationMethods:DiscountedCash Flows(Investment)Most appropriate when:• Exit is imminent• Exit pricing has been substantially agreed• Particularly suitable for valuation debt andmezzanine investments for which value derivesmainly from instrument-specific cash flows andrisks rather than from the value of the enterpriseas a whole• For non-equity instruments, pre-defined terminalvalues enhance the reliability of the technique• Implied discount rate at initial investment shouldbe adjusted over time for changes in marketconditions
  • 14. 14ValuationMethods:IndustryValuationBenchmarksIndustry-specific benchmarks often based onassumption that investors are willing to pay forrevenue and that normal profitability within theindustry does not vary much• Reliable technique only in limited situations• Most likely to be useful as a sanity check againstother valuation indications
  • 15. 15Valuing FundInterestsMay use attributable portion of NAV if:• Reported NAV is appropriately derived usingproper fair value principles as part of a robustprocess• Fair value of underlying investments measuredas of the same date as the fund interestvaluation• Interests in the Fund are not actively traded• Management has not decided to sell the fundinterest for an amount other than applicableportion of net asset valueAdjustments may be appropriate for:• Timing differences• Potential performance or other fees payable• Other factors
  • 16. 16Valuing FundInterests:SecondaryTransactionsData from secondary transactions must beconsidered if:• Relevant terms of the transaction are known• The transaction is considered orderly• Prices in secondary transactions may beinfluenced by factors beyond fair value andbased on assumptions and return expectationsunique to the counterparties• If secondary transaction prices are available, butsecondary market not deemed active, pricesshould be augmented with other inputs, such asNAV
  • 17. 17Application:OtherConsiderationsTerms of internal funding rounds notnecessarily indicative of fair value• When debt is trading at a discount to par,deduct par value from Enterprise Valueunless the subject company has acquiredthe debt in the market and intends to cancelrather than repay• Bridge financing should be included as partof the overall investment being valued, ifconsistent with market participantperspective• When valuing PIK instruments, assessexpected present value of amount to berecovered
  • 18. 18Application:OtherConsiderationsImpact of ratchets and other liquidationpreferences should be assessed relative to thelikelihood that the investor would receivebenefit of full contractual right (in practice, fullbenefits may not be realized)• Mathematical option pricing models arerarely used by market participants, and havenot seen wide usage in the private equitymarketplace• Indicative offers may provide usefuladditional support, but are generallyinsufficiently robust to be used in isolation
  • 19. 19Application:MezzanineLoansPrice at which mezzanine loan was issuedgenerally reliable indicator of fair value atthat date• Should assess whether indications existthat loan will not be fully recovered• Should assess whether changed inrequired yield are indicated• Attached warrants should be evaluatedseparately from the mezzanine loan
  • 20. 2002.CFA Institute GlobalInvestment PerformanceStandards
  • 21. 21Global Investment Performance Standards (2010): Private Equity ProvisionsRecommended Provisions Required ProvisionsFrequency of Valuation PE investments must be valued at least quarterly PE investments must be valued annuallyBasis of Valuation The fair value basis is required The fair value basis is requiredValuation MethodologiesMaterial differences between valuation used in performance reporting and financialreporting should be explained and disclosedDisclose valuation methodologies used in most recent periodSelected Methodologies &AssumptionsKey assumptions used to value portfolio investments should be disclosedThe selected valuation methodology must be the most appropriate for aparticular investment based on its nature, facts, and circumstancesValuation ConsiderationsThe following factors should be considered:1. Quality and reliability of data used in each methodology2. Comparability of enterprise or transaction data3. Stage of development of the enterprise4. Additional considerations unique to the enterpriseChanges in ValuationMethodDisclose material changes to valuation policies and/or methodologies Disclose material changes to valuation policies and/or methodologiesIndustry ValuationGuidelinesDisclose which, if any, industry valuation guidelines adhered to, in additionto GIPSDisclose which, if any, industry valuation guidelines adhered to, in additionto GIPSInvestment PerformanceMultiplesDisclose multiples of committed and cumulative paid-in capital:1. Investment Multiple: Total Value to Paid-In Capital2. Realization Multiple: Distributions to Paid-In Capital3. Paid-In Capital Multiple: Paid-In Capital to Committed Capital4. Unrealized Capital Multiple: Residual Value to Paid-In CapitalDisclose multiples of committed and cumulative paid-in capital:1. Investment Multiple: Total Value to Paid-In Capital2. Realization Multiple: Distributions to Paid-In Capital3. Paid-In Capital Multiple: Paid-In Capital to Committed Capital4. Unrealized Capital Multiple: Residual Value to Paid-In CapitalUse of Valuation Hierarchy The valuation hierarchy (see next slide) should be usedDisclose if the valuation hierarchy differs materially from the recommendedhierarchyValuation Inputs Disclose the use of subjective unobservable inputs in valuing investments Disclose the use of subjective unobservable inputs in valuing investmentsIndependent ValuationReviewValuations should be obtained from a qualified independent third party Not required
  • 22. 22GIPSValuationHierarchy(Inputs)1. Objective, observable, unadjusted quoted marketprices for identical investments in active marketson the measurement date2. Objective, observable quoted market prices forsimilar investments in active markets3. Quoted prices for identical or similar investmentsin markets that are not active4. Market-based inputs, other than quoted prices,that are observable for the investment5. Subjective unobservable inputs for the investmentwhere markets are not active at the measurementdate. Use these inputs only to the extentobservable inputs and prices are not available orappropriate. Unobservable inputs reflectassumptions about the assumptions marketparticipants would use in valuing an investment
  • 23. 2303.Key Takeaways
  • 24. 24Best Practices forValuing IlliquidPortfolio AssetsRecognize that valuation matters, and itwill really matter when something hasgone awry• Document valuation procedures to follow(and follow them)• Designate a member of seniormanagement to be responsible foroversight of the valuation process• Create contemporaneous and consistentdocumentation of valuation conclusionsand rationale
  • 25. 25Best Practices forValuing IlliquidPortfolio AssetsStay abreast of evolving best practices(or know people who do)• Solicit relevant input from theprofessionals responsible for theinvestment, auditors, and third-partyexperts• Check your math• Disclose the process and conclusions -potential investors take comfort intransparency
  • 26. 26ContactInformationTravis W. Harms, CFA, CPA/ABV901-322-9760harmst@mercercapital.comJeff K. Davis, CFA615-345-0350jeffdavis@mercercapital.comMERCER CAPITALClark Tower5100 Poplar Avenue, Suite 2600Memphis, Tennessee
  • 27. 27Portfolio ValuationServicesMercer Capital’s
  • 28. 28AboutMercer Capital• Business valuation and financial advisory firmfounded in 1982• Core competency is the valuation of private equityand debt securities• Valuation and positive assurance opinions• Fairness and solvency opinions• Transaction advisory• Litigation support• 400 assignments annually, primarily for domesticentities• 40 employees (employee-owned)• Valuation and industry thought leaders
  • 29. 29Overviewof ServicesValuation• Tax compliance• Corporate valuation services• Employee Stock Ownership Plan valuationTransaction Advisory Services• Fairness and solvency opinions• M&A and investment banking services• Buy-sell agreements and private company transactionsFinancial Reporting• Private equity, mutual fund, BDC, and other investmentcompany portfolio valuation services• Purchase price allocation• Impairment testing servicesLitigation Support• Expert testimony• Business damages• Shareholder disputes / divorce
  • 30. 30FinancialReportingValuationServicesMercer Capital provides a comprehensive suite of valuation services toassist boards of directors, portfolio managers, financial managers andothers with financial reporting requirements.In an environment of increasingly complex fair value reporting standardsand burgeoning regulatory scrutiny, Mercer Capital helps clients resolvefair value reporting issues successfully.Mercer Capital fair value opinions are consistently accepted by the BigFour audit firms and other reviewing entities.Our professionals hold the Accredited in Business Valuation (ABV)designation from the AICPA, the Accredited Senior Appraiser (ASA)designation from the American Society of Appraisers and the CharterFinancial Analyst (CFA) designation from the CFA Institute.Valuation Services for Investment Funds• Portfolio Investment Valuation• Fairness and Solvency Opinions• Litigation SupportValuation Services for Portfolio Companies• Purchase Price Allocation• Goodwill Impairment Testing• 409A / Equity Compensation Valuation
  • 31. 31Key IndustryVerticalsFinancials• Depositories• Asset managers• BDCs• Insurance• Brokers and investment banksManufacturing• Durable and non-durable goods• Consumer and industrialHealthcare• Facilities companies• Medical devices• Staffing companiesDistribution and Transportation• Wholesale distribution• Asset-based transportation companies (all modes)• Third-party logistics providers
  • 32. 32SeniorProfessionalsJeff K. Davis, CFA• Managing Director• 10 years with Mercer Capital• Spent 13 years as a sell-side analyst covering small-and mid-cap banks and specialty finance• Weekly editorial contributor to SNL FinancialTravis Harms, CFA, CPA/ABV• Senior Vice President• 15 years with Mercer Capital• Extensive financial valuation reporting experience,including on behalf of private equity, BDCs and broker-dealers
  • 33. 33SeniorProfessionalsZ. Christopher Mercer, ASA, CFA, ABAR• CEO / Founder (1982)• Prolific author and thought leader on private securityvaluation• Has prepared and overseen over a thousandvaluations for M&A, tax, litigation and other mattersMatt Crow, ASA, CFA• President• 19 years with Mercer Capital• Senior member of Mercer’s financial reportingvaluation group
  • 34. 34SeniorProfessionalsTimothy R. Lee, ASA• Managing Director• 19 years with Mercer Capital• Heads corporate valuation group with industry focus inbeverage, distribution, construction, retail andtransportationAndy Gibbs, CFA, CPA/ABV• Senior Vice President• 14 years with Mercer Capital• Has completed hundreds of bank and loan portfoliovaluations as head of the depository group for M&A,ESOP, and other purposes