The document discusses the new revenue recognition standard and its potential impacts. It will: 1) Require private equity firms to defer recognition of carried interest income until it is certain the cash will not be clawed back, which may differ from how employees currently receive carry payments. 2) Impact how publicly-listed private equity firms report carry income to analysts due to the discontinuity between GAAP reporting and non-GAAP measures used by analysts. 3) Affect valuations and due diligence for private equity firms as revenue recognition under the new standard may differ from current practices or IFRS standards used in other countries, complicating cross-border deals. Firms need to assess these impacts now on their

1. Quirks in the system
A special report on
accounting and valuation
REVENUE RECOGNITION
Preparing for takeoff p.20
VALUATION COMMITTEES
From good to great p.22
CONTROL
The nuances of control p.24
CHINA
Minding your Ps and Qs p.27
BEST PRACTICES
Q&A: The new normal p.28
YURALAITSALBERT/SHUTTERSTOCK.COM

2. by KATHERINE BUCACCIO
L
ast year, after six long years of
work, the Federal Accounting
Standards Board (FASB) and its
global counterpart the International
Accounting Standards Board (IASB)
agreed to a new, converged revenue
recognition standard.
The new five-step standard will
replace hundreds of industry-specific
revenue recognition requirements
under US GAAP, and enhance the
limited guidance found in international
financial reporting standards (IFRS).
For private fund GPs, the shift promises
an easier way to compare and contrast
the top-line growth at companies
worldwide.
FASB voted to delay the timeline for
adopting the new standard by one year
thispastJuly.Now,forpubliccompanies
following US GAAP, the new rules
take effect for annual reporting periods
beginning after December 15, 2017.
Private companies following US GAAP
will have until 2018 to adopt, but have
the option of adopting early alongside
their public counterparts. Meanwhile,
companies using IFRS must apply the
new revenue standard for reporting
periods beginning on or after January
1, 2017, but can begin doing so early,
regardless of their public/private status.
The implementation delay was
welcomed by the industry, after
stakeholders argued that the original
timetable did not allow enough time
to revamp their practices. But GPs are
being urged by accounting advisors
not to wait to address the standard’s
impacts, but rather to recognize the
deferral as a sign of how significant an
undertaking its adoption will be.
“The ‘rev rec’ standard is clearly
on the agenda with the private equity
finance folks, but what I’m seeing is that
there are a number of things that are
higher priority,” Scott Gehsmann, deal
partner in the compliance practice at
PwC, tells pfm. He cites issues like the
consolidation standard and deal costs
allocations taking precedence.
As of now, the standard may be low
on the priority list, but its changes will
impact high-priority firm functions.
Carried interest accounting may be
subject to a total overhaul, and changes
to key financial metrics and ratios
at portfolio companies, including
EBITDA, could affect due diligence,
investment and exit strategies.
“If they haven’t commenced the
dialogue, they need to start,” Gehsmann
warns.
At the management company
Today, most GPs record carried interest
as it’s achieved – either when a portfolio
company is exited, or when a fair value
estimate indicates they’ve achieved the
performance fee on paper.
The new rules, however, say that any
carry subject to a clawback is not firm
revenue until it is certain the cash will
stay firmly in the GP’s pocket. In other
words, carry isn’t carry until it becomes
impossible for a single bad investment
to result in revenue being clawed back.
For Matt Maulbeck, professional
practice partner at EisnerAmper, the
standard’s effect on carry reporting
will be “the most impactful thing” for
private equity managers.
“The new standard will require them
to defer the recognition of performance
fees until collection is certain, which
may take several years,” he tells pfm.
The manager may still be paying
certain employees as usual, based on
the underlying economic performance
of its funds, so this change in reporting
Preparing for takeoff
Compliance with the new revenue recognition standard may
seem a long way off, but private equity accounting teams need to
start thinking about its possible impacts sooner rather than later
Revenue recognition: no longer an apples to apples comparison
OLAFSCHULZ/SHUTTERSTOCK.COM
20 private funds management • Issue 133 • September 2015
special report: accounting & valuation • REVENUE RECOGNITION
https://www.privatefundsmanagement.net/

3. might yield a discontinuity between
when employees receive carry versus
when its accounted for in the books.
In the past GPs might have been able
to match those revenues and expenses,
Maulbeck notes.
Moreover, the way carry is recorded
in a firm’s financial statement may no
longer sync with what LPs are told.
Most managers will be able to clarify
any discrepancy with confused LPs with
a few phone calls – but publicly-listed
firms like KKR and The Blackstone
Group may need to explain the
situation to outside analysts. This may
even lead analysts to begin considering
non-GAAP financial metrics, in order
to better track these firms’ earnings,
says David Larsen, managing director
at Duff & Phelps.
“Any analyst following that stock
would have to look at non-GAAP
measures as opposed to GAAP
measures, because a big chunk of the
revenue would be missing quarter to
quarter,” says Larsen.
The new standards do not allow for
a seamless transition for publicly-listed
private equity management companies,
but Larsen reckons FASB and IASB
were aware of that fact when they
created the standard, and CFOs from
this narrow group of the market will be
able to adjust.
“It just means GAAP may no longer
become the primary basis to evaluate
performance of those management
companies, and highlights that a
universal accounting standard doesn’t
necessarily work for everybody,” he says.
At the portfolio company
Although the deferral may make it
seem as though compliance with the
new standards is a long way off, the fact
that IFRS will allow early adoption may
become an issue sooner than expected.
Various countries are adopting IFRS
as an entire body of work at different
points in time, and if a private equity
firm is buying a company in the US and
comparing it to public market comps
reporting under IFRS, it will add an
extra layer of work.
“If they have adopted IFRS, you’re
comparing apples to oranges as far as
multiples go. That’s where you have a
due diligence problem,” says Larsen.
GPs should make sure that their deal
valuation models take into account
the impact of the new standard.
For example, if revenues were being
deferred under current GAAP, but
are recognizable earlier under the
new standard, the previously deferred
revenue could be “lost” upon transition
to the new standard for financial
reporting purposes, noted Gehsmann in
a recent industry article on the subject.
And when managing investments,
debt covenants should be considered,
because the amount, timing and pattern
of revenue recognition and EBITDA
could change under the new standard,
Gehsmann added. If a revenue
transaction with a customer includes
a significant financing component,
because of differences in timing
between payment and performance
under the contract, more or less revenue
could be recognized than under current
rules.
Portfolio company exits planned
before the rule becomes effective will be
confronted with disclosure challenges
around the projected impact of the new
standard on the company, the article
noted, further complicating matters.
Despite these concerns, the new
standard will have a positive impact
on due diligence and valuations as
well, allowing managers to have more
information right at their fingertips
when assessing a company with audited
financial statements, says Maulbeck.
“The standard will require more
disclosure around revenue recognition.
Specifically, it requires more
disaggregation of what companies need
to report, especially around the nature
of their revenue, the uncertainties
around cash flows in their revenue and
what judgements are made in terms of
the revenue they’re booking,” he says.
Mark your calendars
CFOs should be planning how to handle
these impacts now, and communicate
the significance to the whole firm,
especially because accounting personnel
are not the only ones who will be
impacted. Lack of preparation and
knowledge from the deal team could
lead to lost revenue and lost time.
“The challenge we see is that the
people in private equity firms doing
the deals are typically not accountants.
Getting an accounting focus involved
on the front end during deal making
is going to be important around this
standard. We see that as a looming
surprise for some of them when the
impacts of the standard start to bite,”
notes Gehsmann.
Within a portfolio company itself,
it’s going to take some time to adapt
from an operational standpoint –
shifting internal accounting systems
and potentially changing contracts and
paying for the associated costs, notes
Larsen.
Although he admits, it’s human
nature to “wait to deal with it until it’s
right in front of you,” Maulbeck notes
that firms receiving substantial upfront
fees and incurring upfront costs have
more data to track, and will have to
consider whether current processes and
systems are sufficient for meeting the
requirements of the new standard.
GPs would be wise to start thinking
about these concerns before the end
of this calendar year, Gehsmann says.
“This topic just can’t fall off the list.”
Issue 133 • September 2015 • privatefundsmanagement.net 21
Preparing for takeoff
https://www.privatefundsmanagement.net/

4. O
nce informal meetings between
portfolio managers and perhaps
an impromptu recruit from the
back office, today’s valuation committee
meetings have become much more
sophisticated—a testament to how far
funds have come in deriving the fair
value of assets.
Some of this can be attributed to fund
managers constantly reviewing and fine-
tuning their practices to confidently
estimate the worth of their portfolios,
an outcome developed after decades of
portfolio monitoring experience. But to
Craig Ter Boss – who has witnessed the
evolution of valuation best practices over
a career spanning 20 years in the industry
– it’s mostly a result of LPs demanding
more robust and transparent valuation
practices, as well as regulatory pressure,
which is forcing funds to formalize
their valuation policies and procedures,
document it all for recordkeeping
purposes and share it with inspectors and
auditors.
“The make-up of the valuation
committee itself is testament to how
far the industry has come,” says Ter
Boss, a New York-based director with
EisnerAmper, the accounting, consulting
and tax services firm. “The fair value
estimate used to be somewhat informally
determined by the portfolio managers
– but now many firms have structured
committees in place with detailed
valuation policies and procedures to
follow.”
Still, the formation of polished
valuation committees – comprised of a
mix of characters to provide a sense of
checks and balances over the process
– is still a relatively new phenomenon
in the private funds universe, Ter Boss
notes. Accordingly, there is still room for
improvement, with one area involving
funds’ most treasured relationship: that
of LPs.
The watchmen
“It wasn’t always the case that investors
presented a host of questions on
valuation,” says Ter Boss. “In the past,
it was all about performance – but over
the course of five or so years, LPs started
asking more pointed questions about
the firm’s operations, including the
back office and the way valuations are
performed.”
This has been mostly limited to LPs’
pre-investment due diligence, Ter Boss
continues. A limited partner advisory
committee is often responsible for
reviewing quarterly estimates, but
generally speaking, LPs tend to ease the
brake on valuation oversight once the
investment is made – either because of
limited manpower or developed trust in
the manager.
“That’s beginning to change. We’re
seeing more LPs periodically review
any changes to the managers’ valuation
policy, asking managers to perform back-
testing and disclose more information on
the valuation inputs. Most interesting to
me, however, has been non-investment
personnel having a more active
involvement on the valuation committee
itself.”
While it would be odd to see an LP
take a seat amongst portfolio managers
during the valuation committee meeting,
more realistic is the creation of a limited
partner advisory or risk committee to
establish “a sense of oversight” over the
valuation committee, says Ter Boss.
The objective, he continues, is for the
LP to regularly monitor whether the
fund follows the valuation procedures
From good to great
The sophistication of valuation committees has advanced leaps
and bounds over the last five years, but EisnerAmper director
Craig Ter Boss says that best practices are still evolving as
managers look to further enhance stakeholders’ trust in their
valuation processes
Valuation committee meetings: more voices around the table
RAWPIXEL/SHUTTERSTOCK.COM
keynote interview: EISNERAMPER
22 private funds management • Issue 133 • September 2015
special report: accounting & valuation • VALUATION COMMITTEES
https://www.privatefundsmanagement.net/

5. promised during the pre-investment
due diligence. Reviewing the valuation
committee minutes is one way to fulfill
that objective. Accordingly, the GP – or
whoever is in charge of the valuation
committee – should keep detailed
minutes and document them thereafter,
advises Ter Boss.
Items to document should include: any
deviations from the valuation playbook;
additions or removals of companies that
are part of the comp stats; changes to the
weighting of valuation methods used;
and revisions to the valuation handbook
itself, among other items.
But funds, take note: a good valuation
committee is more than just strong
recordkeeping practices – “you have to
have the right people involved in the
process too,” advises Ter Boss.
Mixed cast
As alluded to earlier, valuation was
historically a practice left to portfolio
managers during irregular, informal
meetups. Prior to the introduction of
FAS 157 (now known as Topic 820),
firms could hold an investment at cost
during the initial years of ownership,
reducing the need for formal valuation
policies and procedures. CFOs were not
necessarily excluded from the process,
says Ter Boss, but their role was limited
in the valuation process.
Indeed, today a valuation committee
consisting solely of deal partners or
investment personnel is a red flag to
investors and regulators alike, Ter Boss
continues.
“It’s a conflict of interest issue. Having
different voices from different divisions
within the firm on the committee
achieves an appropriate level of checks
and balances. Deal partners may
overvalue their pet projects. Or on the
other side of coin, act too conservative
when estimating value in order to
manage investors’ expectations. The
CFO or some non-deal partner can be
that independent voice pushing for true
discovery of fair value.”
Including a representative from the
compliance team on the committee is a
bestpracticetoo,saysTerBoss.Following
increased oversight powers, regulators
and inspectors have made valuation
a priority during exams. Officials
from the US Securities and Exchange
Commission specifically are seeking
“adequate documentation on how marks
were being calculated, and why certain
assumptions were being made during
the valuation process,” says Ter Boss. A
representative from the compliance team
on the valuation committee can serve as
a safeguard that those requirements are
being met.
Indeed, CCOs have stressed to
pfm in the past that one of their key
responsibilities is also to keep investor
relations and marketing staff as far away
from the valuation process as possible
(for obvious reasons related to conflicts
of interest).
Ter Boss concludes by noting there is
no fixed set of criteria a GP can follow
to achieve a best in class valuation
committee. “Each firm, regardless of
size, will have to undergo an assessment
of their internal resources and staff to
determine what works best for them.”
Even something like “how regularly the
committee meets will vary” with some
firms “meeting on a quarterly basis”
whereas others may hold “monthly
meetings that resemble a valuation
committee-lite,” says Ter Boss.
What firms will not want to do is
present stakeholders with a valuation
committee or valuation process that
resembles what normal practice was
five years ago. According to Ter Boss,
valuation best practices have accelerated
quickly in that short five-year time span,
and do not appear to have hit a wall just
yet.
We’re seeing
more LPs periodically
review any changes
to the managers’
valuation policy,
asking managers to
perform back-testing
and disclose more
information on the
valuation inputs
Ter Boss: a witness to valuation evolution
keynote interview: EISNERAMPER
Issue 133 • September 2015 • privatefundsmanagement.net 23
From good to great
https://www.privatefundsmanagement.net/

6. C
ontrol premium means different
things to different people. The
concept of a control premium
may presuppose the existence of a
minority discount. Market participants
in the private equity and venture capital
industry do not typically think of value
in the context of control premiums
or minority discounts. Therefore, it is
critical that concepts be clearly defined
and articulated so that the use of the
term control premium does not force
the use of a minority discount and that
resultant valuation measurements do
not differ from the perspective of market
participants.
Below, we look at two specific
scenarios related to valuation and
control (non-controlling equity and non-
control equity with debt) as well as two
case studies (see boxouts) for guidance
purposes. However, it should be stressed
that the valuation descriptions below are
by design succinct and therefore focused
on highlighting potential questions.
As fair value determinations require
judgment, the analyses provided may of
course differ after a thorough vetting of
all actual facts and circumstances.
Non-controlling equity
Let’s begin with non-controlling equity.
Remember that lack of control refers to
the inability of the investor to control the
company’s management, strategy and,
in particular, the timing and form of the
exit. This is usually because the investors’
equity position is a minority stake. There
are two potential issues to consider here
then: 1) application of adjustments; and
2) contemplated but not closed exit.
Application of adjustments
In many cases, the application of an
adjustment for a non-control position
will not be appropriate. Generally, a
“minority” investor participates “in
concert” with other investors. They pay
the same proportionate price and receive
the same proportionate return. Further,
while they do not directly control the
timing of an exit, when they are investing
with other like-minded investors who
would maximize value through the sale
of the enterprise, the assumed orderly sale
of the business at the measurement date
provides the best indication of fair value.
In such circumstances, there would not
be an adjustment for lack of control.
Only when facts and circumstances
dictate that a minority owner would
receive disproportionate cash flows or
would maximize value through the sale
of the minority position independent of
the sale of the entire business, would an
adjustment be warranted.
Many alternative asset investments
include pari passu investment features.
Buyers of minority positions pay the
same pro rata amount as control investors
and receive the same proceeds as control
investors. Therefore, individual facts and
circumstances must be considered to
determine if a market participant would
actually pay less for a minority position
given the dynamics of investing in
alternative assets as noted above.
In such limited cases, a valuer
would determine if the value for a
minority position is best achieved based
on estimating the overall business
enterprise value and then applying an
adjustment, or if determining the value
of the minority position using other
methodologies would be appropriate.
The application of an adjustment or an
alternative valuation method would
be supported by individual facts and
circumstances and by market participant
assumptions.
The determination of the appropriate
adjustment, if any, for lack of control
The nuances of control
Valuation can become a challenging exercise when GPs lack
control over management or exit timing – even more so when
debt is involved. Here, valuation experts Stephan Forstmann and
Robert Malagon walk us through the issue
Control board: deceivingly complicated at first sight
BEGOOD/SHUTTERSTOCK.COM
24 private funds management • Issue 133 • September 2015
special report: accounting & valuation • CHAPTER EXCERPT
https://www.privatefundsmanagement.net/

7. depends on the situation at hand as well
as the specific valuation methodology
chosen. A high-level guide would
include:
• If the minority investor pays a
different price than the control
investor, the price paid by the
minority, if deemed fair value,
would be calibrated with inputs
used to value the business or interest
on an ongoing basis.
• The level of adjustment should
not be predetermined (or always a
certain number) but rather should
be calculated based on the specifics
of the transaction. This is intricate
and difficult and requires a fair
amount of experience by the valuer
determining the adjustment.
In summary, the application of
an adjustment for lack of control in
a minority privately held security
may be warranted in certain limited
circumstances. The level of the
adjustment, if any, needs to be calculated
in supportable fashion based on what
market participants would do.
Contemplated but not closed exit
A non-controlling co-investor in an
equity-type investment is inherently at
the whim of the party controlling the
investment as to the ultimate form and
timing of the exit. This occurs even if
the investor was able to insert drag-along
rights into the purchase agreement.
Hence the investor will likely have
limited informational rights as to the
details of exit negotiations. As a result,
to the extent an investor confidentially
does know about suggested price levels
being negotiated by the controlling
stakeholder in regards to a potential
exit, such price levels, while certainly
to be taken into consideration as a fair
value indicator, will need to be evaluated
carefully to determine their relative merit
as compared to more fundamental value
indicators. Again, considerable (and
ultimately documented) judgement will
need to be exercised in this process.
Non-control equity with debt
Lack of control refers to the inability of
the investor to control the company’s
management, strategy and, in particular,
the timing and form of the exit. The
principal market for a sale of a minority
interest may or may not be the M&A or
IPO markets, but given that a market
participant with a minority position
cannot affect the timing of an exit
through the sale of the entire company,
the investor cannot trigger a change of
control provision on the debt. Hence, the
fair value of non-control equity interest
is determined by subtracting from the
business enterprise value the par or face
valueofdebtbecauseamarketparticipant
would determine the price of the equity
position based on the assumption that
the debt would have to be repaid at face
amount. (Note: The minority interest
may also be valued by reference to a
controlling interest, as described above.)
However, the fair value of debt, because
the timing of an exit cannot be affected
by a minority equity holder, would be
determined using a valuation technique
that considers current market yields,
term and credit quality, and leveraging
Level 1, 2 or 3 inputs as appropriate.
(Partially) impaired debt position
In a situation where the investors hold
a minority stake in a company, as well
as debt which now appears impaired, a
relatively complicated valuation exercise
will ensue.
Case study: Non-controlling equity
Situation: Private Company A is owned by three private equity funds
in equal proportions (33 percent of equity each). The company has
EBITDA of $100, debt of $400 and similar companies trade at 7x
TEV/EBITDA. The implied TEV and equity values are $700 and $300,
respectively. A strategic competitor agrees to acquire 100 percent of
Private Company A’s equity for $500. The acquirer believes the value
of cost synergies to be $150.
Key question: What is the fair value of the equity?
a) $500 given the strategic buyer’s acquisition price?
b) $300 given the TEV of $700 and debt of $400?
c) $450 given the value of the equity plus the cost synergies
combined?
Answer: Judgement is necessary, including an assessment of the risk
associated with the transaction closing. Until the transaction closes,
the fair value of the equity could reasonably range from $300 to $500,
given that the implied TEV is $700 and Private Company A has $400 in
debt, assuming no risk to closing. If the time to closing is long and risk
of closing is great, some valuers would likely gravitate towards $300
because they could conclude that not all market participants would
offer the additional $150 paid for synergies.
Issue 133 • September 2015 • privatefundsmanagement.net 25
A word to the wise: Non-controlling equity nuances
https://www.privatefundsmanagement.net/

8. This is because the investor is likely to
have access to very limited information
on which to base the valuation decisions.
Questions that will need to be answered
include:
• Does the apparent (partial)
impairment of the debt indicate that
the fair value of the equity is also
impaired? This is not necessarily
the case, especially in dislocated
markets as experienced during
the 2008–09 financial crisis when
debt markets were indicating very
impaired price levels for performing
loans of healthy companies.
• What publicly available data can
be used that reflects fairly the value
of the instrument in question (as a
comparable)?
• Are there adjacent markets that
trade in lock-step?
• What base-data is available – for
example, projections and last
12-month financial statements? If
these are limited and no further
data will be supplied, how can they
be augmented and/or interpreted?
Differing values for debt
As a direct result of the valuation
methodology described above where
the par value of the debt is subtracted
from the business enterprise value in
determining the fair value of the non-
controlling equity investment versus a
yield analysis for determining the fair
value of the debt position being held,
the same debt position will likely carry
a different value in each determination.
This is a direct result of unit of account
considerations. While seemingly
illogical, the unit of account concept
potentially drives a different valuation
premise for individual securities being
valued.
When looking at the debt on its own,
its fair value is best described by what
the debt could be sold on its own (that
is, without the equity position). Hence,
a yield approach to valuation is likely
the most appropriate approach. When
lookingattheequityonitsown,however,
the application of the business enterprise
value would not correctly reflect the
equity value unless the par value of the
debt is subtracted from the enterprise
value to determine the fair value of the
(non-controlling) equity position.
For a discussion on other valuation
nuances, including ones pertaining to
actively traded debt, non-traded debt and
structured products, please see the PEI’s
Private Equity Valuation handbook.
Both based in New York, Stephan
Forstmann is a managing director in
Duff & Phelps’ Alternative Asset Advisory
practice, whereas Robert Malagon is a
director in the group’s portfolio valuation
service line.
This was an edited excerpt
from a chapter in PEI’s newly
released title “Private Equity
Valuation – the definitive
guide to valuing investments
fairly,” available at: peimedia.
com/books
By
Duff & Phelps
The definitive guide to valuing investments fairly
PRIVATE EQUITY
VALUATION
Case study: Non-controlling equity with debt
Situation: In December 2013, Mid-tier Fund A acquires 10 percent of
theequityofCompanyZand20percentoftheoutstandingseniordebt
at par. At the time of the transaction, Company Z generated EBITDA
of $50 and had $100 in debt paying a 10 percent interest rate for an
implied interest coverage ratio of 5x. Similar companies are traded on
the market at 10x TEV/EBITDA. One year later, the company’s EBITDA
decreased to $25, reducing the interest coverage to 2.5x and similar
companies traded on the market to 4x TEV/EBITDA. Outstanding
debt remains at $100 and implied yield is 20 percent.
Key question: How should each security be valued on December
2008?
a) $0 for the equity given an implied TEV of $100 and par value of
debt of $100?
b) $50 for the equity given an implied TEV of $100 and market value
of debt of $50?
c) Other?
Answer: The solution is (a) since market multiples have traded down
to 4x resulting in a TEV of $100. This would just cover the outstanding
debt, leaving no value for the equity. If supportable, the equity could
have some nominal option value, at best, in this scenario.
26 private funds management • Issue 133 • September 2015
special report: accounting & valuation • CHAPTER EXCERPT
https://www.privatefundsmanagement.net/

9. by KATHERINE BUCACCIO
I
t’s no secret that the Chinese public
markets have been unpredictable
of late. Since July, the government
has been intervening on multiple
rescue missions – suspending trading
for 1,400-plus companies, preventing
shareholders from offloading stakes,
delaying IPOs and, most recently,
devaluing the yuan.
But less visible has been the
effect on managers of private funds.
Managers with publicly-traded
Chinese investments are witnessing
their portfolios experience wild swings
in price, despite believing the true
fair market value of these assets to be
following a more consistent trajectory.
The problem stems from accounting
rules. The Federal Accounting
Standards Board (FASB) and the
International Accounting Standards
Board (IASB) require that actively-
traded securities be valued at P (public
share price) times Q (quantity owned),
which is a suitable metric for liquid
investments.
But for private equity, where
investments are held long-term and
exits are timed to coincide with benign
market conditions, this approach results
in some misleading financial reporting.
Earlier this year for instance, during
a massive market rally, the PxQ rate
artificially ballooned GPs’ valuations –
as high as 100x price/earnings ratios for
some portfolio companies – causing GPs
to report sky-high valuation estimates
that no reasonable buyer would accept.
Another complication are the trading
suspensions imposed by the Chinese
government, most recently in mid-July.
During a suspension, GPs are given the
latitude to value the company based
on unobservable inputs, leading to a
more accurate reflection of what they
feel the company is worth at the time
of measurement. But the subtlety here
is that the measurement may move
substantially from the previous quarter’s
estimate that was artificially inflated (or
deflated) by the PxQ rule.
To those who don’t work in the
firm’s finance and accounting team,
this might seem a technical and
minor point. But GPs are entrusted
to provide investors with a genuine
estimate of the portfolio’s fair value
on a quarterly or annual basis. This is
because LPs most often use the GP’s
reported NAV as their own fair value
estimate. The concern is that GPs will
end up presenting valuations that they
don’t really stand behind, leading to a
potential credibility gap that neither
investors nor inspectors can accept.
One solution may be for GPs to
present a second fair value estimate
– one better reflecting their market
senses – in an investment letter, but it
may not be wise for GPs to appear to
be challenging internationally accepted
accounting standards, especially with
regulators eyeing valuations ever more
closely.
The solution then has to come
from the standard setters themselves.
Unfortunately, we have no reason
to believe FASB will provide much
attention to what is the small corner of
the market owned by private equity, but
the current situation in China does raise
the question of whether or not they
should reconsider the PxQ rule.
Granted, a new rule would probably
take years to introduce (likely long
enough for China’s markets to balance
out again). But if the result would
be a more credible, predictable and
meaningful valuation process for all,
then it is worth waiting for.
Minding your Ps and Qs
Rigid accounting standards are creating a problem for GPs:
China’s recent market volatility is not allowing CFOs to report a
true fair market value of their publicly-listed Chinese assets
Chinese market volatility: spill over effects in private equity
Issue 133 • September 2015 • privatefundsmanagement.net 27
special report: accounting & valuation • CHINA
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10. RIGGSBY/SHUTTERSTOCK.COM
V
aluation and transparency
issues continue to be a hot
topic with regulators and
investors. But what’s been the specific
impact of this trend on GPs?
Ma:Weseeanumberofforcesimpacting
our clients. Even though Dodd-Frank
just turned five, its impact is now being
felt through SEC Enforcement Actions
such as the valuation allegations against
Patriarch Partners and AlphaBridge
Capital as well as more recent expense
allocation allegations against KKR and
Fenway Partners. Then in Europe, the
AIFMD has been active for slightly more
than a year, and now that regulators are
starting to examine and look closer at
alternative investment fund managers we
will understand how well the disclosure
and independence requirements posed
by the Directive have been implemented
by the industry.
Also, there appears to be a growing
demand by institutional LP investors
such as pension funds and sovereign
wealth funds that alternative asset
managers introduce more independence
into the process of valuing their
illiquid assets. From our experience
and observations, this appears to be a
global trend even in jurisdictions where
valuation independence is not required
by regulation.
Given all the new regulations,
scrutiny, and transparency demands
we just discussed, how are funds
dealing with these developments?
Are there best practices you would
recommend in setting up a valuation
process?
Funds are adapting their internal
processes in response to these new
regulatory and investor demands, and
several themes have emerged as best
practices. It’s probably easiest if I list a
few in no particular order.
Firstly, many managers have
established more formal valuation policy
frameworks, which typically consist of
three main elements: a written valuation
policy document; an established
valuation committee that oversees the
process; and a board of directors and/
or the valuation committee that have
ultimate responsibility for determining
the valuation of the funds’ assets.
Secondly, among other things, the
formal valuation policy document
will typically define the roles and
responsibilities of the valuation
committee and the board, identify other
personnel that will support the valuation
process, outline the procedures and
methodologies used in preparing the
valuations, and mitigate conflicts of
interests.
Thirdly, in laying out the valuation
process and procedures, strong
consideration should be given to
establishing a valuation process that
is independent from the investment
process. For larger managers with
substantial and robust infrastructure,
the valuation analysis may be handled
internally and augmented by the
third-party review. Mid- or small-
sized managers may employ third-
party valuation providers to perform
independent valuation.
Ifwecouldpauseyouthere…obviously
no two fund managers are alike, but
given what we just covered in best
practices, what’s the best way to get
the maximum benefits from utilizing
a third party valuation provider?
The valuation provider should develop a
customized approach to suit the needs of
the fund based upon factors such as the
Valuation best practices: continued growth
Q&A: The new normal
Pfm catches up with valuations expert Dr. Cindy Ma to hear
about the latest valuation best practices being adopted by
private fund managers and ask why audits have become so much
tougher in recent memory
keynote interview: HOULIHAN LOKEY
28 private funds management • Issue 133 • September 2015
special report: accounting & valuation • BEST PRACTICES
https://www.privatefundsmanagement.net/

11. type of asset classes, the number and size
of investments, scale and depth of the
fund’s internal valuation infrastructure,
and requirements from existing or
prospective LP investors. Also, the fund
should consider the entire spectrum of
fair value analyses available including
full-independent valuation and a limited
scope analysis.
In a full-independent valuation, the
third-party advisor typically reviews the
recent historical and projected financial
performance of the investment, as
available, and discusses it with the
portfolio manager; prepares a valuation
analysis of the investment using widely
recognized methodologies; and provides
independent conclusions of fair value of
the investment. This scope of service may
be more useful for a manager that does
not have the infrastructure to support an
internal independent valuation function.
Alternatively,amanagerthatdoeshave
a robust internal independent valuation
function may not need a third party to
provide a full independent valuation. In
this case, a limited scope analysis may be
sufficient, where the third-party advisor
reviews the fund manager’s valuation
analysis including market data relied
upon, company performance data and
valuation underlying the analysis, or
provide other observations, and will
comment on whether or not the fair
value conclusions of the manager seem
reasonable, although this does not
constitute an independent conclusion of
fair value.
When the valuations are finally
completed they are generally handed
off to the auditor. How do you think
their review process has changed over
time? What are the most common
questions your clients get now?
Many fund managers have likely noticed
the increased scrutiny by auditors
over the past few years. Among other
things, this is driven by an increased
focus on risk management, and by
increased regulatory oversight of the
auditor community. Auditors have to
meet certain professional standards
that require them to understand the
assumptions utilized in the valuation.
A good valuation firm will not
only provide assistance to the client
throughout the audit process, but will
have had experience with many auditors
and be able to anticipate the critical
issues likely to be raised in the review.
Our clients and the auditors tell us the
process runs best and most smoothly
when they receive a full and complete
report. The report should describe the
methodologies used and why. It might
also cover what is not used and why. The
report should also discuss critical inputs
such as multiples, discount rates, cap
rates, etc. and defend each of these input
assumptions. More is better!
What changes do you think are on the
horizon that fund managers should be
aware of?
I think we have already touched on
many of these. Regulators are likely to
expect managers to have formal written
policies and will focus on a managers’
compliance with its own internal
policies; the regulatory landscape is
likely to become even more complex and
demanding particularly for managers
that operate in multiple jurisdictions;
and investors are likely to increase their
focus on transparency of information.
To expand a bit on this last point, as the
secondary market for fund LP interests
continues to grow, transparency of
fund information along with reliable
(and independent) valuation marks
become more and more important to
LPs, particularly institutional LPs that
periodically rebalance their investment
portfolios through secondary market
purchases and sales.
Have you encountered any other
interesting issues in valuation
recently?
There are probably too many to address
in great detail, but in summary,
among other things, we are seeing
more complicated capital structures
again. As investors continue to hunt
for yield, we are seeing funds focus on
new and emerging asset classes such as
maritime assets, non-performing loan
pools, and long dated infrastructure
assets including investments in
developing markets. Also, volatility in
the commodities markets have led to a
number of interesting valuation issues
and considerations.
Based in New York, Dr. Cindy Ma is the global head
of Houlihan Lokey’s Portfolio Valuation & Advisory
Services practice, focusing on illiquid and complex
securities valuation. She has more than 20 years of
extensive training, academic expertise and hands-on
experience in commodities, derivatives, securities,
foreign exchange, fixed incomes, structured
transactions, hedging strategies and risk management issues. She
has served as consulting and testifying experts for the US Securities
& Exchange Commission and is a member of the Standards Board of
the International Valuation Standards Council (IVSC). Dr. Ma can be
reached at CMa@HL.com or +1.212.497.7970.
keynote interview: HOULIHAN LOKEY
Issue 133 • September 2015 • privatefundsmanagement.net 29
Q&A: The new normal
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