Developing a robust valuation policy is a critical area for investment fund managers. Recent SEC enforcement actions as well as heightened expectations from investors have put pressure on funds to reassess or revise their valuation policies to ensure soundness and compliance. This is especially important for policies around private portfolio companies in which valuations require significant judgment.
In developing valuation policies, fund managers face a number of challenges in complying with GAAP, disclosing the policies accurately to investors, and applying them consistently and properly. The AICPA has issued guidance to help investment companies, auditors, and valuation specialists in this process. This article highlights some of the SEC’s top enforcement areas around valuation policies and discusses the key AICPA principles that funds should consider when reassessing or revising their valuation policies and procedures.
The Importance of a Robust Valuation Policy
The Investment Advisers Act of 1940 requires fund managers to create written policies and procedures “reasonably designed to prevent violation of the Advisers Act by the adviser or any of its supervised persons.” Policies and procedures around the valuation of portfolio assets, particularly illiquid assets that are difficult to value, have come under increased SEC scrutiny with a recent rise in enforcement actions.
The SEC has cited a number of deficiencies, including policies and procedures that are not followed or not enforced; a lack of policies and procedures to oversee compliance by service providers; a lack of annual reviews of policies and procedures or inadequate documentation of annual reviews; and annual reviews that did not address the adequacy of the policies and procedures and the effectiveness of their implementation.
In August of 2019, the AICPA published a guide, titled Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (Valuation Guide), which describes the key principles that valuation policies and procedures should include. Fund managers can arm themselves against SEC scrutiny by ensuring their valuation policy addresses these key principles.
Key Principles of a Valuation Policy
The Valuation Guide details select key principles that fund managers should consider when developing and maintaining a valuation policy: (1) unit of account; (2) valuation methodologies; (3) significant inputs; (4) outputs and conclusions; and (5) administration.
- Unit of Account: A valuation policy should address how the fund defines the unit of account and should ensure that the definition is in line with how market participants transact. In other words, the valuation policy should address the level at which the fund will perform its valuation of an asset. For example, assume a fund holds an investment in both debt securities and common stock of a portfolio company. Should the fund assess the enterprise value of the portfolio company as a whole and then allocate the value to the individual positions?
Defining the unit of account for investments in portfolio companies can be challenging, as a fund may own multiple types of investments within an entity or hold significant positions that allow it to influence the direction of the portfolio company. Fund managers should consider their planned investment exit strategies and ensure that the unit of account defined in their policies aligns with those strategies. They should also establish the unit of account to be the enterprise, individual investments, an entire position of each investment type (e.g., the entire mezzanine debt position, the entire stock position, etc.), or a grouping of debt and equity together, depending on how market participants would likely transact.
- Methodologies: The valuation policy should clearly explain the valuation methodology and the reasons for any methodology changes. For example, to value an early stage portfolio company with no revenue, a fund might use calibration, which is the process of aligning the model (or process) used for valuation to the transaction price that represents fair value on the purchase date. The fund might then change the valuation method to a market or income approach as the company matures. To avoid the appearance of bias in making the change, the policy should explain how the valuation methodologies consider certain developments in the portfolio company.
- Significant Inputs: Significant inputs used in a valuation should be clearly identified and analyzed individually and in the aggregate to evaluate their reliability, relevance and reasonableness. Changes to inputs should be monitored for indications of bias. Valuations should also maximize the use of observable inputs and minimize the use of unobservable inputs. For unobservable inputs, funds should have benchmarks by which to address changes in assumptions relative to changes in value and should calibrate the input to a transaction in the portfolio company’s investment instruments. This calibration is critical, as it provides a position to support the use of unobservable inputs. For example, the SEC has imposed sanctions on fund managers for using valuation models based on unobservable inputs when data related to trades of similar securities was available. The SEC has specifically cited the fund manager’s failure to calibrate its significant unobservable inputs back to these trades.
- Outputs and Conclusions: Management should review valuations at an adequate level of detail to detect material misstatements and should review financial statement disclosures to ensure that they are consistent with valuations. Fund managers should also ensure that valuations are reviewed by individuals who have the appropriate skill sets to; understand the methodology and key inputs used; evaluate the methodology and key inputs to ensure they are reasonable and unbiased by competing interests; and have a sufficient understanding of GAAP in order to identify deviations from required accounting principles. In a recent action, the SEC charged that a fund’s valuation committee violated these principles, as it utilized the fund manager’s relatives and other people without relevant expertise.
- Administration of the Process: The valuation process should be supported by detailed policies and procedures that comply with the principles addressed in the Valuation Guide. This requires fund managers to assess whether their policy adequately describes how valuations are documented and reviewed, the qualifications of those performing the reviews, and how those reviews are documented.
Using Third Parties
In addition to designing a robust valuation policy, fund managers should ensure continuous compliance with their policies and procedures and document their valuations sufficiently. Using a third party to prepare its valuation policies and or analyses does not remove the fund’s responsibility for the valuation conclusions. Fund managers should determine and document that the third party has the relevant experience and expertise based on the type of investment valued, that the methodologies comply with the fund’s policies, and that the significant inputs are appropriate.
How Weaver Can Help
Weaver understands valuation policies and their role in providing comfort and transparency to regulators and investors. Accordingly, Weaver has the experience to advise fund managers on ways to incorporate the key principles outlined above into their valuation policy. If you have questions, please contact us or visit our website for more information.
Authored by Danielle Darley, CPA.
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