While reporting investments at fair value has been required since 1940, the modern era of fair value reporting has its roots in Statement of Financial Accounting Standards No. 157 issued by the Financial Accounting Standards Board in 2006. Of more direct and timely relevance for pension plan and other institutional investors, however, is the fact that 2018 has proven to be one of the most impactful years with respect to valuation since SFAS 157 was issued. And 2019 promises more change, as a veritable alphabet soup of guidelines and regulation will impact both pension plan investors and the managers of the funds they invest in.
As a bedrock principle, these stakeholders and the funds they invest in are required to report their investments at fair value, defined as the amount that would receive in an orderly transaction at the measurement date, as dictated by applicable accounting standards issued by the FASB, Government Accounting Standards Board or International Accounting Standards Board.
While the concepts of estimating fair value are well established, they do require significant judgment to withstand scrutiny and achieve the stated objective of more transparent, defensible valuations that provide relevant, reliable and useful information. The regulations and standards described carry with them real implications, among them:
- Both pension plan investors and managers will need to improve valuation rigor and expand due diligence.
- Pension plan investors will need to improve monitoring or existing fund valuation practices to ensure compliance.
- When valuing direct or co-investments, pension plan investors must ensure that they fully understand and have implemented these regulations and best practices.
Given these consequences — which are now applicable — a brief primer on new and existing guidelines and regulation will be of significant value. These include:
In March, the Alternative Investment Management Association released its updated "Guide to Sound Practices for Hedge Fund Valuation." The guide reflects the changes in the markets and industry with respect to valuation since the previous version was released in 2013. The number of recommendations has been expanded by one, to 17, and a number of the existing recommendations have been enhanced and updated to reflect trends in valuation processes. This version of the guide also better reflects the valuation practices that have developed in the wake of the implementation of the European Alternative Investment Fund Managers Directive. In particular, there is a focus on valuing debt investments and not placing inappropriate reliance on broker quotes or pricing services.
In May, the American Institute of Certified Public Accountants released a working draft of an accounting and valuation guide, titled, "Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies." The guide has been under development for more than five years. The purpose of the guide is to help harmonize the diverse views of alternative investment industry participants, auditors and valuation specialists and to create a user-friendly treatise with case studies that can be used to reason through the valuation judgments faced by investment fund managers, valuation specialists and auditors on a regular basis. The guide throughout its more than 650 pages is rich with examples and will help improve consistency in valuing debt and equity investments. It also includes a section on how to determine the fair value of fund interests.
Last updated in 2015, the "International Private Equity and Venture Capital Valuation Guidelines" is being revised. The 2018 update is expected to enhance guidance with respect to valuing early stage and debt investments. Many fund agreements, especially for European funds, require compliance with the IPEV valuation guidelines. Demonstrating compliance with the IPEV valuation guidelines can assist investors in establishing a basis for using reported net asset value to estimate the fair value of a fund interest.
The International Valuation Standards Council seeks to be seen as a global standard setter for valuation practices and the valuation profession, serving the public interest. The IVSC has several working groups determining to what extent new valuation standards with respect to valuing financial instruments are needed. In particular, the potential need for creating standards for valuing financial instruments — with a focus on governance, framework, data sources and the impact on financial reporting — is being considered. Compliance with IVSC standards is an appropriate due diligence question which pension fund investors may pose.
RICS, ASA and AICPA
In early 2017, representatives from AICPA, the Royal Institution of Chartered Surveyors and the American Society of Appraisers at the encouragement of the Securities and Exchange Commission created the Certified in Entity and Intangible Valuations credential. Accompanying the CEIV credential are the Mandatory Performance Framework and the Application of the Mandatory Performance Framework documents. The MFP and AMPF were developed for all valuation professionals and, together, they provide guidance about how much support, in terms of scope of work delineation and documentation, to prepare or obtain when designing, implementing and conducting valuations for financial reporting purposes. There are preliminary indications that auditors may expect clients to have applied the MPF in the valuation process in advance of the 2018 year-end audit process.
AICPA has recently released for consultation the Financial Instruments Performance Framework with its associated credential, Certified in Valuation of Financial Instruments. The FIPF and CVFI are similar to the MPF and CEIV but are more specifically focused on financial instruments. Given that debt and equity investments are financial instruments, both the MPF and FIPF will apply and may need to be incorporated into pension fund investors and their fund managers' valuation processes.
In June 2017, the Public Company Accounting Oversight Board issued proposed audit standards focused on auditing estimates including fair value measurements. Finalized standards are expected to be issued in the fourth quarter. The proposed standards may require auditors to expand procedures when auditing fair value measurements. In particular, auditors will likely need to expand audit procedures if a pension plan or external manager values investments using broker quotes with limitations or pricing services without sufficient transparency.
Fair value accounting, for both pension plan investors and their investment managers, requires the application of informed judgment to ensure that reported values are robustly determined. The alphabet soup of guidelines described is intended to improve the relevance, reliability and comparability of fair value estimates. These guidelines are expected to provide best practice guidance so that pension plan investors and their managers, along with regulators, auditors and independent valuation service providers are all on the same page, ensuring that judgment is exercised consistently in estimating the fair value of illiquid debt and equity investments. To the extent that pension plan investors or their fund managers' valuation processes are inconsistent with this alphabet soup of guidance, steps should be taken to enhance the valuation process.
The emphasis on judgment in evaluating relevant factors consistent with market participant assumptions, combined with more robust documentation, is the cornerstone of these expanded best practices.
David Larsen is a managing director with Duff & Phelps, based in San Francisco. He is an adviser to the IPEV board, a member of the AICPA PE/VC valuation guide task force and the IVSC financial instruments working group and is a former member of FASB's valuation resource group. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.