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AICPA PE-VC Task Force Update

American Institute of CPAs®

Task Force Mission

Task Force objectives are —Harmonize the diverse views of industry participants, auditors and valuation specialistsProduce a more user friendly guide with examples that can be used to reason through real situations faced by valuation specialists and auditors

Working title:Determining Fair Value of Portfolio Company Investments of Venture Capital and Private Equity Firms and other Investment Companies

Why a New Accounting & Valuation Guide?

ConcernsDiversity in practice contributes to fair value measurements that are not consistent or comparable between investment companies year-over-yearIncreased PCAOB and SEC scrutiny have put pressure on the industry and the audit firms to provide better support for valuation conclusions

Industry Assumptions vs. U.S. GAAP/IFRS Fair ValueInvestors typically are most focused on the ultimate exit for an investment; however, fair value focuses on market participant assumptions in an assumed transaction on the measurement dateConceptually challenging to reconcile market participant assumptions and investment objectives

Current Resources

Cheap Stock Guide (June 2013), focused on equity securities issued as compensationIPEV Valuation Guidelines (December 2012), focused on later stage controlling investments; deferred discussion of enterprise-value allocationsAICPA Audit and Accounting Guide: Investment Companies, which is focused primarily on accounting and auditingAICPA Investment Companies TPAs (TIS 6910)PEIGG – U.S. Private Equity Valuation Guidelines

Co-chairsMark Hayden (Deloitte)Sean McKee (KPMG)

Valuation SpecialistsTravis Chamberlain (CLA)Massimo Messina (GT)Amanda Miller (EY)Ray Rath (Globalview)

AuditorsDale Thompson (BDO)Belanne Ungarelli (PwC)

Industry ParticipantsScott Burger (KPCB)Timothy Curt (Warburg)Quintin Kevin (Adams Street)David Larsen (IPEV, Duff & Phelps)

Task Force Members

Projected Time Line

Mar 2013 Mar 2013 —Mar 2014

Mar 2014 —Apr 2016 Spring 2016 Summer 2016

Outline► Developed

consensus on topics to be covered in the Guide

► Received FinREC approval

Strategy► Subgroups tackle

specific topics; full TF reviews

► Work through examples to build consensus

Initial topics addressed:► Unit of account and

the assumed transaction

► Market participant assumptions

Coordination► Periodic meetings► Frequent callsStrategy► Subgroups tackle

controversial topics► AICPA staff and TF

members draft the guide

Objective► FinREC’s mission is

to determine AICPA’s technical policies regarding financial reporting standards and to improve financial reporting

► FinREC reviews and approves all financial reporting aids, guides, etc. and proposals thereof

Comments► All stakeholders

invited to comment

► Task Force analyzes all comments and modifies the Guide as necessary

► Revised guide is reviewed and approved by FinREC for final issuance

1. Approve Outline 3. Drafting 4. FinREC

review/appr.2. Establish Framework

5. Issue proposal

Outline

0. IntroductionA. Purpose & scope – focused on Portfolio Company Investments of Private

Equity, Venture Capital and other Investment CompaniesB. Existing body of knowledge

I. Fair value and relevant conceptsA. U.S. GAAP and other sourcesB. Best practices

II. Overview of the Industry and its Investment Strategies

III. Market participant assumptionsA. Industry participantsB. How investments are evaluatedC. Holding period and exit strategiesD. Pricing, risk, illiquidity

Outline (continued)

IV. Determining the Unit of Account and the Assumed Transaction for Measuring the Fair Value of InvestmentsA. ASC 946 definitionB. ASC 820 “economic best interest” and “maximizing value” conceptsC. Level of control considerationsD. Examples

- 100% of equity held within a single fund (single reporting unit)- 45% of equity held in each of two funds managed by the same GP- Club Deal, 30% of equity held in each of three funds with different GPs- Entity with large unused NOLs- Debt and equity held within a single fund under the same GP- Debt and equity held in different funds under the same GP- Equity or Debt Investment with Options/Warrants- Multiple Investments in different classes of Equity (Series A, B, C, etc.)- Private Investment in Public Equity (PIPE)

Outline (continued)

V. Overview of valuation approaches and methodsA. Market, income, and asset approaches

VI. Valuations of equity and debt in simple capital structuresA. Typical pricing methods and calibrationB. Enterprise value as a starting pointC. Updating fair value measurement in the absence of recent transactionsD. Common pitfalls

VII. Valuations of equity and debt in complex capital structuresA. Typical pricing for complex investmentsB. Impact of differing rights and privileges C. Allocating equity valueD. Common pitfalls

VIII. Control and marketability

Outline (continued)

IX. CalibrationX. Transaction Costs

A. Impact at initial recognition and when exit is imminentB. Accounting for transaction costsC. Examples

XI. Special SituationsA. Options, warrants, contingent consideration, PIPEsB. Pre-revenue companiesC. Distressed situationsD. Rights and privileges not enforced

XII. AppendicesA. Case studies – Investment Summaries and Valuation ExamplesB. Checklists

Determining the Unit of Account and the Assumed Transaction for Measuring Fair Value

FASB ASC 820 “assumed transaction” for measuring fair value is an exit from the investment on the measurement date• But transactions at intermediate dates rarely happen!

Establish a framework that makes sense for the industry• How does the requirement under FASB ASC 820 to measure fair value

based on an assumed sale or transfer of the Fund’s investment on the measurement date consider market participant assumptions regarding the way that value is expected to be realized from the investment?

• How does the fair value measurement under FASB ASC 820 take into account the strategy that market participants would use to maximize value from the investment, considering their economic best interest?

Status• TF established principles and applied them to examples• Draft chapter submitted to FinREC for approval ym1

ym1 Not sure what to do with this bullet. Maybe replace it with "Draft chapter to be discussed with various stakeholders"?

However, please don't mention SEC/FASB review (in the slides or during the actual presentation) - just say that we'll discuss the chapter with national offices, industry representatives and FinREC to make sure everyone is confortable with the proposed approach.

ym, 9/22/2014

Market Participant Assumptions

Set context for measuring fair value – frame conversations considering the industry perspective:

• What characteristics do market participants consider when evaluating portfolio company investments?

• How do market participants establish their required rate of return, considering the risks and illiquidity of the investment?

• How do market participants consider the expected holding period and the possible ultimate exit strategies for the investment?

• What information do market participants require when evaluating an investment? How do investors make decisions when less than perfect information is available?

Status• Several case studies based on real-world examples developed to ensure

coverage of many different industries, types of investments, investment and exit strategies – follow each investment from issuance to exit

• Primary topic of recent in-person TF meeting (May 2014) ym3

ym3 Do we want to keep this bullet? If so, i would replace "recent" with "last"ym, 9/22/2014

Summary

AICPA PE/VC Task Force mission is to promote consistency and build consensus among stakeholders from industry, audit and valuation• Leverage existing guidance to the extent possible, but recognize the

gaps • Provide industry participants, auditors and valuations specialists with a

one-stop resource

Looking to issue a working draft for comments in 2016

AICPA Technical Practice Aids TIS 6910.34-35

Recent AICPA releases

In February 2013, AICPA released two new technical practice aids (TPAs), TIS Section 6910.34 and 35• Application of the Notion of Value Maximization for Measuring

Fair Value of Debt and Controlling Equity Positions• Assessing Control when Measuring Fair Value

Goal of these TPAs was to answer questions related to a couple of key areas of diversity in practice

Provide a rationale for the assumptions commonly used in the industry, within the GAAP framework

Value Maximization for Measuring Fair Value of Debt and Controlling Equity Positions

Suppose a Fund holds both debt and a controlling equity interest• From a strategy perspective, view these investments in aggregate –

typically will exit both positions at the same time• From an accounting perspective, the debt and equity typically must be

reported separately on the Schedule of InvestmentsValue maximization (ASC 820-10-35-9)

What does this principle imply in this situation?

A reporting entity shall measure the fair value of an asset or a liability using the assumptions that market participants

would use in pricing the asset or liability, assuming that market participants act in their economic best interest.

A reporting entity shall measure the fair value of an asset or a liability using the assumptions that market participants

would use in pricing the asset or liability, assuming that market participants act in their economic best interest.

Implications

May aggregate debt and equity for measurement, using an “enterprise value” approach:• May be appropriate to consider an assumed transaction that

includes both the debt and the controlling equity position if that is how market participants would transact

• If so, must also perform an allocation to debt and equity positions, on a “reasonable and consistent basis”

Typical practice: consider par value for debt, treat equity as enterprise value less debtPossible changes to practice based on TPA:• Consider payoff value to debt instead of par value, OR• Consider fair value of debt, include extra value as equity

(especially if own less than 100% of the equity)

Example – Fund owns 60% of equity, 100% of debt.BEV $200m; Debt $100m par / $80m fair valueSell enterprise on measurement date

Transfer interest to realize value over time horizon

► Equity = $100m► Fund’s interest:

► Equity = $120m► Fund’s interest:

Equity $60mDebt $100mTotal $160m

Equity $72mDebt $80mTotal $152m

Assessing Control when Measuring Fair Value

Suppose control is split across multiple funds (e.g. two sister funds under the same GP, or a club deal)• From a strategy perspective, view these investments in aggregate –

typically all investors will exit the position at the same time• From an accounting perspective, may not aggregate across multiple

funds for the purposes of assessing the assumed transaction

Defining the “asset” (ASC 820-10-55-1)

What does this principle imply in this situation?

The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset … would take place between market participants at the measurement date under current market conditions. A fair value measurement requires a reporting entity to determine all of the following:a. The particular asset or liability that is the subject of the measurement (consistent

with its unit of account…

The objective of a fair value measurement is to estimate the price at which an orderly transaction to sell the asset … would take place between market participants at the measurement date under current market conditions. A fair value measurement requires a reporting entity to determine all of the following:a. The particular asset or liability that is the subject of the measurement (consistent

with its unit of account…

Implications

The unit of account cannot be greater than what the reporting entity (e.g. the Fund) ownsNevertheless, market participants may place value on being part of the controlling group that has the right to determine the company’s strategy. Consider:• Could the controlling group sell the company on the measurement

date?• Are the interests of the members of the controlling group truly aligned?

Typical practice: value business on a controlling basis, value interest within each Fund as its pro-rata sharePossible changes to practice based on TPA:• Describe rationale for using controlling enterprise value as

“the value of the investor units must be no lower than the value they could realize by selling the business today”

Example – Funds collectively own 100% of A Units.Equity $125m; management gets 15% above $110m.Sell enterprise on measurement date

Transfer interest to realize value over time horizon

► A Units = $110m plus85% of $15m ($12.75m)

► Management would get 15% of $15m ($2.25m)

► Funds’ interest:

► Management units have option value ($4.4m)

► Treat this additional value as incremental, not dilutive (total equity => $127.2m)

► Funds’ interest:Liquidation Preference

$110.0m

Upside $12.8m

Total $122.8m

Liquidation Preference

$97.7m

Upside $25.1m

Total $122.8m

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