Since February 2020, uncertainty associated with COVID-19 and related government and public health officials’ actions to reduce the spread of the virus has resulted in dramatic public market volatility and significant economic uncertainty. During this crisis, with unemployment skyrocketing, vast segments of the global populace sheltering in place and an unknown end to the pandemic, investment companies need to exercise significant informed judgment, as they estimate and report to investors the fair value of non-traded and infrequently traded investments, especially as of March 31 and June 30, 2020.
Investment company managers (general partners or GPs) and their investors (limited partners or LPs) consisting of sovereign funds, fund of funds, public and corporate pension plans, endowments, family offices, insurance companies, etc., have a fiduciary duty to measure and report investments at “fair value” These values are used for financial reporting requirements, asset allocation, incentive compensation, portfolio construction, beneficiary transactions, among other purposes.
Fair value is defined by Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Topic 820 as the “amount that would be received in an orderly transaction using market participant assumptions at the measurement date.”
Public market volatility, the expanding uncertainty and unknown duration, and the ultimate economic impact of COVID-19 creates a situation where it is more difficult to apply judgment in determining fair value, especially in the midst of the crisis during the first two quarters of 2020. Yet, fair value must be determined consistently and objectively even in a highly subjective and rapidly changing environment. Fortuitously, in August 2019, the American Institute of Certified Public Accountants (AICPA) published an Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (AICPA PE/VC Guide or the Guide). The Guide provides examples and answers to numerous questions to assist investment companies in exercising judgment when estimating the fair value of private investments.
Fair Value Framework
While market perceptions, government actions and individuals’ behavior are changing rapidly in the current environment, the framework for determining fair value remains consistent. In general, fair value is determined by taking into account the answers to the following questions, including, but not limited to:
- What is “known and knowable” as of the measurement date?
- What is an “orderly” transaction?
- Does an investee company have sufficient liquidity to survive the current economic environment?
- How would market participants transact (especially in times of increased uncertainty)?
- What are the drivers of value–revenue/customers, cost, growth, competition, market conditions, supply chain, operations, etc.?
- How much weight, if any, should be placed on recent or observable market transactions?
- What are the short-term, medium-term and long-term impacts of a market disruption on the business and operations of an investee company?
- How should the potential for extended economic dislocation and potential recession be considered?
- How should potential or actual government and central bank fiscal and monetary actions be reflected?
There are numerous other factors and judgments required in estimating fair value, but for purposes of this discussion, the above highlight many of the key considerations.
It should be noted that historically, private investments were generally less volatile than actively traded public market investments. During a rapid public market upswing, private investments tend to lag and increase in value less steeply. During periods of rapid market downturns, private investments tend to decrease in value less steeply. This is because the drivers of value for non-traded or infrequently traded investments are not specifically or uniquely tied to the second-by-second trading vagaries of the public markets.
Estimating Fair Value in the Current Environment
When estimating the fair value of private investments as of March 31 and June 30, 2020, it is important to thoughtfully and objectively consider the impact of the significant uncertainty created by the rapidly spreading COVID-19 virus and the ancillary impacts on the global economy and public markets. More importantly, when estimating fair value for a specific investment, both the macro environment and investment-specific value drivers should be considered. These include, but are not limited to, the following:
- At a macro level, the current crisis is no different than any other external impact (e.g., significant public market volatility, Brexit, political events, natural disasters, etc.). Yet, in many ways, this crisis is unique in modern history. Curtailing travel, sheltering in place and closing non-essential businesses are dramatically impacting employment, certain industries and economic growth. A recession is highly likely if it has not already begun. The impact on the value of a specific investment should reflect a market participant’s consideration of uncertainty in the macro environment. It is clear that uncertainty has increased, and therefore a market participant would take the increased uncertainty and greater risk into account when determining the amount, they would pay for an investment. The increased risk generally translates into an increased required rate of return and thereby lower asset prices.
- Public market volatility indicates increased uncertainty, but as a result may or may not be useable as a benchmark with respect to a specific non-traded or infrequently traded investment. Uncertainty may differ by geographic region, industry and other factors.
- On the individual investment level, consideration should be given to the short-, medium- and long-term impacts of the pandemic on the investee company’s liquidity and performance compared to prior and future expectations. What is the impact on customers (revenue), supply chain (costs and delivery times), employees (productivity and availability) and growth? In most cases, if not all, it would be expected that projections should be updated to take into account, to the extent knowable, the impact of the crisis and economic decline. A market participant would expect to see updated projections. If updated protections are not available, value drivers may need to be adjusted to account for increased risk and uncertainty.
- Up-to-date projections should be used with appropriate value drivers to estimate fair value. Care should be taken not to double count the impact of uncertainty. For example, if projections have been updated, it may not be necessary to reflect an increased company-specific risk premium (alpha) at the same magnitude, as would be required if projections have not been updated. Similarly, if projections have been updated, it may not be necessary to reflect a change in market multiples, or credit spreads, at the same magnitude as that indicated by changes in comparable public companies or actively traded investments. Value drivers will also need to be updated congruent with projections to which they are applied.
- In all cases, a market participant viewpoint should also be considered–how would a market participant think about increased risk and uncertainty?
- All judgments, supported by objective data and subjective considerations, should be clearly documented to support the ultimate fair value conclusion.
Of critical importance, especially in this crisis environment, is for LPs to receive timely fair value information (estimated for underlying investments as described above) from their GPs. LPs generally use last reported net asset value (NAV) as the starting point for estimating the fair value of their limited partnership interests. As of March 31, 2020, last reported NAV is likely as of September 30, 2019 or December 31, 2019 given normal GP reporting cycles. As of June 30, 2020, last reported NAV of March 31, 2020 will hopefully be available, but intervening impacts on underlying portfolio company valuations may not yet be reflected. For LPs to prepare their own March 31, 2020 and June 30, 2020 financial statements, to exercise their fiduciary duty and to make critical real-time decisions in a crisis environment, they must have relevant and reliable fair valued based NAV as of March 31, 2020, and again as of June 30, 2020, as quickly as possible after the quarter end.
Estimating fair value requires significant informed judgment in the best of times. The current economic environment requires enhanced consideration of individual facts and circumstances with a rapidly changing macro overlay. Some will second guess what was known and knowable as of March 31, 2020 and the impact on value from the second quarter of 2020. However, following robust established valuation processes, exercising informed judgment and following the concepts outlined in the AICPA PE/VC Guide, will help demonstrate the rigor applied and the reasonableness of the judgments used in estimating fair value at all measurement dates, especially as of March 31 and June 30, 2020. In the current environment with increased risk and uncertainty, investors need more than ever for fair value judgments to be sound.
