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Fair Value Measurement

Best Practices  

for Firms Subject to the Investment Company Act of 1940

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Presentation Outline

01. International Private Equity and Venture Capital Valuation Guidelines (December 2012)

02. CFA Institute Global Investment Performance Standards (2010)

03. Key Takeaways

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01. International Private Equity and Venture Capital Valuation Guidelines

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Determining the Unit of Account

Multiple Tranches •  Unit of Account determined on same basis that

Market Participants would transact (single instrument or bundle)

Debt Only •  Unit of Account likely individual debt instrument;

fair value based on yield analysis

Debt and Equity •  Depends on transaction structure of market

participants. In general, private equity investors often invest in concert with one another and realize value only when entire business is sold. Unit of account should be assessed accordingly

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Fair Value Measurement: Conceptual Considerations

To measure fair value of unquoted investments, assume the underlying business is realized or sold at the measurement date, appropriately allocated to various interests, regardless of readiness for sale or intent to sell

•  If multiple investment tranches owned by fund would be transacted simultaneously, they should be valued in aggregate

•  Assume that necessary marketing activities have been completed to allow for hypothetical exchange on measurement date

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Fair Value Measurement: Apportioning Attributable Enterprise Value to Financial Instruments

Incorporate effect of ratchets or other contractual rights in fair value measurement

•  Assume that in-the-money options and warrants are exercised (adjusting for both share count and exercise proceeds)

•  Significant option and warrant positions may need to be valued separately using an appropriate option pricing model

•  When debt must be repaid upon sale of the underlying business, assume FV equal to amount to be repaid

•  If debt would not be repaid, fair value of debt, amount deducted from enterprise value may differ from par value

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Valuation Methods: Selection

Factors to consider: •  Nature of industry and current market conditions

•  Quality and reliability of data used

•  Comparability of enterprise or transaction data

•  Development stage of enterprise

•  Profitability and cash flow attributes of enterprise

•  Unique facts and circumstances

•  Results of calibration analysis

•  Maximize use of techniques that draw heavily on observable market-based measures of risk and return

•  DCF and industry benchmarks should rarely be used in isolation from market-based measures

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Valuation Methods: Price of Recent Investment

Generally most appropriate for early stage companies subject to frequent funding rounds

•  Quality of valuation indication will erode over time

•  Evaluate whether price represented fair value at the time

•  Difference in economic and governance rights

•  Disproportionate dilution of existing investors

•  Strategic motivations of new investor

•  Forced sale or ‘rescue package’

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Valuation Methods: Multiples

Most applicable for investments in established businesses with identifiable stream of maintainable earnings

Steps in applying technique:

1.  Apply appropriate and reasonable multiple to maintainable earnings to derive Enterprise Value

2.  Adjust Enterprise Value for surplus or non-operating items, contingencies, and other relevant factors to derive Adjusted Enterprise Value

3.  Deduct value attributable to senior financial instruments, taking into account potentially dilutive features to derive Attributable Enterprise Value

4.  Apportion Attributable Enterprise Value to relevant instruments using market participant perspective

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Valuation Methods: Multiples

Multiples of total invested capital generally most appropriate because of role of financial structuring in private equity

•  Multiples at acquisition should be calibrated to relevant set of comparable companies

•  Presumption is that multiples based on public company stock prices are indicative of the value of the company as a whole

•  Multiples may be expressed in terms of ‘current’, ‘forecast’, or ‘historical’ earnings, and should be matched to character of maintainable earnings

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Valuation Methods: Net Assets

Likely appropriate for business whose value derives mainly from underlying fair value of assets rather than earnings

Potentially appropriate for unprofitable or marginally profitable businesses

Steps in applying technique:

1.  Derive Enterprise Value by measuring value of assets and liabilities

2.  Deduct value attributable to senior financial instruments, taking into account potentially dilutive features to derive Attributable Enterprise Value

3.  Apportion Attributable Enterprise Value to relevant instruments using market participant perspective

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Valuation Methods: Discounted Cash Flows (Enterprise)

Flexible, but risky, valuation technique

•  Required inputs (detailed cash flow forecasts, terminal value, discount rate) require substantial subjective judgment

•  Indicated value often sensitive to small changes in inputs

•  Generally perceived to be more useful as a cross-check of values estimated under market-based techniques

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Valuation Methods: Discounted Cash Flows (Investment)

Most appropriate when: •  Exit is imminent

•  Exit pricing has been substantially agreed

•  Particularly suitable for valuation debt and mezzanine investments for which value derives mainly from instrument-specific cash flows and risks rather than from the value of the enterprise as a whole

•  For non-equity instruments, pre-defined terminal values enhance the reliability of the technique

•  Implied discount rate at initial investment should be adjusted over time for changes in market conditions

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Valuation Methods: Industry Valuation Benchmarks

Industry-specific benchmarks often based on assumption that investors are willing to pay for revenue and that normal profitability within the industry does not vary much

•  Reliable technique only in limited situations

•  Most likely to be useful as a sanity check against other valuation indications

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Valuing Fund Interests

May use attributable portion of NAV if: •  Reported NAV is appropriately derived using

proper fair value principles as part of a robust process

•  Fair value of underlying investments measured as of the same date as the fund interest valuation

•  Interests in the Fund are not actively traded

•  Management has not decided to sell the fund interest for an amount other than applicable portion of net asset value

Adjustments may be appropriate for: •  Timing differences

•  Potential performance or other fees payable

•  Other factors

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Valuing Fund Interests: Secondary Transactions

Data from secondary transactions must be considered if:

•  Relevant terms of the transaction are known

•  The transaction is considered orderly

•  Prices in secondary transactions may be influenced by factors beyond fair value and based on assumptions and return expectations unique to the counterparties

•  If secondary transaction prices are available, but secondary market not deemed active, prices should be augmented with other inputs, such as NAV

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Application: Other Considerations

Terms of internal funding rounds not necessarily indicative of fair value

•  When debt is trading at a discount to par, deduct par value from Enterprise Value unless the subject company has acquired the debt in the market and intends to cancel rather than repay

•  Bridge financing should be included as part of the overall investment being valued, if consistent with market participant perspective

•  When valuing PIK instruments, assess expected present value of amount to be recovered

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Application: Other Considerations

Impact of ratchets and other liquidation preferences should be assessed relative to the likelihood that the investor would receive benefit of full contractual right (in practice, full benefits may not be realized)

•  Mathematical option pricing models are rarely used by market participants, and have not seen wide usage in the private equity marketplace

•  Indicative offers may provide useful additional support, but are generally insufficiently robust to be used in isolation

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Application: Mezzanine Loans

Price at which mezzanine loan was issued generally reliable indicator of fair value at that date

• Should assess whether indications exist that loan will not be fully recovered

• Should assess whether changed in required yield are indicated

• Attached warrants should be evaluated separately from the mezzanine loan

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02. CFA Institute Global Investment Performance Standards

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Global Investment Performance Standards (2010): Private Equity Provisions

Recommended Provisions Required Provisions

Frequency of Valuation PE investments must be valued at least quarterly PE investments must be valued annually

Basis of Valuation The fair value basis is required The fair value basis is required

Valuation Methodologies Material differences between valuation used in performance reporting and financial reporting should be explained and disclosed Disclose valuation methodologies used in most recent period

Selected Methodologies & Assumptions Key assumptions used to value portfolio investments should be disclosed The selected valuation methodology must be the most appropriate for a

particular investment based on its nature, facts, and circumstances

Valuation Considerations

The following factors should be considered: 1.  Quality and reliability of data used in each methodology 2.  Comparability of enterprise or transaction data 3.  Stage of development of the enterprise 4.  Additional considerations unique to the enterprise

Changes in Valuation Method Disclose material changes to valuation policies and/or methodologies Disclose material changes to valuation policies and/or methodologies

Industry Valuation Guidelines

Disclose which, if any, industry valuation guidelines adhered to, in addition to GIPS

Disclose which, if any, industry valuation guidelines adhered to, in addition to GIPS

Investment Performance Multiples

Disclose multiples of committed and cumulative paid-in capital: 1.  Investment Multiple: Total Value to Paid-In Capital 2.  Realization Multiple: Distributions to Paid-In Capital 3.  Paid-In Capital Multiple: Paid-In Capital to Committed Capital 4.  Unrealized Capital Multiple: Residual Value to Paid-In Capital

Disclose multiples of committed and cumulative paid-in capital: 1.  Investment Multiple: Total Value to Paid-In Capital 2.  Realization Multiple: Distributions to Paid-In Capital 3.  Paid-In Capital Multiple: Paid-In Capital to Committed Capital 4.  Unrealized Capital Multiple: Residual Value to Paid-In Capital

Use of Valuation Hierarchy The valuation hierarchy (see next slide) should be used Disclose if the valuation hierarchy differs materially from the recommended hierarchy

Valuation Inputs Disclose the use of subjective unobservable inputs in valuing investments Disclose the use of subjective unobservable inputs in valuing investments

Independent Valuation Review Valuations should be obtained from a qualified independent third party Not required

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GIPS Valuation Hierarchy (Inputs)

1.  Objective, observable, unadjusted quoted market prices for identical investments in active markets on the measurement date

2.  Objective, observable quoted market prices for similar investments in active markets

3.  Quoted prices for identical or similar investments in markets that are not active

4.  Market-based inputs, other than quoted prices, that are observable for the investment

5.  Subjective unobservable inputs for the investment where markets are not active at the measurement date. Use these inputs only to the extent observable inputs and prices are not available or appropriate. Unobservable inputs reflect assumptions about the assumptions market participants would use in valuing an investment

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03. Key Takeaways

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Best Practices for Valuing Illiquid Portfolio Assets

Recognize that valuation matters, and it will really matter when something has gone awry

• Document valuation procedures to follow (and follow them)

• Designate a member of senior management to be responsible for oversight of the valuation process

• Create contemporaneous and consistent documentation of valuation conclusions and rationale

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Best Practices for Valuing Illiquid Portfolio Assets

Stay abreast of evolving best practices (or know people who do)

• Solicit relevant input from the professionals responsible for the investment, auditors, and third-party experts

• Check your math

• Disclose the process and conclusions - potential investors take comfort in transparency

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Contact Information

Travis W. Harms, CFA, CPA/ABV 901-322-9760 harmst@mercercapital.com

Jeff K. Davis, CFA 615-345-0350 jeffdavis@mercercapital.com

MERCER CAPITAL Clark Tower 5100 Poplar Avenue, Suite 2600 Memphis, Tennessee 38137 www.mercercapital.com

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Portfolio Valuation Services

Mercer Capital’s  

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About Mercer Capital

•  Business valuation and financial advisory firm founded in 1982

•  Core competency is the valuation of private equity and debt securities

•  Valuation and positive assurance opinions

•  Fairness and solvency opinions

•  Transaction advisory

•  Litigation support

•  400 assignments annually, primarily for domestic entities

•  40 employees (employee-owned)

•  Valuation and industry thought leaders

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Overview of Services

Valuation •  Tax compliance •  Corporate valuation services •  Employee Stock Ownership Plan valuation

Transaction Advisory Services •  Fairness and solvency opinions •  M&A and investment banking services •  Buy-sell agreements and private company transactions

Financial Reporting •  Private equity, mutual fund, BDC, and other investment

company portfolio valuation services •  Purchase price allocation •  Impairment testing services

Litigation Support •  Expert testimony •  Business damages •  Shareholder disputes / divorce

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Financial Reporting Valuation Services

Mercer Capital provides a comprehensive suite of valuation services to assist boards of directors, portfolio managers, financial managers and others with financial reporting requirements.

In an environment of increasingly complex fair value reporting standards and burgeoning regulatory scrutiny, Mercer Capital helps clients resolve fair value reporting issues successfully.

Mercer Capital fair value opinions are consistently accepted by the Big Four audit firms and other reviewing entities.

Our professionals hold the Accredited in Business Valuation (ABV) designation from the AICPA, the Accredited Senior Appraiser (ASA) designation from the American Society of Appraisers and the Charter Financial Analyst (CFA) designation from the CFA Institute.

Valuation Services for Investment Funds

•  Portfolio Investment Valuation •  Fairness and Solvency Opinions •  Litigation Support

Valuation Services for Portfolio Companies

•  Purchase Price Allocation •  Goodwill Impairment Testing •  409A / Equity Compensation Valuation

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Key Industry Verticals

Financials •  Depositories •  Asset managers •  BDCs •  Insurance •  Brokers and investment banks

Manufacturing •  Durable and non-durable goods •  Consumer and industrial

Healthcare •  Facilities companies •  Medical devices •  Staffing companies

Distribution and Transportation •  Wholesale distribution •  Asset-based transportation companies (all modes) •  Third-party logistics providers

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Senior Professionals

Jeff K. Davis, CFA

•  Managing Director

•  10 years with Mercer Capital

•  Spent 13 years as a sell-side analyst covering small- and mid-cap banks and specialty finance

•  Weekly editorial contributor to SNL Financial

Travis Harms, CFA, CPA/ABV

•  Senior Vice President

•  15 years with Mercer Capital

•  Extensive financial valuation reporting experience, including on behalf of private equity, BDCs and broker-dealers

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Senior Professionals

Z. Christopher Mercer, ASA, CFA, ABAR

•  CEO / Founder (1982)

•  Prolific author and thought leader on private security valuation

•  Has prepared and overseen over a thousand valuations for M&A, tax, litigation and other matters

Matt Crow, ASA, CFA

•  President

•  19 years with Mercer Capital

•  Senior member of Mercer’s financial reporting valuation group

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Senior Professionals

Timothy R. Lee, ASA

•  Managing Director

•  19 years with Mercer Capital

•  Heads corporate valuation group with industry focus in beverage, distribution, construction, retail and transportation

Andy Gibbs, CFA, CPA/ABV

•  Senior Vice President

•  14 years with Mercer Capital

•  Has completed hundreds of bank and loan portfolio valuations as head of the depository group for M&A, ESOP, and other purposes