Valuation of Level 3 portfolio companies: Why is it so important, and how can I help make the audit process easier?

Private equity funds are required to conform to FASB ASC 820 Fair Value Measurements and Disclosures, which establishes a hierarchy used to measure fair value. Investments with limited market activity for which the investment and significant management judgments or estimations are classified as Level 3 investments. Level 3 investments must have a valuation completed to determine the fair value at each year-end. 

A private equity fund’s balance sheet and income statement are typically minimal, and the majority of the financial statements revolves around the annual valuation. As a result, valuations are at the heart of most private equity audits. Whether the fund invests in privately held oil and gas, manufacturing, real estate healthcare, technology companies or anything else, determining the fair value at each year-end is paramount to both the private equity fund and the auditor. Consequently, this is often the most difficult part of the audit of Level 3 investments for everyone involved, as key inputs – such as discount rates and multiples – are subjective and can result in large variances in fair value conclusions.

From a fund manager perspective, there are several steps that can be taken to help make the process easier. A few things to consider when moving into year-end valuations and the annual audit, include:

Consulting the AICPA guide

Starting with its June 1, 2019, issuance, the American Institute of Certified Public Accountants (AICPA) releases an annual “Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” (otherwise known as 'the Guide'). This details best practices for the valuation of investments in this space. Most firms, including Baker Tilly, have whitepapers summarizing some of the key components of this – many of which will be covered in this article. This is a resource and starting point when preparing valuations, as it will provide insight into auditor expectations..

Selecting valuation methodologies

One of the most specific points from the Guide is the types of valuation methodologies utilized. Valuation methodologies fall into one of three valuation approaches: market approach, income approach and asset (also commonly referred to as cost) approach. Common market approach methodologies include the comparable company analysis and the comparable transaction method. The discounted cash flow method is the most common of income approach methodology. The asset approach includes asset-based valuation (fair market value of assets less liabilities) and sum of the parts valuation method..