Article

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

March 31, 2021 · Authored by Lauren Hayes, Sylvia Dyke

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 an absence of market activity for the investment and significant management judgments or estimations are required to develop valuation input to be 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 vast majority of the entire set of 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 or healthcare 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 things that can be done to help make the process easier. A few things to consider when moving into year-end valuations and the annual audit, including:

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” (the Guide). This details out 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 as to what auditors need or are expecting.

Selecting valuation methodologies

One of the most specific points from the Guide is the types of valuation methodologies utilized. Valuations will usually be based on the following methodologies: discounted cash flow method; comparable company analysis; comparable transaction method; asset-based valuation method; sum of parts valuation method; or prior transaction method. A well-performed valuation generally uses multiple approaches – at least two or three – and weights the values to come up with a final valuation. Should you currently only prepare your valuation with one methodology, try utilizing other approaches for a blended fair value.