Stout recently hosted a conference in Atlanta discussing issues, trends, and best practices related to valuation. The panel focused on recent enforcement actions with private funds and featured the following panelists:

• Jesse R. Morton, Stout, Dispute Consulting Director & Southeast Forensic Services Leader
• Jamie Spaman, Stout, Valuation Advisory Managing Director
• Matt Rogers, Stout, Dispute Consulting Director & National SEC and Accounting Practice Leader
• Peter Anderson, Eversheds Sutherland, Partner
• Jody Foster, Symphony Consulting LLC, President
• Kevin Brawner, Trident Fund Services, Senior Manager

The panel addressed a series of topics including:

• Why valuation is an enforcement priority for regulators
• Common valuation related issues
• Valuation related accounting rules, regulations, and guidance
• Best practices policies, procedures, and processes for valuing Level III assets
• Fund administrator roles and responsibilities
• Preparing for an audit or regulatory examination
• Key takeaways from recent valuation related issues and enforcement actions

The following is the first installment of our review of a recent expert panel discussion on enforcement actions involving private funds. In this installment, the panel discusses why valuation is an enforcement priority for regulators, common valuation related issues, and relevant accounting guidance. See the second installment for the panel discussion on best practices around valuing Level III assets and the benefits of using an independent third-party valuation specialist, and the third installment for the panel discussion on the impact of a recent enforcement action, how a fund can best prepare for an audit and regulatory examination, and how funds can best avoid regulator scrutiny of their valuation process.

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Jesse Morton kicked off the panel discussion by providing valuation-related background. Morton stated that the valuation of assets (and liabilities) is a critical topic because financial reporting requires that certain assets and liabilities be measured at fair value. FASB defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

While many assets and liabilities have readily determinable market values, some require fair value measurement to estimate a transaction price. Some examples include, but are not limited to, privately owned businesses, real estate, thinly traded securities, intellectual property, some mortgage-backed securities, and, more generally, complex security instruments. Since the valuation of these, and other, assets (or liabilities) often do not have readily determinable market values, the market values must be calculated using some estimates, which raises the risk of error and/or manipulation. Because funds use these valuations to calculate net asset value (NAV), manipulation and/or errors can result in misstated returns, incorrect purchase or redemption values, and improper tax calculations. In addition, scrutiny by regulators – most notably the SEC – and possible enforcement actions could result in penalties, fines, suspension, debarment, and/or the hiring of an independent third-party (often at a substantial cost) to oversee remediation.

Why Is Valuation an Enforcement Priority for Regulators?

Matt Rogers started by providing a background of the SEC’s purpose, which he believed helped put into perspective why valuation is such a priority for regulators. Rogers noted that the SEC’s focus is on investor protection, and that since investors rely on the valuation of underlying assets to determine a fund and public company’s total value, an accurate and reliable valuation is required to protect investors against manipulation.

Peter Anderson indicated that a prime example of why valuation is a priority for regulators was highlighted by an enforcement action that was released on the eve before the discussion. Specifically, Anderson noted that the SEC announced charges against the accounting firm Anton & Chia (A&C), which was charged with improper professional conduct related to their audit of three microcap companies. Among other charges, the SEC stated that A&C “accepted [company] management’s grossly inflated and wholly unsupported valuation of the company’s largest tangible asset.” Anderson, however, emphasized that typically the SEC’s enforcement actions are not about “legitimate differences of opinion”, but rather where there are “outrageous valuations.” Anderson noted that the A&C enforcement action fell into the “outrageous valuation” category based on the facts and circumstances highlighted in the press release.

Lastly, Kevin Brawner noted that from a fund perspective, the reason why valuation is so important is because it ultimately results in the calculation of the fund’s NAV, which is then used to determine the purchase price into the fund, the redemption price for investors who exit the fund, and the fees that investors pay the fund for managing their investments.

What Are Some Common Valuation-Related Issues?

Jamie Spaman responded that when valuing illiquid assets, either the firm, company, or a third-party provider is trying to figure out the price at which market participants would value an asset. Accordingly, whoever is performing the valuation must make certain assumptions including:

• What other market participants think of the asset being valued
• The selection of a valuation method
• The valuation method inputs. Observable inputs may be gathered from independent sources while unobservable inputs require assumptions about market participant opinions
• There will be a hypothetical transaction in an orderly market at the date of measurement
• Not applying an “investment lens” to the asset being valued – i.e., the firm holding the asset presumably purchased the asset for a determinable period of time for which they think there will be a gain in the future, so they are looking at the assets in a completely different way

These assumptions often are issues when performing a valuation because most of them require subjectivity and, therefore, it is not necessarily an exact science.

Provide an Overview of the Accounting-Related Rules, Regulations, and Guidance.

Brawner provided a brief overview of the accounting related rules, regulations, and guidance most directly relevant to valuation. Brawner started by describing ASC 820 (previously FAS 57), which has been in effect for about 10 years. ASC 820 defined “fair value” and provides a framework for getting to a valuation, which includes improving and expanding the number of disclosures that are required for valuing assets and liabilities. ASC 820 also requires asset managers to categorize assets and liabilities into three different categories, as follows:

• Level I: These are the most easily valued assets because they are readily marketable, have a liquid market, and have readily available pricing. An example of a Level I asset is a security that trades regularly on a stock exchange such as the NYSE.
• Level II: These are ‘hybrids’ of Level I and Level III because they are sometimes traded on open markets but are very thinly traded and there is not necessarily a liquid market. An example of a Level II asset is a security that is traded on a stock exchange or pink sheets, but is traded very infrequently so the price is not readily determinable.
• Level III: These are harder to value assets where there is no publicly traded market and where pricing inputs are not readily determinable.

Spaman noted that the line between a Level II asset and a Level III asset is sometimes “blurry,” especially when a firm is getting different trading prices and quotes from different brokers.

Brawner also explained that ASC 820 requires significant disclosures in the financial statements related to Level III assets, including tables in terms of what the inputs are in the models used for valuation, ranges in the models, sensitivity of the inputs, risks related to the inputs, and significant disclosure around valuation methodologies.

Anderson noted that from an investor perspective, the importance of Level III assets and the related disclosures is that it tells them that the assets are illiquid, so there likely will not be an “easy exit” from the asset and, consequently, the investment.

Spaman indicated that there are different approaches to valuing assets – the cost approach, market approach, and income approach. They are differentiated as follows:

• Cost approach: Valuation depends on the costs associated with ‘creating’ or ‘building’ the asset.
• Market approach: Valuation depends on what comparable assets in the market have sold for and then making adjustments for differences between the assets.
• Income approach: Valuation depends on the projected cash flows of an asset, discounted to present value.

Spaman stated that when valuing assets in a private company, the appropriate approach is typically dependent upon the level of security being valued (e.g., senior debt, preferred equity, options, etc.) and the performance of the company (i.e., growing, stable, or declining). The approach used may change over the life of an investment as the company transitions from stages of performance or moves through its life cycle.

See the second installment for the panel discussion on best practices around valuing Level III assets and the benefits of using an independent third-party valuation specialist, and the third installment for the panel discussion on the impact of a recent enforcement action, how a fund can best prepare for an audit and regulatory examination, and how funds can best avoid regulator scrutiny of their valuation process.