Independance
Economy Following a significant downturn in public company valuations in 2022 and a jump in the cost of borrowing in 2023 the FCA is due to conduct a sweeping review of private market valuations, demonstrating the importance the regulator places on oversight of privately held investments which are subject to the same underlying market conditions as public companies, but whose value impact is not observable in real time. Covid-19 was a global public health crisis for several quarters, leading to an extended period of economic volatility, operational challenge and disruption to established business models. All sectors were impacted in different ways and companies within sectors have been impacted differently in terms of operational and financial performance, and the profile of recovery. Recent quarters have also been characterised by a myriad of economic challenges ranging from supply chain and energy price issues to changing consumption patterns, inflation and increased interest rates.This brings significant challenges to assessing the value of illiquid investments such as privately held companies, and a greater degree of complexity to the determination, review and audit of the carrying value of portfolio investments. Even in dislocated markets, fair value remains the most relevant and reliable information for Limited Partners (“LPs”). However, such volatility naturally decreases the shelf-life of valuations, leading to more frequent assessment of value being demanded. Portfolio investment valuation is no longer just a year-end concern but is increasingly being considered through quarterly valuation cycles to ensure investors in alternative assets are provided with timely valuations that reflect current economic conditions. Some private equity firms are doing a lot more than others to broaden the analytical underpinnings of their valuations, ensure up-to-date reporting, document subjective judgements, and substantiate conclusions.
Scrutiny
Perhaps the most important consideration when establishing or reviewing a fund’s valuation function is independence. Across Europe, the AIFMD requires that an Alternative Investment Fund Manager (AIFM) has appropriate and consistent procedures so that a proper and independent valuation of the investments can be performed. The directive states that the valuation function can be performed either by an external valuer which is independent from the AIFM, or the authorised AIFM itself provided that the valuation task is functionally independent from portfolio management and remuneration policy; and that other measures are in place to ensure that conflicts of interest are mitigated and undue influence upon the employees is prevented *2 . It also says that “where the valuation function is not carried out by an external valuer, the home regulator may require the authorised AIFM to have its valuation procedures and/or valuations verified by an external valuer”. Similarly, the IPEV Valuation Guidelines emphasise, as best practice, the use of external advisers and/or independent internal valuation committees to review valuation methodologies, significant inputs, and fair value estimates for reasonableness *3 .
External scrutiny of the practices supporting investment values comes in many forms, not just via the demands of LPs. The selection and application of methodologies as well as the subjective inputs and assumptions that underpin fair value estimates have become increasing focal points for both auditors and regulators. A recent publication by the UK’s largest auditor, PwC, stated that “the big question for firms is whether your results will stand up to intensifying investor, regulator and auditor scrutiny, particularly around the effects of the pandemic on the value of your portfolio investments” *4 . Also noting that the strength of the valuation function is “likely to be an important differentiator, both now and as we emerge from the Covid-19 emergency over the long-term”. Similarly, the Financial Accounting Standards Board (FASB) has included the assessment of fair value as one of the topics that should be “top of mind for auditors and their clients” in upcoming audits. A ‘Special Valuation Guidance’ paper issued by the IPEV board highlights several important considerations in light of the challenges and uncertainties brought about by recent events * 5 , noting that: 1 . Every investment will need extra analysis 2. Strong valuation processes should continue to be followed 3. Valuers are encouraged to think critically when estimating fair value 4. LPs continue to be best served by GPs providing timely fair value information
Notes
* 1 https://www.ft.com/content/ee008ac7-2f0f-4b65-a016- 0e2ec00e8c26?shareType=nongift * 2 https://eur-lex.europa.eu/LexUriServ/LexUriServ. do?uri=OJ:L:2011:174:0001:0073:EN:PDF. * 3 https://www.privateequityvaluation.com/Portals/0/ Documents/Guidelines/IPEV%20Valuation%20Guidelines%20 -%20December%202018.pdf?ver=2018-12-21-085233- 863×tamp=154538236011 * 4 https://www.pwc.com/gx/en/private-equity/private-equity- survey/pwc-pe-survey-2021.pdf * 5 https://www.privateequityvaluation.com/Portals/0/ Documents/IPEV%20Special%20Valuation%20Gudiance%20-%20 31%20March%202020.pdf
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