By Elizabeth Lewis, CPA, Business Assurance & Advisory Services Senior Manager | Mary Margaret Sword, CPA, Business Assurance & Advisory Services Manager | Financial Services Industry Team
2020 Best Practices When Performing and Documenting the Investment Valuation Process
With Q4 quickly approaching, many are left with the question “How do I value my illiquid investments during COVID-19, at a time when there are still so many uncertainties?” 2020 has required us all to adjust our usual routines, processes, and procedures to accommodate the new normal, and investment valuations for quarterly or annual reporting will be no exception. While valuing investments may seem daunting under the current circumstances and it is impossible to predict the future, you still have the responsibility to determine the fair value of each of your investments using the best available information to you at that time of valuation. Inappropriate valuations can lead to inaccurate management fees or carried interest charged, as well as misleading communications to investors regarding portfolio values.
It is important to formally document the factors considered when performing the valuation process in 2020, including any relevant assumptions, estimates, or changes from prior period policies. Consider the following best practices when performing and documenting the valuation process:
- Fair value is determined at a particular point in time, based on assumptions market participants use. Therefore, factors and observable outputs should be considered as of that specific date. This will be all the more relevant for 2020 as we have seen significant swings throughout the year. Data is becoming stale very quickly! If typically your valuation process includes information gathering ahead of year end, this is a year where “waiting until the last minute” may be necessary.
- Obtaining and understanding underlying inputs to valuation can be a time consuming process. Although you must consider reasonably available information, you do not need to take extensive or cost-prohibitive efforts to gather supporting data.
- Each investment within your portfolio needs to be considered independently from the others, as current conditions can vary greatly among different industries, regions, and markets. Previously pooled investments for valuation purposes may no longer be considered homogeneous.
- While it typically is important to practice consistent, standard valuation policies, if your policy does not account for pandemic-like events, you may need to stray from the policy. For instance, holding an investment at cost due to a specific timeline as detailed in your standard valuation policy may not be appropriate this year if other factors indicate there could be a decline or increase in value. Even for very recent purchases that would typically be kept at cost, our current environment requires consideration of whether even this makes sense.
- Discount rates, along with illiquidity and uncertainty premiums should be reviewed for reasonableness. For instance, if the discount rate used is traditionally the risk-free rate, the emergency cuts made by the Federal Reserve may lead to an inaccurate valuation if those reduced rates are not relevant. Consider use of an actuary if material differences may result in the valuation based on a selected rate.
- When utilizing expected future cash flows as part of your valuation process, it is important to consider the effects we’ve already seen from COVID-19. Predicting the future is always difficult and this year has exponentially more uncertainty involved. Are there other valuation methods that require less subjective judgment?
- When using third parties for valuation information, it is important to understand their processes and considerations regarding COVID-19 as well.
Create a Road Map for Future INvestment Valuations
We expect the impact of COVID-19 to be significant for many investments. When all is said and done, your most important asset will be a summary memo or documentation of your unique valuation process, detailing the assumptions and factors considered for each individual investment and a substantiated conclusion. This can be shared with external parties such as auditors or summarized for investor communication. Having detailed, written notes around all the considerations will help provide a road map for future valuations should the uncertainties linger. Here’s hoping they do not, but for now, we’re all in this together!
Additional Resources for Financial Service Firms
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.