Contributed by Daniel Barber, CPA and Marshall Harvey, CPA of Elliott Davis
In May 2018, the AICPA’s Private Equity and Venture Capital Task Force released a working draft of an accounting and valuation guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”). The final publication is expected to be released in 2019 and is likely to become the “gold standard” that will be applied by investment fund valuation committees and their auditors in evaluating the fair values of portfolio companies. This article is part of a multi-part series exploring the key topics of the Guide and related implementation matters.
Chapter 6 – Valuation of Debt Instruments of the Guide provides guidance for the valuation of debt instruments or debt-like preferred stock, both in situations when the debt or debt-like investment is the subject of the measurement, and in situations when the debt or debt-like investment is held by a third party and its value is considered as an input in valuing the equity interest. The fair value of debt reflects the price at which the debt instrument would transact between market participants, in an orderly transaction at the measurement date.
There are many variables to consider when valuing debt instruments. Some of the contractual terms to consider are coupon rate, contractual maturity, amortization, pre-payment provisions, change of control provisions, and conversion rights. Company and market variables to consider include traded prices, broker quotes, market interest rates, overall market conditions and company-specific credit issues and historical and projected financial performance.
Fair Value of Debt Instruments when Debt is the Unit of Account
The fair value of debt may not be the same as its face value. A fair value of debt lower than the face value reflects a situation where debt holders are locked into the investment at a below-market interest rate. A fair value of debt higher than face value reflects the situation where the portfolio company is required to pay an above-market interest rate to the debt holders. If there are pre-payment provisions, debt instruments at above-market interest rates may have a lower fair value than those that do not have pre-payment provisions.
When a traded price as of the measurement date is not available or is deemed not to be determinative of fair value, the typical valuation technique to estimate the fair value of the debt is to use a discounted cash flow analysis, estimating the expected cash flows for the debt instrument (including any expected prepayments) and then discounting them at the market yield. This is commonly known as the “yield method.”
The market yield for debt as of the measurement date can be measured based on the credit quality and credit risk of the portfolio company and the change in credit spreads for comparable debt instruments. If the portfolio company has other debt instruments that are traded, the change in yields for these instruments might be good indicators of the change in yields for debt instruments that are not traded.
Credit quality and credit risk can be evaluated in several ways. Alternatives include complex models involving synthetic credit rating algorithms or methods and models using qualitative factors relevant to the particular portfolio company. In these instances it is important to calibrate the model used to the issuance price of the debt and consider changes in the portfolio company’s credit quality as indicated by the model used.
If debt includes change of control provisions, the penalty or benefit to the debt holder associated with a below or above market yield is considered only through an anticipated liquidity event for the portfolio company. Expected cash flows including change of control provisions at the date of the expected liquidity event, along with the market yield of the debt, and the portfolio company’s overall credit quality will be the primary metrics used to determine the fair value of the debt assuming the debt is not publicly traded.
Value of Debt for the Purpose of Valuing Equity
Chapter 6 of the Guide also discusses approaches for valuing debt for the purpose of valuing the equity interests in the enterprise, given a reasonable estimate of the enterprise value. One widely used approach for valuing equity interests is to estimate the enterprise value and then subtract the value of debt. The value of debt for the purpose of valuing equity will typically be estimated using the same valuation methodologies used for estimating the fair value of debt.
The value of debt for the purpose of valuing equity reflects the cost that market participants transacting in the equity would assign to this liability given the expected interest and principal payments over the expected term of debt. Market participants transacting in the equity may make different assumptions than market participants transacting in the debt, as these transactions would take place in different markets. Market participants transacting in the equity would consider the impact of the debt on the investment knowing that the company ultimately would be responsible for redeeming all the debt, not just a piece. In addition, the usual and customary due diligence for a transaction in the equity would typically provide better information about the company’s strategies, and thus, the equity holders might make different assumptions regarding the expected timing of a liquidity event or other factors. Therefore, the value of debt used in estimating the fair value of equity may be different than the fair value of debt considered independently.
A common valuation technique used by private companies for estimating the value of debt for purposes of valuing equity is to include the future payoff of debt within the model used for allocating the enterprise value among the claims of the portfolio company. For paid-in-kind debt without covenants, valuation of the debt is based on the future payoff for the debt typically equals its principal plus accrued interest through maturity. For debt that pays cash interest or is amortizing, the value of the debt may be higher than an equivalent debt in which the interest accrues through maturity because failure to make the obligated payments will trigger default earlier and improve the chance of recovery.
One final observation is that the decline in the fair value of debt is usually accompanied by a decline in the enterprise value of the portfolio company. As a company’s performance declines, its cost of capital typically increases resulting in a decline in the fair value of its debt. The overall decline in the enterprise value of the portfolio company is typically shared by its debt and equity components.
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