Fair Value Best Practices and Implementation

Overview
Given the difficulty of valuing illiquid assets and the potential for conflict of interest, hedge funds, private equity firms, and other investment managers and financial institutions (“Asset Management Firms”) are receiving greater attention from regulators, investors, auditors, politicians, and other industry participants, with the trend toward a well defined and consistently applied valuation policy that complies with the relevant reporting standards, greater transparency and independence. As the securities held by investors are becoming increasingly complex and continue to rise in number and value, the need for established guidelines, which apply consistent valuation methodologies in determining the fair value of their portfolio investments, is becoming increasingly important. Asset Management Firms should review their valuation policy and related procedures on a periodic basis to ensure compliance with relevant pronouncements and/or guidance set forth by the Securities and Exchange Commission (“SEC”), the Financial Services Authority (“FSA”), the Securities and Futures Commission (“SFC”), the Financial Accounting Standards Board (“FASB”) and other regulatory authorities.

Definition of Fair Value

ASC 820 modifies the GAAP definition, determination, and disclosure of Fair Value. As such, Fair Value in accordance with FASB Accounting Standards Classification Topic 820: Fair Value Measurements and Disclosures (“ASC Topic 820”) is defined 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”. Further, ASC Topic 820 establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. In addition, the transaction to sell an asset or transfer a liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition of ASC Topic 820 focuses on the price that would be received to sell the asset or paid to transfer the liability (i.e., an “exit” price), not the price that would be paid to acquire the asset or received to assume the liability (i.e., an “entry” price).

Valuation Inputs and the Fair Value Hierarchy

The valuation techniques described in Appendix B and C stress the importance of maximizing the use of “observable” versus “unobservable” inputs. Observable inputs are defined as inputs that reflect the assumptions market participants would use in pricing an asset or liability developed based on market data obtained from sources independent of the reporting entity. Unobservable inputs are defined as inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing an asset or liability developed based on the best information available in the circumstances. To clarify the distinction between observable and unobservable inputs and increase consistency and comparability in Fair Value measurements, the decision trees in Appendix B and C establish a Fair Value hierarchy that prioritizes valuation inputs into three levels. The Fair Value Hierarchy is described below in further detail.

• Level 1 Inputs – quoted prices (unadjusted) in active markets for identical assets or liabilities.
• Level 2 Inputs – inputs other than quoted prices included within Level 1 Inputs that are observable for the asset or liability, either directly or indirectly (i.e., quoted prices in Inactive Markets).
• Level 3 Inputs – unobservable inputs for the asset or liability.

The following sections describe in detail, the acceptable and preferred valuation techniques for several investment types.

Publicly Traded Equity

Fair Value for publicly traded equity securities (“Public Equity”) traded in an active market (defined as any market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis) should be based on the closing price reported for the last trading day prior to the valuation date for which such data is available to determine Fair Value. In cases where unrestricted listed equity is traded in an inactive market (defined as markets in which there are a few transactions for the asset or liability, the price is not current or price quotations vary substantially either over time or among market makers or in which little information is released publicly) the observed price should be adjusted or augmented by other valuation techniques to determine Fair Value.

Restricted Securities

Market approach valuation techniques should be used to estimate the Fair Value of restricted listed equity in the same manner as described for unrestricted listed equity. In such instances, a discount for lack of marketability is often applied to the indicated value derived from the market approach to arrive at a Fair Value estimate. However, consistent with ASC 820, the discount adjustment should only be applied if the restriction is specific to the security to be transferred. The discount should reflect the amount that market participants would demand for assuming the risk of being unable to access public markets for the security for a specific period. The magnitude of the discount will depend on several factors such as the nature and duration of the restriction, the extent to which buyers and sellers are limited by the restriction and other factors specific to the security and the investors.

Section 144A Stock

For common stock that is acquired via a PIPE (Private Investment in a Public Entity) structure, (generally 144A stock) where the stock purchase agreement calls for the company to register the securities within a specific timeframe (generally 60 to 180 days), the time period and certainty that the company will meet the registration requirement should be considered when determining Fair Value. As indicated above, an appropriate adjustment may be applied relative to the freely-tradeable, exchange traded common stock to reflect the restriction.

Private Equity

For the immediate time period following a transaction, the determination of Fair Value for equity securities in which no liquid trading market exists (“Private Equity”) can generally be approximated based on the transaction price (absent any significant developments). Thereafter, (or in the interim, if significant developments relating to such portfolio company or industry occur which may suggest a material change in value) Asset Management Firms should value each investment by applying generally accepted valuation methods including market transaction and comparable public company multiples, which are based on a measurement of the company’s historical and projected financial performance (typical metrics include: enterprise value/latest 12 months EBITDA or projected fiscal year EBITDA, enterprise value/ latest 12 months revenue or projected fiscal year EBITDA). Valuation multiples that are relevant to the industry and company in the investments held should be considered and relied upon. Valuation multiples should be assessed and may be adjusted on a go-forward basis based on the business risk associated with the subject company in which the investment is held. In addition, the implied entry multiples should be considered as benchmarks in valuing unlisted equity. In circumstances where no financial performance metrics are available, Asset Management Firms should rely on other non-financial related metrics applicable to relevant progress from the original investment date to the valuation date. An additional methodology is the use of a discounted cash flow analysis whereby forecasted cash flows to be generated by the subject company are discounted to present value at an appropriate discount rate. These methodologies can be utilized to determine an enterprise value (“Enterprise Valuation Methodologies”) from which net debt is subtracted to determine equity value. If key valuation metrics change over time, that change and reasoning behind that change, should be documented in an internal investment memo .

Warrants

Warrants may or may not be traded in an active market. In cases where an active market does exist, the quoted price as of the valuation date should be relied upon to estimate Fair Value. In other circumstances, warrants may be valued using an option pricing model (e.g., the Black-Scholes option pricing model or a binomial option pricing model). Inputs utilized in option pricing models include current stock price, strike price, time to maturity, risk-free rate, and volatility. If the equity of the underlying business is actively traded, the quoted stock price should be relied upon. Otherwise the stock price will be estimated through a valuation analysis, similar to that performed for private equity securities. For companies with complex capital structures (e.g., preferred stock, convertible preferred, etc.), an enterprise value waterfall analysis should be performed, which factors in the rights and privileges of each class of security in front of the common stock. Factors to consider when making a volatility assumption include: the underlying volatility of the option currently being traded, the underlying volatility of traded options for similar publicly traded companies, or the underlying volatility of traded options companies within a similar industry. The length of time utilized to calculate volatility should be applicable to life of the option, but the selection of time will be determined by the deal team and/or internal pricing committee.

Liquid Debt

Debt securities (such as high yield bonds) in which there exists a liquid trading market should be valued either (i) by using one of the many debt pricing services or (ii) by requesting the current trading prices from one or more investment banks who make a market in such securities, and in either case using the latest actual price if traded on such valuation date (if available), or else the average of the bid/ask prices on the last date prior to the valuation date for which such data is available.

Illiquid Debt/Preferred Stock

For debt and preferred stock securities for which no liquid trading market exists, Fair Value will generally approximate cost unless the borrower’s enterprise value, overall financial condition (such as deterioration of financials, missed payments, or falling out of compliance with covenants) or other factors such as divergence of the stated interest rate versus the market rate, lead to a determination of a different value. For debt accruing payment-in-kind (“PIK”) interest, the interest will be added to the face value for valuation purposes as long as the other indicators determine there is appropriate value in the underlying company to cover the debt plus the PIK.

In such cases, the Debt/Preferred Stock should be valued by applying an appropriate discount rate (which may be higher or lower than the actual interest or dividend rate of the security to be valued) to the expected cash flows from such security, including the anticipated principal value recovery in the event of a sale or liquidation of the issuer. The applicable discount rate applied to the cash flow should be derived based on re-pricing the expected interest rate as of the valuation date using the current capital structure and current market pricing for a particular level of Debt/Preferred Stock. Metrics that can be used to determine allocation of capital structure include: credit rating, debt to EBITDA and other debt covenants at funding. To determine the coverage available to Debt/Preferred Stock holder and the current reallocation of the capital structure, an enterprise value must be determined. The enterprise value can be determined by utilizing the Enterprise Valuation Methodologies discussed in the Private Equity valuations. In addition to reviewing market pricing on Debt/Preferred Stock, an analysis should be performed to ensure the Debt/Preferred Stock has adequate coverage based on an enterprise value waterfall analysis (“Waterfall Analysis”). The Waterfall Analysis entails allocating claims against enterprise value to the debt and equity of the company, beginning with the most senior debt, down to the most junior equity.

Convertible Securities

Debt or preferred stock securities convertible into common stock (“Convertible Securities”) should be valued using one of the following methods based on a determination of the likely exit for that investment:

(i) If the likely exit is determined to be through a sale or liquidation of the company whereby the Convertible Securities are redeemed, the Fair Value of the investment should reflect the face value or liquidation preference value of the Convertible Securities.

(ii) If the likely exit is determined to be through a registered public offering whereby the Convertible Securities are to be converted into readily tradable common stock of the company, the Valuation Committee should value the Convertible Securities, including the effect of any accrued dividends, in the same manner as it determines the valuation of Public Equity.

(iii) If the likely exit is determined to be a private sale of the company, Asset Management Firms should value the Convertible Securities, including the effect of any accrued dividends, in the same manner as it determines the valuation of Private Equity giving effect to the conversion of the Convertible Securities into fully diluted common stock.

(iv) In addition, if the value of the Convertible Security is not believed to be accurately reflected in the scenarios above, a supplemental analysis can be performed to determine the value of the Convertible Security as combining a straight bond and a call option that allows the investor to exchange the bond for equity. In this scenario, the methodology for Warrant Valuation can be followed to value the call option and the Debt/Preferred Stock valuation to value the debt.

Credit Default Swaps

Since the CDS market is a dealer market, the average of bid/ask quotes from an active dealer in the particular CDS should be used to mark the investment.
For CDS Indices such as the ABX or CDX, the bid/ask average or composite quote from a third-party expert resource should be used to mark positions, with adequate documentation retained.