Houlihan Capital provides insight on unique valuation considerations for crypto asset managers including accurate valuations, regulatory developments, & best practices.
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More and more asset managers are being confronted with compliance and reporting challenges associated with holding investments in the cryptoasset sector. The question of valuation is at the center of many of these challenges. In this whitepaper, Houlihan Capital will discuss some of the technical obstacles to accurate valuation in the sector before highlighting recent regulatory developments involving valuation that may also be relevant to the reader. Brief guidance towards solutions and best practices is provided throughout.
Technical Challenges
Cryptocurrencies and tokens with readily observable prices, like Bitcoin and Ethereum, only comprise a small subset of investable assets in the cryptoasset (or “crypto”) sector. A common understanding among experts is that this investment space encompasses the wide variety of instrument types and entities derived from or supporting the implementation and/or commercialization of blockchain technology. It ranges from the newly invented or niche, such as “SAFTs” issued in connection with in-development protocols, to the well-trodden or conventional, such as standard preferred equity in a high-growth Software-as-a-Service company. As the reader likely knows from experience, many of these investments are illiquid and hard to value – what would be designated “Level 3” assets in a financial reporting context.
Why are these investments hard to value? Firstly, valuation is an inherently difficult exercise where an active market for the subject interest does not exist. This limitation forces reliance on significant unobservable inputs, introducing a subjective element into the valuation process that the valuator must manage with appropriate model selection, model application, and assumptions. Even with the most straightforward of fact patterns – for example, the valuation of standard equity in a mature-stage company in an established industry – this still requires a lot of know-how to do well.
Secondly, appraisal of financial assets in the cryptoasset sector has an additional level of difficulty for the same reasons it can be challenging to value other kinds of venture capital investments. That is, the sector is for all intents and purposes a subcategory of venture capital allocation, meaning the problems normally associated with early-stage valuation remain attendant. A valuation exercise is no less likely to be complicated by the underlying entity’s lack of operating history, lack of meaningful financial metrics, unpredictability of exit scenarios, limited information rights, or any other of a long list of issues that plague value measurement in the VC world.
Lastly, valuations in the cryptoasset sector can be especially tricky because they frequently require, among other things, working knowledge of a nascent industry and its new technologies, along with the ability to adapt traditional methods and techniques to unique business models in the absence of definitive guidance. Those substantial demands combined imply a steep learning curve, with many opportunities to err on the way to a value estimate for a given investment.
None of the technical challenges outlined above obviate the need to complete valuations. At times, the best that can be done is to move forward with a process in good faith, attempting to perform a balanced and unbiased valuation. To that end, when tasked with measuring fair value of a cryptoasset sector investment for financial reporting purposes, Houlihan Capital’s approach is still informed by the AICPA valuation guide, Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The valuation guide lays out some helpful best practices for these situations. One common solution is to apply a calibration method. Chapter 10 of the guide outlines a calibration method as follows:
“Calibration is the process of using observed transactions in the portfolio company’s own instruments… to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the original observed transaction as well as any more recent observed transactions in the instruments issued by the portfolio company. On the original transaction date…using the selected valuation techniques with the calibrated inputs will result in a fair value of the portfolio company investment that equals the transaction price. At subsequent measurement dates, these input assumptions (for example, financial metrics for the company such as revenues and EBITDA, projected revenues and EBITDA, or projected cash flows; non-financial metrics for the company including specific operating key performance indicators such as number of customers, volume, efficiency measurements, and so on; and market-related inputs such as valuation multiples, cost of capital, or other factors) should then be updated to reflect changes in the investment (e.g., portfolio company performance and expectations) and changes in market conditions (e.g. valuations, cost of capital, etc., in the relevant universe of guideline public companies).”
As the first step in applying this guidance, we often estimate the portfolio company’s equity or enterprise value at the time of initial investment by reference to the initial investment. By leveraging the relevant details of this “original observed transaction,” such as purchase price, deal terms, the company’s capital structure, etc., this can typically be done relatively simply with one or more generally accepted techniques.
More judgment is frequently required beginning with the second step of applying the calibration method, which is anticipated to be the solving of a key valuation model input (e.g., EV-to-EBITDA multiple). Here a challenging fact pattern may begin to force expert interpretation of, or sometimes extrapolation from, the text of the AICPA guide. For example, the recency of investment, the portfolio company’s stage of development, and/or information constraints may mean that company-specific metrics (e.g., EBITDA) cannot or should not be used. For similar reasons, use of forecasted financials and an income approach may also be impractical. In such cases, it is common for valuation practitioners to adopt a simplified procedure whereby direct quantification of changes in market conditions is emphasized and company-specific developments (to the extent any are known) are relegated to being a secondary, layered consideration. In practice, this can look like adjusting the implied equity value by a percentage selected based on the movement of market capitalizations of comparable public companies from the date of investment to the current measurement date.
When valuing an investment in the crypto sector, the truth of the matter is that there is no formulaic solution, and no guide can ever be truly comprehensive. It takes expert knowledge and experience to arrive at conclusions that consistently make sense and are defensible. We suspect this is part of the reason why our firm has received a record number of referrals for, and inquiries about, our valuation services in recent months. Added to the long-term trend of funds of all types being held more strictly to fair value accounting standards, the serious headwinds faced by the crypto sector in the last couple years have seemingly pushed more fund managers to finally enlist the services of independent third-party valuation firms. More managers should probably do the same in our opinion, noting Houlihan Capital’s clients report, on average, faster audit completion and overall high satisfaction.
One service offering that is consistently appreciated by our clients, and thus perhaps deserves special mention, is the valuation of “locked” or “vesting” tokens where an active market exists for the subject tokens. As a freely tradeable token’s price is known, the objective is only to assess an appropriate discount therefrom. While a consensus framework for valuation of most cryptoasset investments does not exist, this would appear to be an exception, or nearly so. Reasoning that locked tokens (i.e., a holding of tokens bound by a programmatic release schedule) are analogous to restricted shares, a generally accepted method for deriving discount estimates is based on the cost to insure the tokens against the risk of encountering lower market prices when unrestricted sale becomes possible for them, with “insurance contracts” modeled as protective put option pricing models. Houlihan Capital’s exact solution in this mold has been refined to the point of hyper-efficiency and maximal audit-defensibility.
Recent Regulatory Developments
While regulatory frameworks are still adapting to the peculiarities of the cryptoasset sector, it is clear the industry is receiving more attention from governments and standard-setting bodies in recent years. Globally, there have been countless legal opinions, policy initiatives, enforcement actions, guidance releases, etc. resulting from the increased scrutiny. While not relevant to all these developments, the concept of valuation is an evident theme.
The trend is plain to see in the United States, which may be the most important jurisdiction to the future of the sector. One explicit, and heralding, example of the new paradigm is the “Risk Alert” released by the SEC’s Division of Examinations (“DOE”) on February 26, 2021. With its publication, valuation of “Digital Asset Securities” was announced as an area of focus for the DOE’s future examinations. The alert specifically highlights that future examinations of investment advisers managing cryptoassets on behalf of clients will include a review of valuation methodologies, including those used to determine fair value and valuation after significant events.
A more recent underscoring example is the proposed updates to the U.S. Generally Accepted Accounting Principles (GAAP) Financial Reporting Taxonomy related to a Proposed Accounting Standards Update on Intangibles—Goodwill and Other—Crypto Assets, published by the Financial Accounting Standards Board (“FASB”) on March 23, 2023. The proposed updates, which would create Subtopic 350-60 of U.S. GAAP, include important new elements and modifications related to valuation and applying to all entities that hold cryptoassets. Of note, the following would be required:
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- Measure certain crypto assets at fair value each reporting period with changes in fair value recognized in net income.
- Present (1) crypto assets measured at fair value separately from other intangible assets in the balance sheet and (2) changes in the fair value of crypto assets separately from changes in the carrying amounts of other intangible assets in the income statement.
- Disclose the name, cost basis, fair value and number of units for each significant crypto asset holding.
- Disclose valuation methods and procedures.
The examples above are acknowledgments of the important role valuation plays in protecting cryptoasset investors specifically, however this pattern holds for the broader regulatory landscape in the US as well. Changes that are, at the text level, silent on crypto may be no less pertinent to asset managers with exposure to the sector than if those changes had been directly targeted at them.
As an illustration, we can point to perhaps the most impactful regulatory event in years, which also happens to be one of the most recent: On August 23, 2023, the SEC adopted sweeping reforms under the Investment Advisers Act of 1940 (“Advisers Act”) to enhance the regulation of private fund advisers. Private fund advisers registered with the Commission should read the new rules and amendments in full, available HERE. The changes create major compliance obligations involving the valuation of fund investments. Houlihan Capital is helping its clients minimize the costs, risks, and operational complexities of satisfying these obligations – namely, the regulatory requirements of the following three (3) rules:
Quarterly Statement Rule
This rule requires registered private fund advisers to provide quarterly statements to investors that disclose fund-level information on performance, cost of investing in the fund, fees, and expenses. Regarding fund performance, the rule requires advisers to illiquid funds to disclose a gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of each such fund’s portfolio. Determining the value of the unrealized portion of an illiquid fund’s portfolio can be technically challenging, sometimes necessitating reliance on sophisticated models and multiple unobservable inputs. Most private fund advisers are either ill-equipped to consistently perform valuations of illiquid investments or simply find the recurring exercise a distraction from core functions. Of course, the SEC is quick to point out advisers’ conflict of interest here, being they are typically evaluated and, in many cases, compensated based on unrealized performance. Outsourcing the appraisal of hard-to-value investments to an independent third-party expert such as Houlihan Capital addresses all these concerns, ensuring valuations are performed with professional competency and precluding the possibility that the SEC views the adviser’s valuation practices as deceptive.
Audit Rule
This rule requires private funds advised by registered fund advisers to undergo a financial statement audit that meets the requirements of the audit provision in the Advisers Act custody rule (rule 206(4-2)). In addition to providing protection for the fund and its investors against the misappropriation of fund assets, an audit by an independent public accountant provides an important check on the adviser’s valuation of private fund assets. Part of the audit process is evaluating the selection and application of valuation methods, including the significant assumptions and data used within those methods. Experienced private fund advisers know the pain of this aspect of audit, wherein it may be unclear how exactly to appease the audit partner (often as a valuation specialist communicates coded guidance or questions), leading to delays and cost overruns. By hiring from audit firms and constantly working with auditors to provide objective, independent and defensible opinions of value that meet all accounting and regulatory requirements, Houlihan Capital’s work product has been refined to be exceptionally clear, concise, and complete in preempting issues that could be raised in audit review. To the extent questions are still received on our recommended fair value measurements, our experts can draw on vast institutional knowledge gained from years of answering similar questions over thousands of projects, including repositories of verbatim audit Q&A.
Adviser-led Secondary Transactions Rule
This rule requires an adviser to obtain a fairness opinion or valuation opinion in connection with adviser-led secondary transactions, whereby the adviser offers fund investors the option to sell their interests in the private fund or to exchange them for new interests in another vehicle advised by the adviser. Further, it is necessary for the adviser to engage an “independent opinion provider” to this purpose, which means “a person that provides fairness opinions or valuation opinions in the ordinary course of its business and is not a related person of the adviser.” In other words, it is necessary to hire an entity such as Houlihan Capital. Our engagements are designed to reduce the risk of providing biased opinions, and our professionals have the experience in valuing most types of illiquid investments, even esoteric ones. Houlihan Capital is a premier provider of, and thought leader on, fairness opinions, including for adviser-led secondary transactions. See www.fairnessopinion.com for more information.
About Us
Houlihan Capital is a leading valuation, financial advisory and investment banking firm committed to delivering superior service to our clients. As an early valuation provider helping pioneer the cryptoasset investment industry, we have the experience to help investment professionals in the space make timely business decisions, meet financial reporting requirements, and lessen their administrative burden. We have a proven track record as a trusted valuation provider to some of the largest and most reputable asset managers,’40 Act funds, private equity funds, hedge fund advisors, venture capital firms, and fund administrators around the world. Houlihan Capital is SOC-compliant, a Financial Industry Regulatory Authority (FINRA) and SIPC member, and committed to the highest levels of professional ethics and standards.
For questions or inquiries regarding cryptoasset valuations, please contact:
Joe Brennan, CPA
Senior Vice President
jbrennan@houlihancapital.com
