Valuation issues affecting Alternative Funds Presentation at Jersey Funds Association training session

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Miles Ross
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1 Presentation at Jersey Funds Association i training session Mike Byrne 26 October 2010 PwC Page 1 December2009

2 Agenda Consideration of the Valuation issues affecting different types of Alternative Funds: Section I - Private Equity Section II - Real Estate Section III - Fund of Funds III (A) - Fund of Hedge Funds III (B) - Fund of Private Equity Funds III (C) - Other Funds of Funds PwC Slide 2 October 2010

3 Section I - Private Equity Background to Fair Value requirements Overview of different valuation techniques Detailed example of Multiples Based Valuation Current issues in respect of PE Valuation PwC Slide 3 October 2010

4 Section I - Private Equity Reporting fair value Ultimately investors are focused on realised value: However, the advisor needs to be able to measure unrealised value for three important reasons: Underlying investors often need to report at fair value Market practice is now to report at fair value in the financial statements It is an important part of internal monitoring mechanisms Page 4

5 Section I - Private Equity All major GAAPs (UK - FRS 26/ IFRS - IAS 39/ US GAAP -FAS 157): Require fair value accounting Increasing guidance on how to determine fair value issued over last 2 years The International Private Equity and Venture Capital Valuation ation Guidelines, developed by the British, European and French Venture Capital Associations, define fair value as: the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm s length transaction This is basically consistent with the definition contained within accounting standards Page 5

6 Section I - Private Equity Valuation Hierarchy from most reliable to least reliable The Valuer should exercise his or her judgement to select the methodology that is the most appropriate for a particular investment : Pi Price of recent investment t reliability? Earnings multiple established maintainable earnings Net assets asset-based rather than earnings Discounted cash flow - flexible but subjective. Useful cross-check. Industry valuation benchmarks - limited it situations. ti Milestone analysis may apply in limited circumstances Page 6

7 Section I - Private Equity Multiple based Valuation Earnings 100 Multiple 8 Enterprise value 800 Net debt (400) Equity value 400 Percentage ownership 90% Carrying value 360 PwC Slide 7 October 2010

8 Section I - Private Equity Multiple based Valuation - Earnings Which figure should be used: Sales / EBITDA / EBITA / EBIT Current / Historic / Forecast / Average Support for rationale / documentation Page 8

9 Section I - Private Equity Multiple based Valuation - Multiple Availability of multiples Consistency and comparability Quality of evidence available Support for rationale / documentation Level of discount to be included Page 9

10 Section I - Private Equity Multiple Based Valuation - Net debt Provision of supporting information Management / Audited Accounts Reconciliation of Figures in Valuation to Audited figures Track record / Consistency What to include / exclude Subordinated debt Support for rationale / documentation Page 10

11 Section I - Private Equity Multiple based Valuation - Percentage ownership Audit approach agreement to underlying confirmations Treatment of Management shares & options / Fully Diluted Support for rationale / documentation Page 11

12 Section I - Private Equity Multiple based Valuation Carrying value Discussion of any differences between calculated Fair Value and Proposed Carrying Value Support for rationale / documentation Page 12

13 Section I - Private Equity Presentation of proposed Fair Values to General Partner Include summary of all factors which feature in Fair Value Calculation Add commentary on overall business performance / key personnel / key contracts, suppliers, pipeline, etc. / general economic conditions Consider use of graphs, tables, track records GP should document this meeting Page 13

14 Section I - Private Equity Summary of key issues in the current market Impact of recession / recovery on portfolio companies Understanding the impact of distressed markets on comparable companies Exit Strategy do the discounts in the valuation reflect reality of current exit opportunities? Debt covenants is there any indication that the portfolio is close to breaching covenants? Page 14

15 Section II Real Estate Understanding the different types of property Focus on Investment Property Understanding Investment Property valuations Current issues in Real Estate t valuation PwC Slide 15 October 2010

16 Section II Real Estate Understanding the different types of Real Estate: Investment Property: A property (land and/or building) held to earn rentals or for capital appreciation (or both) Development Property: Properties which on completion are intended to be investment properties Trading gproperties: p Properties developed or purchased for immediate resale Owner occupied property: Property held for use in the production or supply of goods or services or for administrative purposes PwC Slide 16 October 2010

17 Section II Real Estate Investment Property: We will focus on Investment property in today s presentation as this is the most common type of property held in Jersey funds As per the structure chart, you can see that there are many different parties involved, more so than are involved in other types of funds Key is understanding the terms of engagement g of each party, their duties and obligations and the limitations within each role PwC Slide 17 October 2010

18 Section II Real Estate Typical Investment Property Structure Unitholders Shareholders Owns Distribution Owns Dividend Property Fund Manages RE Fee Fund Manager Retail Property Manager Management Fee Net Property Income Owns Owns Net Property Income Management Fee Commercial Property Manager Manages Shopping Centre Office Tower Manages Rent Rent Tenant Tenant Page 18

19 Section II Real Estate Understanding the key inputs within the Valuation Report Income from underlying property passing rent & estimated rental values Rental Yield applicable to the type & location of property Inflation, Cost of capital for the entity Initial & Long term yield Assumptions around break periods, refurbishment periods, etc. Page 19

20 Section II Real Estate Understanding the Limitations within the Valuation Report Valuation Report is based on certain key assumptions, as stated within their report this may include: Reliance on information provided to them by third-parties (e.g. Managing gagents) May make certain assumptions as to Cashflows, Occupancy Rates, Rental Yields, Void periods, Acquisition & Disposal costs May not have all information in respect of incentives / rental guarantees May be significant differences e between ee these assumptions and the specific circumstances of the entity Page 20

21 Section II Real Estate Areas for the Directors / GP to focus on: Is the valuation performed by a qualified valuer (e.g. RICS) and in line with recognised methodology (i.e. Red Book )? What valuation approach has been followed? Does the valuer have expertise in that market / territory / segment? What controls have been put in place to provide the Valuer with all key information? Page 21

22 Section II Real Estate Areas for the Directors / GP to focus on (continued): What is the report date and what is the valuation date? Understand any limitations or caveats within the Valuation report Are there any uncertainty clauses contained within the report? (i.e. RICS Guidance Note 5)? Page 22

23 Section II Real Estate Current issues in Real Estate Valuation Split used to be Primary / Secondary, now it s Prime / Non-Prime Debt Funding for Non-Prime is very difficult Very limited speculative development pre-let almost mandatory Tenants Covenants / Occupancy reliability? Valuations market is very fragmented, certain sectors (e.g. West London offices) outperforming others Market liquidity remaining difficult Page 23

24 Section III Fund of Funds Objective of this section The issue of directors responsibility under Jersey Law is not something I'm going to cover today, different views exist as to how much a director is required to do. Instead I'm going to focus on the issue of what is required in order to give reasonable assurance that the NAV of the Fund is correctly reported. Page 24

25 Section III (A) Fund of Hedge Funds To understand Funds of Hedge Funds, we must first understand what a Hedge Fund is: Wider range of investment and trading activities than traditional investment funds Different overall sectors exist, every hedge fund has its own investment strategy, investing in a broad range of investments including shares, debt and commodities Seek to hedge some of the risks inherent in their investments using a variety of methods, most notably short selling and derivatives Hedge fund" has also come to be applied to certain funds that do not hedge their investments Page 25

26 Section III (A) Fund of Hedge Funds Does anyone recognise this picture? Page 26

27 Section III (A) Fund of Hedge Funds Or maybe this one? Page 27

28 Section III (A) Fund of Hedge Funds You only find out who is swimming naked when the tide goes out. Warren Buffett, letter to the shareholders of Berkshire Hathaway Inc., 2002 Page 28

29 Section III (A) Fund of Hedge Funds Fraud affecting Hedge Funds Over the last 3 years, the world has seen significant cases of Fraud in the Investment Management Industry: Bernie Madoff (Madoff) Dec 08 - $17bn (150 years in prison + $170bn forfeiture) Marc Dreier - Dec 08 (not hedge fund but alternative) $700m (20 years) Arthur Nadel (Scoop) Jan 09 - $168m+ -(14 years in prison) Page 29

30 Section III (A) Fund of Hedge Funds With the benefit of hindsight, what can we learn from Madoff that can be applied going forward? If it looks too good to be true, it probably is? Do the levels of return make sense? Do the levels of return correlate to the risks involved? What level of transparency is there in the Investor Reporting? Who are the parties involved in the Fund? Custodians Auditors Administrators Investment Advisors Page 30

31 Section III (A) Fund of Hedge Funds Valuation of Hedge Funds The Hedge Fund and Fund of Hedge Fund have been impacted by the significant difficulty faced by the financial markets key issues: Lack of transparency in investment strategies Activity levels in markets, equivalent assets and market volumes, etc. Financial markets has improved but restricted trading conditions remain Accuracy and reliability of Broker Pricing Linkage of those striking valuation (administrator) with those who understand the investments (investment manager) Page 31

32 Section III (A) Fund of Hedge Funds Valuation of Hedge Funds (continued) Side Pockets very difficult area due to inherent illiquidity Valuation of illiquid assets (i.e. unlisted shares, derivatives etc) Illiquid assets last traded price, discounts, evidence of transactions, orderly vs inactive markets Page 32

33 Section III (A) Fund of Hedge Funds Valuation of Fund of Hedge Funds Key areas to be considered: Does FoHF Manager / Administrator understand the NAV of underlying Fund? Understand how the Investment manager / Administrator are comfortable that NAVs provided reflect fair value by: Review of audited F/S against NAV provided and consider accounting policies of Financial Statements, auditors, opinion, etc. Final vs Estimates analysis and follow up of differences Results of initial and follow up due diligence (monitoring) Page 33

34 Section III (A) Fund of Hedge Funds Valuation of Fund of Hedge Funds (continued) Understanding the appropriate NAV on gated/restricted redemption investments should a discount be applied? Risk Management processes of Investment Manager to monitor expected returns of underlying Page 34

35 Section III (A) Fund of Hedge Funds We see a spectrum of environments in which Fund of Hedge Funds operate. The quality of this control environment directly impacts: Reliability of interim & final valuations Increased likelihood of detection of error or fraud Early sign-off of year-end financial statements Reduced audit fees Page 35

36 Section III (A) Fund of Hedge Funds STRONG ENVIRONMENT Strong Control Environment -Strong Due Diligence on Investment -Strong ongoing monitoring of Investment Manager -Strong evidence of monitoring correlation of NAV to underlying strategy HIGH CONTROLS LOW CONTROLS Availability of reliable, audited financial statements CONCLUSION STRONG OVERALL ENVIRONMENT, GOOD REASONS TO BELIEVE NAVs CAN BE RELIED UPON Page 36

37 Section III (A) Fund of Hedge Funds MEDIUM ENVIRONMENT Medium Control Environment -Moderate Due Diligence on Investment -Some ongoing monitoring of Investment Manager -Some evidence of monitoring correlation of NAV to underlying strategy HIGH CONTROLS LOW CONTROLS Some audited financial statements are available CONCLUSION MEDIUM OVERALL ENVIRONMENT, MAY NEED TO CONSIDER IF NAVs CAN BE RELIED UPON Page 37

38 Section III (A) Fund of Hedge Funds WEAK ENVIRONMENT No evidence of a Control Environment -No formal Due Diligence on Investment -No program for ongoing monitoring of Investment Manager -No monitoring correlation of NAV to underlying strategy HIGH CONTROLS LOW CONTROLS Audited financial statements are not available for underlying Funds CONCLUSION VERY LITTLE EVIDENCE THAT NAVs CAN BE RELIED UPON, CONSIDER APPROACH CAREFULLY Page 38

39 Section III (B) - Fund of Private Equity Funds The starting point is to understand the GAAP and reporting framework which applies to your FoPEF: UK GAAP are investments at Fair Value / Market Value or other basis of valuation, e.g. Directors / GP Value IFRS / US GAAP requires all underlying Funds to be at Fair Value, may require significant additional work In line with the terms of the LPA may provide flexibility to adopt values based on most recently available NAV Key point to note what do your Investors require? Page 39

40 Section III (B) - Fund of Private Equity Funds Understanding the GAAP the underlying Funds report under: Underlying Funds may report under a different GAAP to the Fund, and different GAAPs may produce different results: UK GAAP investments may be carried at historic cost IFRS likely to be at Fair Value, but understand possible consolidation impact US GAAP likely to be at Fair Value Other GAAPs may apply, e.g.: Italian GAAP historic cost applies to investment, need to perform own fair value assessment Page 40

41 Section III (B) - Fund of Private Equity Funds Consequence of non-fair valued fund in IFRS or US GAAP FoPEF: If underlying fund does not report Fair Value, FoPEF may be required to separately determine Fair Value: Only expected to apply if material discuss with Board / auditors Underlying Fund may be able to provide fair value information May be able to use general information to determine reasonable fair value Page 41

42 Section III (B) - Fund of Private Equity Funds Other points of note in Fund of Private Equity Funds: Carried interest treatment underlying Fund may not provide for carry, NAV effectively overstated and accordingly may need to calculate discount Consideration of underlying tax risk and possible impact on valuation Page 42

43 Section III (C) - Other Fund of Funds Many of the issues are similar to other Funds of Funds discussed above Understanding the status of each investment is the Fund: Traded Listed but not Traded Not listed, priced by Administrator Not listed, priced by Manager Understanding the underlying Funds strategies and how this may affect valuation Page 43

44 Section III (C) - Other Fund of Funds Key issues (continued) Frequency of Valuation Understanding who are the parties involved: Custodian Investment Advisor Board structure Auditors Look back testing to compare Estimate NAVs to Final audited NAVs Page 44

45 Any questions? Mike Byrne Director PwC Twenty Two Colomberie, St Helier, Jersey, Channel Islands JE1 4XA direct dial +44 (0) mobile +44 (0) fax +44 (0) PwC

46 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it PricewaterhouseCoopers CI LLP. All rights reserved. PricewaterhouseCoopers refers to the Channel Island firm of PricewaterhouseCoopers CI LLP or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. PricewaterhouseCoopers CI LLP, a limited liability partnership registered in England with registered number OC309347, provides assurance, advisory, and tax services. The registered office is 1 Embankment Place, London WC2N 6RH and its principal place of business is Twenty Two Colomberie, St. Helier, Jersey JE1 4XA. PwC

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