June 20, 2018
SVCA Interview with Srividya Gopalakrishnan, Managing Director, Duff & Phelps
How do you see the trajectory for PE/VC investments into Singapore and Southeast Asia moving? How does this trend underline the need for fair value reporting?
Southeast Asia is one of the world’s fastest-growing regions for PE and VC investments. Though Southeast Asia has been trailing behind China and India, the pace of growth has increased dramatically in the last few years. According to Duff & Phelps Transaction Trail, PE/VC investments into Singapore companies have increased from USD$ 880 million in 2013 to USD$ 6.1 billion in 2017, excluding two mega buyout deals in 2017 (Global Logistics Properties and Equis Energy).
There are several funds and fund management companies based in Singapore that invest across the Asia-Pacific and global markets. This fuels a need for fair value reporting, not only to be compliant with local accounting standards, but also to meet investor needs for various purposes such as financial reporting, asset-allocation, manager-selection, risk monitoring, and management compensation.
Fair value reporting has been proposed and encouraged for some time. SVCA has been a member of the International Private Equity & Venture Capital (IPEV) institution since 2011. In practice, however, have you seen any changes in terms of adoption and usage?
Globally, fair value reporting has been a requirement in many countries for over 70 years. Several decades back, however, cost was often used as a proxy for fair value. In the last two to three decades, several institutions such as FASB, IASB, PEIGG, IPEV etc., have come up with their own standards and/or guidelines for fair value estimation. In recent years, we have seen alignment of the fair value concept and definition among standard setters and now, it is imperative to report fair value under most accounting rules. Fair value is now consistently defined as the amount that would be received in an orderly transaction, determined using market participant assumptions, at each measurement or valuation date.
In Singapore and much of Southeast Asia, it is a requirement for investment managers to report the fair value of investments, based on prevalent accounting standards adopted from IFRS. Specific standards such as IFRS 13, IFRS 9 or IFRS 3 (for control investments) provide further guidance on fair value estimation. While the practice in Singapore and Southeast Asia is to report the fair value of investments, we do see several misconceptions in the assumptions used by fund managers when reporting fair value estimates.
What are some of these common misconceptions? Are we falling short of global benchmarks?
Most of the common mistakes we see in fair value reporting are the result of taking a highly simplified approach to valuation. While this makes the process easier, it could provide an unreliable end-result. For example, an approach that uses cost to estimate fair value because “nothing much has changed” or where there has been no recent investment could give rise to potentially erroneous results that over or understates the true fair value. We also see cases where investment features such as options, warrants, and other securities are ignored, which could overvalue related investments. In the VC space where frequent investment rounds occur, we often see the investment being marked based on the latest round and on a fully diluted basis. This practice can be risky as it could often lead to highly inflated values, considering that VC investments are typically in preference shares, with each round of investors having different dollar values attached to their liquidation preference, even if all terms are similar. This problem gets further accentuated when common shares are valued based on a recent preference round on a fully diluted basis.
The most common inconsistency in valuation that exists in our market is not applying the principle of “calibration”. Required under IFRS and US GAAP, calibration is a simple concept which uses the initial investment price, when deemed fair value, as a benchmark for identifying the inputs used for future valuation estimates. Future valuations should begin with calibration analysis and the value adjusted for any changes in investment performance and market conditions. Calibration is a powerful tool that can help determine fair value on a consistent basis and provides support for difficult judgments.
However, Southeast Asia is not alone in these misconceptions or practices. They are somewhat prevalent in other parts of the world as well. Having said that, some of the mature markets for PE/VC investments have had more experience, scrutiny, and continued guidance in performing such valuations. For example, the AICPA  recently published a working draft on “Valuation of Portfolio Company Investment of Venture Capital, Private Equity Funds and Other Investment Companies” , which was put up for public consultation in May 2018. This guide provides several hundred pages of guidance on the topic and provides several real-life examples. Considering that fair value definitions and standards have aligned globally, we can leverage such guidance in Singapore and Southeast Asia as we continue to improve our fair value estimates.
We have seen several funds raise new capital for investment into technology and new economy start-ups. Does fair value reporting pose a challenge for this asset class?
PE/VC investment into the technology sector in Singapore, Malaysia, and Indonesia, has increased substantially from US$ 672 million in 2015 to US$ 5.9 billion in 2017. A significant proportion of these investments have been made into companies which are pre-profit and sometimes even pre-revenue. These investments pose a valuation challenge as traditional metrics used for established companies cannot be applied. Instead, using some of the key concepts discussed earlier such as calibration, adjusting for rights, preferences and upside terms etc., we can estimate the fair value of such investments. Approaches such as Probability Weighted Expected Return Method (PWERM), Contingency Claims Analysis (CCA), milestone based analysis, and so on can be used to value such companies. There is no “one-size fits all” solution and approaches can be customized only after a thorough understanding of the investment rationale, detailed terms, cap table, business changes, and how the investment was priced at the last round of financing among other factors.
What about fair valuation of debt instruments? Is this required and how can this be done, given that the availability of comparable yields in Asia is limited and considering that most investors have traditionally used “amortized cost” as a proxy to fair value.
Fair value for performing debt investments is typically estimated using an income approach, assuming the instrument is not traded (actively traded debt and equity investments are valued at P*Q or price * quantity). However, prior to discussing valuation based on a discounted cash flow analysis, it is important to analyze if the loan is performing and whether there is sufficient enterprise value /collateral coverage. Even though we have significant data constraints on comparable yields in Asia, fair value can be estimated for these instruments through a yield-calibration approach, whereby the initial IRR is determined and then adjusted for market and credit quality changes.
For non-performing loans, further analysis is required to estimate fair value. Different approaches such as enterprise value recovery, liquidation, and/or income approach on a recovery basis could be used.
Several investors in our region have traditionally used amortized cost to report the value of debt instrument. With the adoption of IFRS 9, the investor needs to put the instrument through a business model test and a cash-flow characteristics test to determine whether fair value estimation is required. Typically, if an asset is held with the intention of selling it, which would be the case for most alternative investment funds, the fund will need to report fair value. Fair Value reporting is also necessary for investors in the fund. If a manager reports amortized cost, the investors in the fund may not be able to use reported Net Asset Value (NAV) as the fair value for the fund interest.
So what’s next on the horizon? What developments should our members prepare for other than IFRS 9 implementation?
In addition to the development of standards and guidance as discussed earlier, we are seeing an increasing trend towards credentialization of valuers. For example, the Institute of Valuers & Appraisers of Singapore (IVAS), which was set up under the auspices of the Ministry of Finance, registers business valuers under its Chartered Valuer & Appraiser programme. Some of the global initiatives in this space are the CEIV credential and Business Valuation Quality Mark initiative by IVSC.
With respect to valuation standards within Southeast Asia, we are observing a progressive shift towards global valuation standards that will encompass the requirements of regulators, investors, limited partners, and other stakeholders while complying with best practices and corporate governance principles. In addition, we see both limited partner investors and regulators focusing more and more on independence and rigor in the valuation process resulting in greater demand for fund managers to enhance their valuation process through the use of experienced, credentialed, independent valuation experts who validate fair value estimates.
 Duff & Phelps Transaction Trail Report: https://www.duffandphelps.com/-/media/assets/pdfs/publications/valuation/2017-transaction-trail-annual-issue.ashx
 Private Equity / Venture Capital
 Financial Accounting Standards Board (FASB), International Accounting Standards Board (IASB), Private Equity Industry Guidelines Group (PEIGG), International Private Equity & Venture Capital (IPEV).
 International Financial Reporting Standards (IFRS)
 American Institute of Certified Public Accountants
 Source: Duff & Phelps Transaction Trail Report: https://www.duffandphelps.com/-/media/assets/pdfs/publications/valuation/2017-transaction-trail-annual-issue.ashx
 Internal Rate of Return
 International Financial Reporting Standards 9 – Financial Instruments
 Certified in Entity & Intangible Valuations (CEIV)
 International Valuation Standards Council