Published on November 15, 2008
Accounting and Valuation Issues i dli ‐ Examining new Fair Value Rules PIPES CONFERENCE 2008 ESPEN ROBAK CHRIS JOHNSON ELE KLEIN NEIL PINCHUK © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
FAS 157 Definitions 2 Fair value: the price that would be received in an orderly transaction between market participants on the measurement date. Orderly transaction: market exposure usual and customary marketing activities usual and customary marketing activities not a forced transaction. Exit price: the price received upon sale in a hypothetical Exit price: the price received upon sale in a hypothetical transaction. Based on assumptions of market participants. p p p © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Valuation Inputs (the “levels”) 3 Valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs – FAS 157 Fair Value Hierarchy – focus on inputs, not techniques: Level I – Observable Inputs: unadjusted market prices for identical assets. assets Level II – Observable Inputs: quoted prices for similar assets in active markets, quoted prices for identical or similar securities in inactive markets, other observable market inputs, and inputs derived from markets other observable market inputs and inputs derived from or corroborated by the market. Level III – Unobservable Inputs: everything else. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Level II Measurements 4 Quoted prices for similar assets or liabilities in active markets. Example: PIPE securities, other restricted securities. Quoted prices for identical or similar assets in inactive markets. Markets with few transactions. Markets with few transactions Markets where prices are not current, or where quotes vary over time or among market makers. Principal‐to‐principal markets or other markets where little information is publicly available. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Level II Measurements (cont.) 5 Observable data other than quoted market prices. Interest rates and yield curves. Volatilities. Credit risks and default rates. di i k dd f l Inputs derived primarily from observable market data through correlation or regression analysis. through correlation or regression analysis The key distinguishing characteristic (relative to Level III inputs) is that the fair value problem is solved by market inputs) is that the fair value problem is solved by market participants. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Recent Implementation l i Guidance ‐ Center for Audit Quality ‐ Securities and Exchange Commission Securities and Exchange Commission ‐ Financial Accounting Standards Board ‐ Department Of Labor Department Of Labor © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Center for Audit Quality 7 White paper on “Measurements of Fair Value in Illiquid (Or Less Liquid) Markets.” “Questions have arisen about (…) whether current market prices are more indicative of distressed sales”. In 2004 release, the SEC held that the registrant violated GAAP by using a definition of fair value that assumed GAAP b i d fi iti f f i l th t d supply and demand were in reasonable balance. Specifically, the SEC objected to the practice of ignoring Specifically the SEC objected to the practice of ignoring quoted prices and “taking the longer view”. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Center for Audit Quality (cont.) 8 If transactions are occurring in a usual and customary manner, those deals are not “forced” sales. The fact that transaction volume is low does not indicate the sales are forced or distressed sales. Decreased volumes in a market do not necessarily mean the market has become inactive. th k th b i ti “Markets with a reduced transaction volume under current conditions are still considered active if current conditions are still considered active if transactions are occurring frequently enough on an ongoing basis to obtain reliable pricing information.” gg p g © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
SEC Comment Letter 9 March 2008 letters Specifies disclosures for MD&A, especially for any model‐ driven valuations Notes that FAS 157 does not require mark to market if “market” consists of forced or distressed sales “Supporters of using fair value believe that investors and other users of financial statements are better served by knowing, where possible, what something is currently worth rather than relying on management assumptions – which many experts deride as a rose‐tinted “yes, but it is going assumptions which many experts deride as a rose tinted “yes but it is going to go up again” approach. ‐ Financial Times, April 1, 2008 Lynne Turner: […] the notion that if you have a distressed asset, you can avoid market prices, which is not the spirit or intention of this rule market prices which is not the spirit or intention of this rule”. – FT April 1 08 FT, April 1, 08. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
FSP 157‐3 10 FASB Staff Position: Fair Value in Inactive Markets Warns against broker quotes, in particular. Provides amendment to FAS 157 – new Example. p Invested in AA tranche of CDO Market increasingly inactive, widening bid‐ask spreads, volume down Few observable transactions, no current quotes, widely varying quotes Approach chosen: increase discount rate from when markets were active, supplement with data from indicative quotes. Supported by SEC September 30 release. Supported by SEC September 30 release © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
DOL Letter (June 2008) 11 To pension plan investors in hedge funds. “A process which merely uses the general partner’s established value for all funds without additional analysis may not insure … fair market value” Plan administrators “must have a thorough knowledge of the general partner’s valuation methodology” th l t ’ l ti th d l ” © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
LP Interest Discounts? 12 Funds‐of‐funds, pension funds and other investors invest at NAV: entry price. Should the exit price be adjusted for lock‐ups? If an LP investor wants to sell its interest, would buyers If an LP investor wants to sell its interest would buyers demand a haircut from NAV for a two‐year lockup? In most situations, “issue went away” Question: what happens when gates go up? Often valuation uncertainty/volatility associated with gates. Not a point where investors typically put new money in. p yp yp y Acceptable to value “liquidating” portfolio at different level than ongoing portfolio? © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Questions for Panel 13 Recent guidance – did any of that help? g y p Going from Level I to Level II – what rules or standards can we rely on? y When, if ever, can we ignore market evidence? Determining fair value when every sale is a fire Determining fair value when every sale is a “fire sale” Broker quotes vs mark to model Broker quotes vs “mark‐to‐model” The LP valuation discount issue is back – and this time for good? time for good? © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Specific Valuation Evidence ifi li id ‐ Restricted Stock Discounts ‐ Warrant Discounts ‐ Convertible Securities Valuation © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Restricted Stock Discounts 15 70.0% 60.0% 50.0% Discount 40.0% 30.0% 30 0% D 20.0% 10.0% 10 0% 0.0% 0 0 0 0 0 0 0 0 0 0 0 0 0 10 30 50 70 90 11 13 15 17 19 21 23 25 27 29 31 33 35 Days of Illiquidity Remaining © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Restricted Stock Discounts (ct) 16 Market Block Size Revenues Holding Market Volatility Discount Cap ($ ) C ($m) ($m) ($ ) Period P id Price Pi (Days) 293 450% 124 203 $7.89 86% 28.3% Average 203 76 38 210 4.03 77 22.9 Median 407 35 48 227 13.11 81 12.8 1st Quintile 100 59 54 251 3.63 74 19.4 2nd Quintile 90 40 54 105 3.85 76 22.9 3rd Quintile 232 256 13 229 5.24 5 24 68 35.0 35 0 4th Q i til Quintile 99 274 7 197 2.70 104 47.5 5th Quintile © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Warrant Discounts 17 Market Stock Intrinsic Delta Money- Volatility Discount Cap ($m) Price Value ness 231 $6.81 $2.31 0.817 0.202 86.3% 42.7% Average 153 4.12 0.38 0.831 0.153 69 44.2 Median 229 7.66 2.16 0.903 0.471 52 15.3 1st Quintile 160 4.96 1.42 0.841 0.317 66 30.2 2nd Quintile 127 4.40 0.43 0.794 0.139 60 44.5 3rd Quintile 123 2.45 0.00 0.830 -0.058 83 56.8 4th Quintile 106 2.44 0.00 0.803 -0.184 90 66.9 5th Quintile © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Basics of Convertible Valuations 18 Convertible valuations can be at a premium to “intrinsic” or as‐if‐converted value. Reflects the value of the “floor” downside protection to the equity value of the instrument. value of the instrument Implies little or no illiquidity discount for the underlying shares – effective registration statements and no “implied” blockage. Valuations can be at a discount from face value. Risky, highly illiquid positions in nano‐cap issuers. Significant deterioration in the stock price. Significant deterioration in the stock price Usually “fallen angels” with or without floating conversion prices. Severe illiquidity for the underlying convertible. Most convertibles: value somewhere in‐between. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
Questions for Panel 19 Convertible debt bifurcation analysis – models y or market data? Valuation impact of shortening Rule 144 period. p g p How do agreement terms affect fair value? Registration rights Warrant call caps Cashless exercise Effect of going through the reverse merger Effect of going through the reverse merger process. © Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500
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