Houlihan Lokey conference, fueled by the SEC’s Karpati, sees more valuation scrutiny in the near future
The SEC and other US and international regulatory agencies were concerned about hedge fund fraud and lack of transparency during the downturns of the last decade. But private equity funds are now in the crosshairs, and the valuation of their portfolios is at the center of much of the new concern.
This message, fueled by recent comments by the SEC’s Bruce Karpati (and similar comments from Carl DeFlorio), was central to an intensive half day Private Equity Valuation Roundtable in New York on May 15th, organized by Houlihan Lokey (HL). Conference organizer Cindy Ma highlighted the changing environment by (literally) playing Bob Dylan’s “The Times They Are A-Changing” between sessions.
Multiple perspectives but the same conclusion on the importance of independent valuations. David Preiser, co-President of HL, kicked off the proceedings by commenting that his firm is seeing more requests for guidance from the private equity sector on the regulation of valuation their portfolios. HL would know, since it sees the market from three sides—investor, M&A service provider, and valuation expert (Ma is the Head of their Portfolio Valuation & Advisory Services Practice).
These concerns are natural because carried interests are being debated in the political world, and limited partners are becoming “insistent and focused” in conversations with private equity general partners in issues of transparency, who can demand (and receive) special treatment, and more, Preiser said.
The SEC (and international regulators, particularly in the EU) has refocused resources in valuation-related areas, and from all sides, “increased enforcement must be expected,” Preiser predicts. Meanwhile, the competition for investments is higher than ever, so “those who adapt well will flourish. Those who don’t, won’t.”
Private equity has its own set of valuation conflicts of interest, exposing valuation of these illiquid assets to political and regulatory attention. For instance, Preiser cites a growing “interfund valuation” problem for the larger limited partners and fund of fund investors, particularly; the situation when, as one fund closes, a second is still initiating capital calls, “frequently investing in the same assets to the detriment of the initial fund, for instance.”
HL panelist Gary Kaminsky (ConceptOne, and former counsel at the SEC’s Enforcement Division) said ” I think the regulators now view valuation issues as cutting to the integrity of the investing institutions, since hard-to-value assets and enterprise risk management systems are global issues for private equity too.”
Clear guidance from the regulators on their valuation expectations. The government has been much more transparent over the last few years. They’re trying to tell investors what they’ll be looking for,” Kaminsky said. Despite this, in many cases, the regulators are “seeing compliance and risk management systems in place that are surprising them.” Reviews become full-blown examinations as a result.
“Having a deliberative process around valuation internally is something enforcers are expecting to see,” Kaminsky confirmed. He sees may firms hiring valuation experts internally, and better systems being constructed. The initiative from the SEC isn’t all about fraud, either, he believes. They’re going beyond that, “challenging whether a chief compliance officer has the correct experience. And they’re comparing your public statements with what you’re actually doing,” perhaps particularly during the investment period.
Jason Brown (Ropes & Gray) commented on the lessons learned by three main actions brought by the SEC against PE firms. Oppenheimer, for instance, got in hot water for changing valuation methods on a fund of funds product, even though they said they were using independent valuation experts. The SEC noted that the change in valuation method resulted in a change of IRR from 3% to 38%.
Commercial Reasonableness and FMV in Healthcare Valuation webinar on the 29th
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Featuring: Mark Dietrich and James Pinna Date: Wednesday, May 29, 2013 Time: 10:00am-11:40am PT / 1:00pm-2:40pm ET Earn 2 CPE Credits |
Why you should attend:
The Stark Law, the anti-kickback statute, the False Claims Act, and Internal Revenue Service 501(c)(3) status all include regulations and sanctions requiring that transactions in the healthcare field be both commercially reasonable and at fair market value. While appraisers and businesses have refined the definition of fair market value over the past several years, such consensus and guidance on commercial reasonableness has yet to be created. Despite this, increased government commentary has underscored the need to understand and ensure that this requirement is met for all financial arrangements between parties in a position to refer.
Expert Mark Dietrich and attorney James Pinna address the requirements set forth by the many statutes regulating healthcare transactions, and what appraisers need to know in order to be in compliance with their stipulations of standards of value and commercial reasonableness.
| Register Online Today for $179.00
$179 Webinar/$269 Webinar and Training Pack* |
Agenda
- Fair market value defined
- Commercial transactions
- Physician workforce, recruitment, and retention
- Does the transaction make sense in the absence of referrals?
Duff & Phelps’ Larsen sees more thorough valuation work now required under IFRS 13
This past January 1, International Financial Reporting Standard No. 13 (IFRS 13) went into effect. It provides guidance on how to measure an asset’s fair value, but many companies haven’t even begun to implement it. Plus, certain aspects of the new rules will be particularly troublesome.
Speaking on a recent webcast, David Larsen (Duff & Phelps) said IFRS 13 applies to most corporations because it requires disclosures of fair-value measurement for M&A activity, asset impairment, or activity involving certain investment entities. During the webcast, attendees were asked: Have you started implementing IFRS 13? About half (47%) said they had started it, but over a third (38%) said they had not. The rest (16%) said they had completed full implementation.
Stumbling block: IFRS 13 now requires a lot more substantiation of the valuation techniques used in obtaining fair value, such as comparisons of different measurements to observable market data. This is known as “calibration,” and it is “one of the most important tools in IFRS 13 … and likely one of the least understood and least applied,” Larsen said.
Under IFRS 13, companies now must disclose fair values according to a “fair value hierarchy,” which categorizes the inputs used in valuation techniques into three levels. The hierarchy gives the highest priority (Level 1) to quoted prices in active markets for identical assets or liabilities and the lowest priority (Level 3) to unobservable inputs.
In its disclosures, a company must also explain qualitative sensitivity analysis if changing inputs would result in alternative assumptions about fair value. There must also be a quantitative disclosure for Level 3 inputs.
Larsen noted: “The expansion of disclosures could be a new thing for many; a lot of judgment goes into the disclosure area.”
Causation is pivotal to credible damages testimony, Fannon points out
Nancy Fannon (Meyers, Harrison & Pia) is concerned that recent BVWire reports on causation and lost profits leave the impression that damages experts don’t have to consider causation. Failure to link your damages to the actions of the defendant and rule out all causes for the loss, she says, makes an expert vulnerable at deposition or on cross-examination and a likely candidate for exclusion at trial.
“I frequently find that the misconception among experts is that they do not need to address cause,” which, she feels, may contribute to a general lack of credibility with the court. “The question is,” she goes on to say, “how can you calculate the extent of damages flowing from the breach, if you don’t consider the realm of things that could have caused the plaintiff’s presumably declining results? Is the attorney going to tell you the economy is down, prices went up, his client’s product is nearly obsolete, a new competitor went in down the street? I don’t think so. That’s our job to ferret it out.”
Survey confirms that buyers find reasons to reasons to reduce the purchase price more often than not
Most private-target M&A deals have price adjustments favorable to the buyer immediately prior to, or after, the closing, a new study confirms. This won’t surprise most BVWire readers–but does this mean the valuations were wrong?
The 2013 SRS M&A Post-Closing Claims Study analyzes post-closing issues and payouts across 420 private-target acquisitions, comprising $66.7 billion in stated deal value. Shareholder Representative Services (SRS) is a post-closing expert for private-company M&As. Overall, the study shows that two-thirds of all deals had issues arise after closing, and one in five deals with claims actually had exposure exceeding half of the escrow.
Other interesting findings: Of the deals analyzed, 8% had at least one claim made in the final week of the escrow period. Final escrow releases were delayed due to claims in 30% of deals. Almost three-quarters (73%) of deals with post-closing purchase price adjustment mechanisms saw adjustments, which were more often buyer-favorable than seller-favorable. Of these adjustments, 27% were ultimately modified from the initial amount claimed.
What do you think? Is there a tendency for sellers to overvalue acquisition targets? Are buyers not doing enough due diligence into value to justify the prices they’re paying (or relying on this technique as a simple negotiating technique)? Or is this phenomenon merely a result of the complex negotiation and deal structure process inherent in these deals? Write to the editor here.
Front-burner topics highlight upcoming CPE events
How has the growth in the volume and prominence of patent infringement claims shaped the methods and analysis employed to present those claims? Find out as the Online Symposium on Economic Damages continues on May 7 with Hot Topics in Patent Royalty Damages, featuring expert Richard Bero (The BERO Group) and attorney Robert Surrette (McAndrews Held & Malloy Ltd.).
Emerging trends in the service industry are affecting the practice of business appraisal. Learn about this and how to avoid or overcome classic valuation pitfalls on May 8 during Valuing Professional Practices, a 100-minute webinar that features Kevin Yeanoplos (Brueggeman and Johnson Yeanoplos).
Proving causation for lost sales undermines an expert’s testimony
In lost profits cases, the causation element puts the plaintiff’s damages expert in a quandary, we reported here a few weeks ago. Do you assume liability and strictly focus on damages, or testify to it?
In a recent patent infringement case, the expert unsuccessfully opted to do the latter. Both parties produced “advanced energy” surgical products for laparoscopic and minimally invasive procedures. The plaintiffs claimed the defendant violated three of its patents for ultrasonic surgical devices and the federal court (D. Conn.) agreed.
To establish the requisite linkage between the defendant’s violation and their lost sales under the Panduit test, the plaintiffs tried to establish the market share allocation they would have had “but for” the defendants’ infringing devices. The court agreed with the definition of the market the plaintiffs’ expert proposed: a single market for advanced energy cutting and coagulating devices in which the litigants were the largest players and competed directly with each other. The plaintiffs did so with two different types of products, instruments using ultrasonic energy and those using radiofrequency (RF). Witnesses agreed that both types of energy worked for the same surgeries. This, the expert stated, meant they could function interchangeably.
If, in the 2010 “actual market,” the plaintiffs had a 24% market share, in the 2010 “but for” market, the plaintiffs would have a 54.2% market share, regardless of the defendant’s access to “immune” ultrasonic products and its own line of RF products, the expert calculated. For 2011, the plaintiffs’ actual market share was 27.5%, but, under the expert’s reconstruction, it would be 60.2%. This increase was due to a steady rise in the use of RF technology, he said, referencing a 2010 report from the Millennium Research Group (MRG) on vessel-sealing instruments.
The defendant’s expert claimed primarily that the “immune” products would fill in the “hole” the absence of the infringing devices left in the market. The court rejected this model but also found the market reconstruction of the plaintiffs’ expert problematic. The research study included information that “undercut” his “but for” market reconstruction. There was insufficient evidence to infer that “RF technology would have taken over the advanced energy market to the extent [the plaintiffs’ expert] claimed.” Because the plaintiffs did not prove causation, their case for lost profits damages failed.
However, the expert’s reasonable royalty analysis fared much better. Ultimately, the court awarded $141 million in royalty damages. Read the complete digest of Tyco Healthcare Group LP v. Ethicon Endo-Surgery, Inc., 2013 U.S. Dist. LEXIS 43992 (March 28, 2013) in the JuneBusiness Valuation Update; the opinion will be available soon at BVLaw.
Valuing odd investments in an ERISA plan
A brewery, diamonds, liens, water rights—even a slaughterhouse—are the kinds of investments pension plan sponsors are adding to their portfolios, reveals an article in the New York Times. Plan sponsors like these investments because they avoid the need for cash they would otherwise have to use to plug funding gaps. Plus, if these assets yield high returns, it reduces the level of investment needed to fund the plan in full.
The ripple effect on valuation professionals is that the U.S. Department of Labor, which must approve large, in-kind pension contributions, could require the hiring of an independent fiduciary to bring in a valuation expert to assess the unusual asset, according to Susan Mangiero (Fiduciary Leadership), writing in Pension Risk Matters. “As a trained appraiser, I would tell anyone who asks that there are multiple items that must be assessed as a precursor to determining fair market value of the asset in question,” she says.
For example, if the asset has multiple owners, can the plan exercise authority over how it’s used, disposed of, and/or managed for purposes of adding to the asset’s value? If others have claims on the asset, what is the plan’s pecking order if the asset throws off cash or gets sold? Since unusual assets may not trade in an active secondary venue, what is the appropriate discount for lack of marketability so that the ERISA plan does not overpay?
Watch out: The DOL wants to designate appraisers as a fiduciary for an assessment they render about an ERISA plan. This effort, along with other factors, has made pension and ESOP valuations a minefield for appraisers. To learn more, Mangiero will participate in a May 14 BVR webinar, Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser, along withRob Schlegel (Houlihan Valuation Advisors) and ERISA attorney James Cole (Groom Law Group).
Overvaluation penalty is fair, tax court concludes
The Tax Court has overturned its own precedent in ruling that a taxpayer may not avoid the 40% gross valuation penalty for overvaluing a tax shelter. Taxpayers have been able to avoid the penalty short of trial merely by conceding on grounds unrelated to valuation or basis. But now, in AHG Investments, the court shifted gears and followed the majority rule in the appellate courts and sided with the IRS, which had waged a decades-long battle on this issue.
What it means: This ruling may trigger more trials focusing on valuation issues, since the value of the underlying assets is typically the fundamental issue in abusive tax shelter cases. It also means investors need to be more careful when presented with a business deal that promises tax benefits based on assets with a questionable valuation.
The 2013 Mergerstat Review has arrived
BVR is shipping out the first copies of the year this afternoon, so if you’ve pre-ordered you’ll have your 2012 large transaction comps handbook in the next few days. If you haven’t ordered, it’s available here.
Available exclusively via BVR’s partnership with FactSet, the Review provides comprehensive and accurate statistics and analysis of the largest mergers and acquisitions involving U.S. companies, including privately held, publicly traded and cross–border transactions. It also analyzes unit divestitures, management buyouts and certain asset sales. It’s an essential part of industry analyses and guideline company approaches. Besides the annual report, users receive the FactSet Mergerstat Monthly Review – for current 2013 transactions–delivered as PDF.
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