Valuation and Compliance Regulatory Update

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Valuation and Compliance Regulatory

Update

David Larsen

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Managing Director, Duff & Phelps

AnnMarie Croswell

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Managing Director, Duff &

Phelps’ Kinetic Partners division

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We are your regulator and we are here to help!

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10. The Global Search for Investors & Investments—Does geography

matter?

TOP 10 Valuation & Regulatory Questions

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The Global Search for Investors and Investments EU—Does

geography matter?

• The EU and AIFMD - Deciding where you want to market

– Reverse Solicitation: There are many risks for those looking to work exclusively on a reverse solicitation basis

– Offshore funds such as Cayman cannot obtain an AIFMD passport, so must rely on

National Private Placement Regimes (“NPPR”); Only a few NPPRs are workable and cost effective

– Best Route? - Most non-EEA managers choose the UK, Netherlands, Sweden and Finland to make Article 42 notifications

» No gold-plating in UK & Netherlands; some additional steps in Sweden and Finland – Key jurisdictions where NPPR is too difficult and not effective: France, Germany, Spain,

Denmark

– If marketing in jurisdictions such as France and Germany you may want to consider setting up an EEA fund (e.g. Irish or Luxembourg) in order to reach investors in these locations and appoint an independent third-party ManCo for the risk management aspect and portfolio management is delegated back to US SEC Registered Investment Adviser

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• The Long Arm of the US SEC and CFTC jurisdiction reaches to Asia • GP’s looking to invest into China, Hong Kong or Singapore:

– consider whether the investment will cause the Asia manager to register with the SEC / CFTC

– whether manager has satisfactory compliance program in place

– whether GP’s compliance mandate can be satisfied by SFC or MAS regulatory regimes • Key areas of compliance scrutiny for investments in Asia managers

– Conflicts and ownership structure – Expert networks

– Market Conduct

The Global Search for Investors and Investments

Asia – Does geography matter?

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9.

A Consultation Draft of the Updated IPEV Valuation Guidelines has been

released—Why should I care?

10. The Global Search for Investors & Investments—Does geography matter?

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• Last update December 2012

• Proposed Changes http://www.privateequityvaluation.com/consultation – Update on IASB Unit of Account Progress

– New guidelines to emphasize the need to value investments held by the reporting entity, the need for consistency, backtesting and expanded discussion of valuing early stage investments – Clarification on how to think about the value of debt for purposes of determining the value of

equity

– Clarified guidance with respect to valuation techniques

– Differentiate between earnings multiples and revenue multiples – Negative bias towards DCF removed

– Expanded description of calibration

– Special Considerations expanded to include: » Minority positions

» Mathematical Models, guidance updated » Sum of the Parts

2015 Proposed Updates to IPEV Valuation Guidelines

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8.

Regulation—What are the SEC’s Exam Priorities and Enforcement

Results?

9.

TOP 10 Valuation & Regulatory Questions

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• 2015 focus areas included – PE firms fees & expenses

– Branch offices and their compliance programs – Large Firm Monitoring

– Best Execution / Order Routing – Cybersecurity

– Recidivism

• SEC FY 2015 Enforcement Results – 807 enforcement actions

– Orders totaling 4.2b in penalties and disgorgements • Broken Windows Approach

• Added expertise in areas such as PE

Regulation– What are the SEC’s Exam Priorities and

Enforcement Results

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7.

Uncertainty vs Materiality—What is FASB thinking?

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Regulation—What are the SEC’s Exam Priorities and Enforcement Results?

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TOP 10 Valuation & Regulatory Questions

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Disclosure: Uncertainty

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FASB is contemplating Fair Value disclosure modifications which include (not applicable to private companies):

• Paragraph 820-10-50-2(g) (narrative discussion) will be refocused on information about the uncertainty in measurement at the reporting date and not about sensitivity to future

changes

• Paragraph 820-10-50-2(bbb) (quantitative information about significant unobservable inputs) should include both:

• (1) the range of the unobservable inputs used and

• (2) the weighted average of the unobservable inputs used

• Disclosure of the time period used to develop any significant unobservable inputs that are based on historical data would be required

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Disclosure: Materiality

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FASB has issued two exposure drafts focused on Materiality (comments are due December 8, 2015):

• Amendments to FASB Concepts Statement No. 8, Conceptual Framework for Financial

Reporting intended to clarify the concept of materiality. Specifically, these amendments

would be made to Chapter 3, Qualitative Characteristics of Useful Financial Information.

• Proposed Accounting Standards Update (ASU), Notes to Financial Statements (Topic 235):

Assessing Whether Disclosures Are Material, focuses on the “entity decision process,” and

is intended to promote the appropriate use of discretion by organizations when deciding which disclosures should be considered material in their particular circumstances.

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Fees, Expenses & Conflicts of Interest—Is there a systemic problem?

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TOP 10 Valuation & Regulatory Questions

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Fees, Expenses and Conflicts of Interest, is there a

systemic problem?

• SEC is closely reviewing how RIAs disclose the allocation of fees and expenses to their investors. Identified risks:

– Payments to Consultants – Shifting of expenses

– Characterization of expenses – Hidden fees

– Valuation

• SEC: “Given the high rate of deficiencies observed in PE in connection with fees and expenses, we will continue to conduct examinations in this area.”

• SEC headlines

– Issues with the use of affiliated entity / Operating partners - ~10m penalty; ~30 penalty • Disclosure, Disclosure, Clear Disclosure: Review and update disclosures, compare fund

documents and policies against current practices, test fees and expenses

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5.

AICPA PE/VC Guide Taskforce—Is progress being made?

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Fees, Expenses & Conflicts of Interest—Is there a systemic problem?

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released—Why should I care?

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AICPA PE/VC Valuation Guide Taskforce

• Task Force objectives are:

− Harmonize the diverse views of industry participants, auditors and valuation specialists − Produce a more user friendly guide with examples that can be used to reason through

real situations faced by valuation specialists and auditors • Working title:

− Determining Fair Value of Portfolio Company Investments of Venture Capital and Private Equity Funds and other Investment Companies

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Working Outline of the Practice Aid

I. Overview of the Industry and Its Investment Strategies II. Market Participant Assumptions

III. Determining the Unit of Account and the Assumed Transaction for Measuring the Fair Value of Investments

IV. Overview of Valuation Approaches and Methods

V. Valuation of Equity and Debt Securities in Simple Capital Structures VI. Valuation of Equity Securities in Complex Capital Structures

VII. Control and Marketability VIII. Calibration

IX. Backtesting

X. Transaction Costs XI. Special Topics

XII. Frequently Asked Questions Appendix

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Cybersecurity—Why is it a Global Focus?

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AICPA PE/VC Guide Taskforce—Is progress being made?

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released—Why should I care?

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Cybersecurity - why is it a Global Focus?

Push from Global Regulators -

• OCIE Round One - Summary of Cybersecurity Findings – April 2015 • OCIE Round Two – Further Examination – Sept 2015

• NFA - Information Systems Security Program – Oct 2015

• HK SFC and HKMA, Singapore MAS – Circulars and Warnings: Highlighting Cyber Threats and reminders to conduct assessments – November 2014, September 2015

Expectations on Advisers

• Inventory information assets and identify confidential data

• Conduct a cybersecurity review (technical measures, policies, procedures) • Suggest use of a threat and vulnerability risk assessment

• Cyber security via technical measures, policies, procedures and training are implemented to reduce risks

• Review service provider information security risks

• Have a formal cybersecurity response and recovery plan

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Reduce your Cybersecurity risk

A 10 step approach

What’s involved?

Step 1 • Inventory IT assets and classify confidential data Step 2 • Threat Vulnerability Risk Assessment

• Identify further measures ; conserve investment to mitigate the highest risks • Manage the mitigation of risks with IT and associated IT service providers

Step 3 • Examine and reduce service provider security risks; adjust service provider contracts Step 4 • Review prime site technology resilience and service continuity measures

Step 5 • Review business continuity plans with respect to cybersecurity resilience Step 6 • Cybersecurity incident response and recovery procedure

• Have the ability to recover from a cyber attack of any nature

Step 7 • Review governance structure for cybersecurity

• Tailor IT security and Staff IT Acceptable Use Polices

• Check protection for regulation electronic record retention requirements • Update compliance policies

Step 8 • Staff Cybersecurity and IT Acceptable Use training

Step 9 • Conduct an independent network penetration test to minimize external hacking risk Step 10 • Deliver a regulatory Cyber Security review report

• Investor Due Diligence – update DDQ for cybersecurity or have investors ODD responses ready

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3.

FASB/IASB—Are any other changes in the wind?

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Cybersecurity—Why is it a Global Focus?

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A Consultation Draft of the Updated IPEV Valuation Guidelines has been

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FASB/IASB—Potential Changes

IASB:

• Still contemplating changes to Unit of Account Guidance (entire interest vs single share)—could there be a change to the P*Q rule?

FASB/IASB:

• Leases—deliberation continues; when implemented will likely impact multiples used to determine fair value

• Revenue Recognition—deferred to 2017 or 2018; will impact multiples used to determine fair value

• Revenue Recognition Transition Resource Group (TRG) considering discussing carried interest at a future meeting

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Proposed AML Rules—What do we need to know?

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FASB/IASB—Are any changes in the wind?

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A Consultation Draft of the Updated IPEV Valuation Guidelines has been

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Proposed AML rules for SEC Registered Investment

Advisers—What do we need to know?

• Proposed Rules were about 10 years in the making • Affects all SEC RIAs - globally

• FinCen: generally, proposed three regulatory changes that would impact SEC registered investment advisers:

– Establish and maintain an AML program

– Require submission of suspicious activity reports

– Subject the RIA to BSA requirements as a “financial institution”

• Start now to consider how to build a risk based AML compliance program

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Valuation—Nine years after SFAS 157; Are there any new valuation

questions/challenges?

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Proposed AML Rules—What do we need to know?

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FASB/IASB—Are any changes in the wind?

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Uncertainty vs Materiality—What is FASB thinking?

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TOP 10 Valuation & Regulatory Questions

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Old Valuation Challenges

• Unit of Account

• Valuing Early Stage Companies

• Market Participant Perspectives vs Auditors need for documentation • LP’s Valuation of Fund Interests

New Valuation Challenges

• Suspended Trading • Unicorns

• PCAOB/SEC concerned that Uncertainty exceeds Materiality • Daily vs Monthly vs Quarterly vs Semiannual Valuations

• GASB’s new Fair Value Standard impacting LPs

http://www.privateequityvaluation.com/consultation

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