Hedge funds: Next opportunity for valuation specialists?
Last week two separate reports from U.S. Treasury Department committees identified valuation as key to the survival of the hedge fund industry—which now manages over $2 trillion in assets. “Valuation is ultimately at the core of any investment,” says Principles and Best Practices for Hedge Fund Investors (from the Investors’ Committee to the President’s Working Group on Financial Markets [PWG]):
The increasing complexity and diversity of hedge fund portfolios and the increasing allocation to complex investments has resulted in a significant increase in efforts to formulate tools and processes for accurately valuing them….Auditors and institutional investors are striving currently to improve valuation techniques in the context of hedge funds increasingly investing in less liquid assets and harder to value assets.
Likewise, the Best Practices for the Hedge Fund Industry (from the Asset Managers’ Committee to the PWG) has “raised the bar” by advocating the adoption of “robust valuation procedures,” including those that would segregate responsibilities between portfolio managers and those responsible for valuations.
But can these assets be valued? The hedge fund industry’s call for self-regulation and disclosure is “an act of desperation,” says a new posting by Peter Schwartz at Pension Risk Matters. The funds want to avoid government oversight and regain public trust, he contends, by resolving the problem of valuation. “There is a palpable sense…that all would be well if we only knew how to value structured securities and derivatives.” But we don’t, he says. “The credit rating agencies don't. The banks don't. The hedge funds don't. Institutional investors don't.” Absent rigorous valuation data, methods, and models, he says, “there is no floor to the risk that financial institutions face when they toy with structured securities and derivatives.”
Susan Mangiero, publisher of Pension Risk Matters, disagrees. While self-regulation and market discipline would be ideal, “I'd like to think that calls for reform are positive reactions to problems rather than ‘desperate’ pre-emptive strikes against statutory mandates,” she says, in a recent posting (April 17, 2008). Mangiero believes that analysts can, under most circumstances, value complex securities with an appropriate “toolbox,” including: 1) reasonable assumptions; 2) appropriate and tested models; 3) understandable and available data; 4) identification of relevant risk factors that drive value; 5) methodology that reflects relevant economic considerations; 6) disciplined, systematic processes; and 7) common sense. “Ultimately, value equals price when a willing (and hopefully informed) buyer and seller agree on terms,” Mangiero says. “Until then, should we surrender to what some deem as villainous fair value accounting rules or roll up our shirtsleeves and get to work, acknowledging that a calculated ‘value’ may differ from an eventual price?”
To hear more from Mangiero, tune into her live teleconference with Rob Slee and Aswath Damodaran on “Measuring Risk,” presented from the upcoming NYSSCPA Business Valuation conference Monday, May 19, 2008. For more information, click here.
More news, less politics, to ‘feed’ BV appraisers
In asking what content BV appraisers and analysts would most like to see covered in the BVWire™, our latest online survey garnered more responses than any other (except a poll on BV professional standards). Interestingly—only a quarter (25.8%) of respondents want to see more information on BV standards and report writing. By far, the majority want updates on traditional valuation approaches (62.9% of respondents checked off this item) and on the assessment and application of discounts and premiums (54.8%). Nearly half (about 46%) want more coverage of valuation by the courts and by the IRS. And more than a third (33.9%), after reviewing the five choices, simply ticked off “all of the above.”
“Many of us hunger for information regarding what other practitioners are doing,” comments one. “We spend hours reading material that only applies to valuators doing 50 million dollar deals,” says another, “but practically every month I wonder what I’m spending my money on. I feel like the kid in Charles Dickens, looking through the window watching the family eating their nice dinner while I go hungry.”
At the same time, “fair value, the FASB and the SEC are significantly influencing the profession and therefore warrant coverage,” says another respondent. (Just look at the sold-out courses and conferences on fair value, this person points out.) “With the way things are going,” observed another, “fair value could very well become fair market value.” “I don’t really care about the ‘politics’ of fair value,” one analyst says, summing up what seemed to be the general consensus. “I do want the ‘news’ about it, but also other valuation issues.” The survey is still live and taking responses; in the meantime, we appreciate all the feedback—and will continue to strive for balanced coverage of critical issues that impact BV practitioners and the related financial, legal, and accounting professions in the BVWire as well as other products and services from BVResources. For instance, click here to send us suggested topics for future teleconferences—and if we end up producing your idea, you’ll receive a complimentary line (a $249 value).
Top ten SIC searches
What is the most frequent SIC Code search in the Pratt’s Stats® database? We ran a recent query and found that by far, Pratt’s Stats users are looking for transaction data relating to SIC 5812 (restaurants, non-drinking), with 277 searches since the beginning of last month. Software technology was second, with 220 searches for SIC 7372; and transaction data regarding doctors and medical clinics (SIC 8011) was third with 129 searches. The remaining top ten:
||searches for SIC
||8711 – Engineering services
||8742 – Management consulting services
||7361 – Employment agencies
||1711 – Plumbing, heating, air conditioning
||7389 – Business services
||1731 – Electrical work
||6411– Insurance agencies/brokers
But as business appraisers know, it’s how you understand and apply the transaction data that really counts toward creating a credible valuation conclusion. To that end, the May 2008 issue of The Business Valuation Update™ features an excerpt from the new release, The Comprehensive Guide to the Use and Application of the Transaction Databases, by Nancy Fannon and Heidi Walker and published by BVResources; pre-order a copy for shipment early next month here.
Also in the May BVU: An article by Gary Trugman, “Practical Solutions to Problems in Valuing the Very Small Business.” The article is also included among the ancillary reading materials to the next BVR teleconference, “Valuing the Very Small Company,” when Ron Seigneur and Stacy Collins join Trugman to discuss every aspect of these challenging assignments, from pre-screening the client to collecting the financial documents to applying market data from the relevant transaction databases. To register for the April 30, 2008, event, click here.
How Duff & Phelps Report isolates high-risk companies
One of the hallmarks of the Duff & Phelps Risk Premium Report is its exclusion of highly leveraged, financially distressed companies from its baseline data, placing them into a separate “high financial risk” portfolio. When a subscriber recently asked how (by what criteria) this separate category is created, Roger Grabowksi provided the following overview:
“For each year since 1963, we filtered the universe of companies to exclude the following:
- Companies lacking 5 years of publicly traded price history;
- Companies with sales below $1 million in any of the previous 5 fiscal years; and
- Companies with a negative 5-year-average EBITDA (earnings before interest, taxes, depreciation and amortization) for the previous 5 fiscal years.
“Companies that pass this test have been traded for several years; have been selling at least a minimal quantity of product; and have been able to achieve some degree of positive cash flow from operations. This screening responds to the argument that the ‘small cap’ universe may consist of a disproportionate number of high-tech companies, start-up companies, and recent Initial Public Offerings; and that these unseasoned companies may be inherently riskier than companies with a track record of viable performance. The number of companies eliminated by these criteria varies from year-to-year over the sample period. Once we eliminated these companies, we created a separate portfolio for those with any one of the following characteristics:
- Companies identified by Compustat® as in bankruptcy or in liquidation;
- Companies with 5-year-average net income available to common equity for the previous 5 years less than zero (either in absolute terms or as a percentage of the book value of common equity);
- Companies with 5-year-average operating income for the previous 5 years (defined as sales minus (cost of goods sold plus selling, general and administrative expenses plus depreciation)) less than zero (either in absolute terms or as a percentage of net sales);
- Companies with negative book value of equity at any of the previous 5 fiscal year-ends; and
- Companies with debt-to-total capital of more than 80% (with debt measured in book value terms and total capital measured as book value of debt plus market value of equity).
“We excluded these companies from our base set and placed them in a separate ‘high financial risk’ portfolio, thereby seeking to isolate the effects of high financial risk. Otherwise, the results might be biased for smaller companies to the extent that highly leveraged and financially distressed companies tend to have both high returns and low market values. It is possible to imagine financially distressed (or high risk) companies that lack any of the above characteristics. It is also easy to imagine companies which have one of these characteristics but which would not be considered financially distressed. Nevertheless, we are confident that the resulting ‘high financial risk’ portfolio is composed largely of companies whose financial condition is significantly inferior to the average, financially ‘healthy’ public company.
“The number of companies classified as ‘high financial risk’ varied over the sample period,” Grabowski concludes. “These companies represented approximately 25+% of the data set in recent years, but less than 5% in 1963. Certain technical changes in methodology have resulted in a greater number of companies falling into the ‘high financial risk’ portfolio than in versions of this study published prior to 2000.” To order the 2008 Risk Premium Report, click here.
The Appraisal Foundation seeks new board members
The Appraisal Foundation has begun its annual search for qualified candidates to serve on the Appraiser Qualifications Board (AQB) and the Appraisal Standards Board (ASB). There are currently up to three vacancies on the AQB; applicants should have a minimum ten years’ appraisal experience and familiarity with appraiser qualifications. The AQB meets four times per year for a total of approximately ten days. There are up to four vacancies on the ASB, and applicants should also have familiarity with USPAP as well as ten years of appraisal experience. The ASB meets five times per year for approximately fifteen days total. Individuals serving on both boards receive compensation for their time and travel reimbursement, and will serve terms of up to three years. Applications are due August 1, 2008. For more information, click here.
IASB and FASB to meet
The International Accounting Standards Board convened in London for two days for their semi-annual meeting with the Financial Accounting Standards Board, April 21-22, 2008. On the Boards’ extensive agendas: an update on the status of their Memorandum of Understanding and a discussion of their prior decision to adopt the entity perspective in their Conceptual Framework. To access all agenda papers and an archived webcast of the meeting, click here.