BVWire Issue #148-3 | January 21, 2015


New research suggests PE firms manipulate valuations

Soon-to be-released research suggests that private equity funds are not doing valuations properly, reveals a report in the International Business Times. PE firms may have “effectively embellished their returns to make them look more attractive to pension managers,” says the report.

Against theory: A key element of PE firms’ marketing pitch is that their investments overall are less volatile, or less risky, than the S&P 500 index. The new research challenges that position. “The industry’s assertion contradicts classic financial theory, which stipulates that highly levered investments are inherently more volatile than less-leveraged investments,” says investment banker Jeffrey Hooke (FOCUS), a co-author of the new study. “Our study casts doubt on that marketing ploy.” Hooke worked on the new study with researchers from George Washington University

"The investments in private companies may only appear safer because the private equity managers are in control of how the investments look on paper, not because the actual value of the assets [is] more stable or better performing,” he told IBT.

Last year, BVWire pointed out that scrutiny would increase on PE fund valuations due to concerns by the Securities and Exchange Commission over alleged overvaluations. The SEC implemented an audit program and stepped up its enforcement actions. For more information, see the article in the August 2014 issue of Business Valuation Update, “Best Practices for Fund Valuations Amid Ongoing SEC Crackdown” (subscription required).

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Sleeper case set to awaken soon in Tax Court, says Bogdanski

According to Prof. John A. Bogdanski (Lewis & Clark Law School), the most intriguing valuation controversy making its way through the Tax Court is a charitable contribution case that has progressed much further than might have been expected. Bogdanski discussed it during his recent webinar, “Business Valuation in the Federal Tax System in 2014.”

‘Convoluted’ facts: This is essentially a tax shelter case, Bogdanski says, and the facts are appropriately “convoluted.” The donor, an LLC called RERI, was a partnership for tax purposes. During its short life, it donated an interest in another LLC, known as Holdings, to a university. A corporation originally was the sole member of Holdings, but in 2002 it split its membership interest into two “temporal interests.” Holdings’ only asset was the sole membership interest in another LLC, Hawthorne, which, in turn, owned property in Southern California that it leased to AT&T as a web hosting facility.

The donor acquired its partial interest in Holdings for $2.95 million and, in August 2003, pledged a $5 million gift to a university. The university agreed to hold the interest for at least two years and then sell it, with the proceeds to be credited against the gift pledge. On its tax return, the donor claimed a value for the donated interest of $32.94 million.

In December 2005, the university sold the Holdings interest to another LLC controlled by the donor for $1.94 million, which sold the interest to an unrelated individual buyer for $3 million. That buyer then contributed the Holdings interest to another charity, claiming a value for it of $29.93 million.

Huge value gap: The donor arrived at its value by using present-value tables promulgated under the Tax Code’s section 7520. It hoped to exploit a feature of the provision which assures that the values of the present interest and future interest add up to the value of the property underlying the time-divided interests, without discounts.

The IRS balked and sought dismissal of the case on summary judgment. The valuation was improper as a matter of law for two reasons. One, the tables were inapplicable to the situation at hand. The donated interest was in Holdings, but the appraiser valued the underlying property that belonged to Hawthorne. Also, the interest was not a “standard” remainder, as specified in section 7520, but was a “restricted beneficial interest.” The donation imposed a two-year hold-and-sell requirement on the university.

The court found the IRS had not shown as a matter of law that the restriction was of consequence to the valuation of the interest. It noted that neither party had addressed the huge discrepancy in value between the claimed value of the Holdings interest and the consistently low prices it commanded during multiple actual sales. On its face, that gap seemed “violative of the unrealistic and unreasonable fair market value standard,” the court allowed. But, barring further exploration of the facts, it could not conclude that the application of section 7520 in this case was unreasonable and unrealistic.

Two, the IRS argued that the donor’s valuation did not meet the “qualified appraisal” standard. For one, the appraiser valued the wrong property—the underlying real estate rather than the donated Holdings interest. Also, the appraisal did not mention the hold-and-sell restriction. And, the appraiser employed “investment value,” instead of the fair market value. The court found that all of these arguments were material factual disputes requiring resolution at trial.

Unusually ‘forgiving’: As Bodganski sees it, just in terms of the appraisal alone, Judge Halpern was unusually “forgiving.” A stricter Tax Court judge (and they exist) flat out would have disallowed an appraisal that failed to meet the requirements on so many levels. The appraiser’s invocation of the “investment value,” as opposed to fair market value, could have triggered a ruling for the IRS, Bogdanski says. Trial is set for April. The main issue is whether the hold-and-sell requirement substantially changed the value of the interest the university got in Holdings from that of the appraised underlying real property. If the IRS can show that, Bogdanski says, it may yet win the war.

Stay tuned. The court’s opinion of RERI Holdings I, LLC v. Comm’r., 2014 U.S. Tax Ct. LEXIS 34 is available at BVLaw.

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Deadline looms for comments on USPAP

Comments are due February 2 on the Fourth Exposure Draft of proposed changes for the 2016-17 edition of the Uniform Standards of Professional Appraisal Practice (USPAP). USPAP is issued by the Appraisal Standards Board (ASB) of the Appraisal Foundation.

Key issue: Of special interest to valuation experts, particularly those involved in litigation, are the standards related to reports and recordkeeping. In an earlier exposure draft, the ASB proposed changes that would require that all draft reports be kept regardless of whether they were later superseded. This proposal was later eased somewhat to apply only to final reports. Now, in the current exposure draft, the ASB proposes no changes to the existing recordkeeping rules concerning reports.

You can also give your comments verbally at the upcoming public meeting of the Appraisal Standards Board. It will be held on February 6 in New Orleans. For details on this meeting, click here.

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Be careful when using transaction databases

In a recent court case, a judge scolded a valuation expert who misused data contained in BIZCOMPS (see the Dec. 3, 2014 issue of BVWire). Avoiding trouble when using transaction databases is just one of the topics covered in The Comprehensive Guide to the Use and Application of Transaction Databases, Third Edition. This newly expanded edition is a must-have for any appraiser who relies on the market approach. Author Heidi Walker, CPA, ABV, ASA (Meyers, Harrison & Pia, LLC), covers the most popular transaction databases, including Pratt’s Stats, BIZCOMPS, S&P Capital IQ, and many more. Plus, she analyzes rules of thumb, prior transactions, and other market indications of value.

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Valuation ops in the legal marijuana business

Valuation opportunities exist in the legal marijuana business—but they are accompanied by a number of challenges and obstacles. Market research firms forecast significant growth for the next several years. At the same time, the regulatory environment is hazy. A new BVR special report gives a rare look at the challenges of valuing sellers and dispensaries of medicinal marijuana. The industry has a short history, a high level of risk, high volatility, and a complex, quickly evolving regulatory structure. This is all covered in the report, Marijuana Dispensaries: A Budding Industry Brings Opportunities and Challenges for Business Appraisers.

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Preview of the February 2015 issue of Business Valuation Update

Here’s what’s coming up:

  • Data About the Size Premium Challenge Conventional Wisdom (BVR Editor). An interview with Michael A. Crain (Financial Valuation Group) that focuses on research he has been doing on cost of capital, with a special emphasis on the size premium.
  • Different BV Standards Have More in Common Than You Might Think (BVR Editor). Amid criticism about the fragmentation of the BV profession, a new analysis of the five sets of BV standards reveals that they do not conflict with each other. Includes a link to a chart prepared by Mark Hanson (Schenck SC) and Mark Kucik (Kucik Valuation Group).
  • Court Case Points Up Pitfalls to Avoid When Using Transactional Databases (BVR Editor). An appraiser faces trouble in court over the misuse of BIZCOMPS.
  • An In-Depth Review of the Duff & Phelps Risk Premium Calculator (Jessica Landay, CVA, and Brenda Clarke, CPA/ABV/CFF, CVA). Detailed analysis of the updated online tool used to calculate cost of equity capital.
  • Public Shareholders, Fair Value, and the “Market-Out Exception” in Appraisal Statutes (Gilbert E. Matthews, CFA, and Michelle Patterson, J.D., Ph.D.). Exhaustive analysis that demonstrates that the common view that the market-out exception completely denies public shareholders the right of appraisal is, in fact, inaccurate.

To read these articles—as well as digests of the latest court cases—see the February 2015 issue of Business Valuation Update (subscription required).

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BV movers …

People: Jeff Baliban joins the New York City office of Citrin Cooperman as partner in the Valuation and Forensic Services group … Kyle Garcia was promoted to managing director at Financial Research Associates of New York City … Christina Cannellos Henchman joins the Massachusetts firm MFA Cornerstone Consulting as a director in its valuation practice … Charles A. Wilhoite, managing director and national director of health care services at Willamette Management Associates, has been appointed to the board of the Portland, Ore., branch of the Federal Reserve Bank of San Francisco.

Firms: The Lansing, Mich., firms Charles Garfield Amboy PC and Warmels & Comstock PLLC have announced their merger … Prager Metis CPAs LLC has acquired the New York City firm Polakoff & Michaelson, whose focus is family office services and high-net-worth individuals … the Wisconsin firm Schenck SC has announced its merger with the Manitowoc-based Kroening, Stangel, Swetlik & Zinkel LLP, which provides accounting, tax, and consultancy services to nonprofit organizations and family-owned and privately held businesses.

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CPE events

Any appraiser who deals with family limited partnerships should tune in to our next webinar, which is devoted to special challenges in this area.

Valuations for Complex FLPs (January 27), featuring: Bruce Johnson (Munroe, Park & Johnson Inc.). Once an appraiser adopts a more analytical method for valuing FLPs by using the income and market approaches, there are certain types of partnerships that may be considered complicated. This webinar will focus on valuing complex FLPs, including multiple asset FLPs, oil and gas FLPs, and non-income producing FLPs, using case studies. Plus, Johnson will share his opinions on issues such as how to handle FLPs that own privately held stock, other partnership interests, venture capital funds, and promissory notes.

Other upcoming webinars of interest:

Using Regression Analysis To Value Small Controlling Interests (January 29), featuring Robert Dohmeyer (Dohmeyer Valuation Corp.) and Peter Butler (Valtrend). This is Part 1 of BVR's 2015 Special Series on Financial Modeling.

Advanced Lattice Modeling for Equity and Debt Securities (February 3), featuring Jason Andrews and John Sawyer (both with Alvarez & Marsal). This is Part 2 of BVR's 2015 Special Series on Financial Modeling.

Buy-Sell Agreements (February 12), featuring Brian Burns and Chris Mitchell (both with Dixon Hughes Goodman).

We welcome your feedback and comments. Contact the editor, Andy Dzamba at: or (503) 291-7963 ext. 133
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In this issue:

PE valuations

Sleeper case

USPAP comments

Transaction data pitfall

Cannabiz valuations

Feb. BVU preview

BV movers

CPE events








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