Estimated reading time: 2 minutes

The article in brief:

• Companies carrying minority equity stakes at cost under ASC 321 are feeling pressure to estimate their fair values due to COVID-19.
• One company reviewed its holdings and found a significant delta between book value and fair value.
• The same market volatility compelling companies to reassess non-control equity holdings creates challenges for doing so, but they are surmountable.

One sometimes overlooked development related to the economic slowdown from COVID-19 is the need for companies—both public and private—to review the valuation of various non-controlling investments in other entities.

These investments may have come about as part of a joint venture, a corporate venture capital fund, or as in-kind equity payments for services rendered. In any such case, until there is an observable transaction that shows the fair value of the investment, the ASC 321 accounting standard allows companies to carry investments in non-traded equity securities (e.g., shares in a private company or non-traded warrants in any company) at original cost unless certain qualitative factors suggest that current fair value is below cost. And during the record decade-long economic expansion that followed the Great Recession, most companies didn’t need to think twice about non-control assets on their balance sheets since the original cost was usually lower than fair value.

Now, however, with large economic segments disrupted by the pandemic, the earnings of many entities are getting squeezed, and the value of their peers may have declined sharply. As a result, companies carrying certain investments in private entities realize that cost may no longer be the appropriate mark for some assets and are conducting valuation reviews.

Case Study: Media company client with a portfolio of advertisers

VRC recently helped a privately held media company that was carrying non-controlling equity stakes and equity warrants in nearly a dozen entities, which it had acquired through in-kind payments for advertising, conduct a complete valuation review of the portfolio. The combined book value of the investments was more than $50 million.

In many ways, the resulting report resembled the work product that our portfolio valuation group provides to private equity firms, hedge funds, and private credit managers on a monthly or quarterly basis. We delivered a summary documenting each asset—the rights and preferences of the relevant share class within the portfolio company’s overall capital structure and the approach we took for calculating fair value, including:

• Historical and projected financial information
• Enterprise value and the value of the corresponding security at the time of investment
• Changes in value for comparable companies to calibrate value changes
• Discount rates
• Volatility data from comparable public companies
• Liquidity haircuts
• The option pricing methodology used to value warrants (and, in some cases, equity)

The valuation exercise determined that the differences between book value and fair value were often significant, in part due to changes in the underlying fundamentals and in other times simply due to the passage of time. Although values of individual investments were determined to be both up and down, investments with a lower value were impaired while the investments with higher values were continued to be carried at cost.

Valuation Subtleties

Arriving at fair value of the minority investments is always a challenge because of the limited access minority shareholders have to entity-level financial information. The current market environment is also especially challenging due to the impact of COVID on cashflows and cashflow projections. A final challenge is the noise from the public equity markets that have rallied significantly since the pandemic first appeared earlier this year, arguably, in many cases, beyond what the fundamentals would suggest. Calibrating public company information, including high multiples, in the context of privately-held entities whose earnings are telling a different story is as much art as science.

Conclusion

Valuing investments in private companies is always tough—and doubly so in an economy that continues to be rocked by a pandemic. But companies will increasingly find that carrying a portfolio of those assets at pre-pandemic cost is a position that is difficult to support, especially in a year-end financial statement audit.