PIPEs Conference Panel

Accounting and Valuation Issues
i dli

‐ Examining new Fair Value Rules
PIPES CONFERENCE 2008

ESPEN ROBAK
CHRIS JOHNSON
ELE KLEIN
NEIL PINCHUK

© Pluris Valuation Advisors LLC ● www.PlurisValuation.com ● 212.248.4500

FAS 157 Definitions
2

Fair value: the price that would be received in an orderly
transaction between market participants on the
measurement date.
Orderly transaction:
market exposure
usual and customary marketing activities
usual and customary marketing activities
not a forced transaction.
Exit price: the price received upon sale in a hypothetical
Exit price: the price received upon sale in a hypothetical
transaction.
Based on assumptions of market participants.
p p p


Valuation Inputs (the “levels”)
3

Valuation techniques used to measure fair value shall
maximize the use of observable inputs and minimize the use
of unobservable inputs – FAS 157

Fair Value Hierarchy – focus on inputs, not techniques:
Level I – Observable Inputs: unadjusted market prices for identical
assets.
assets
Level II – Observable Inputs: quoted prices for similar assets in active
markets, quoted prices for identical or similar securities in inactive
markets, other observable market inputs, and inputs derived from
markets other observable market inputs and inputs derived from
or corroborated by the market.
Level III – Unobservable Inputs: everything else.


Level II Measurements
4

Quoted prices for similar assets or liabilities in active
markets.
Example: PIPE securities, other restricted securities.
Quoted prices for identical or similar assets in inactive
markets.
Markets with few transactions.
Markets with few transactions
Markets where prices are not current, or where quotes vary over
time or among market makers.
Principal‐to‐principal markets or other markets where little
information is publicly available.


Level II Measurements (cont.)
5

Observable data other than quoted market prices.
Interest rates and yield curves.
Volatilities.
Credit risks and default rates.
di i k dd f l
Inputs derived primarily from observable market data
through correlation or regression analysis.
through correlation or regression analysis
The key distinguishing characteristic (relative to Level III
inputs) is that the fair value problem is solved by market
inputs) is that the fair value problem is solved by market
participants.


Recent Implementation
l i
Guidance

‐ Center for Audit Quality
‐ Securities and Exchange Commission
Securities and Exchange Commission
‐ Financial Accounting Standards Board
‐ Department Of Labor
Department Of Labor


Center for Audit Quality
7

White paper on “Measurements of Fair Value in Illiquid
(Or Less Liquid) Markets.”
“Questions have arisen about (…) whether current market
prices are more indicative of distressed sales”.
In 2004 release, the SEC held that the registrant violated
GAAP by using a definition of fair value that assumed
GAAP b i d fi iti f f i l th t d
supply and demand were in reasonable balance.
Specifically, the SEC objected to the practice of ignoring
Specifically the SEC objected to the practice of ignoring
quoted prices and “taking the longer view”.


Center for Audit Quality (cont.)
8

If transactions are occurring in a usual and customary
manner, those deals are not “forced” sales.
The fact that transaction volume is low does not indicate
the sales are forced or distressed sales.
Decreased volumes in a market do not necessarily mean
the market has become inactive.
th k th b i ti
“Markets with a reduced transaction volume under
current conditions are still considered active if
current conditions are still considered active if
transactions are occurring frequently enough on an
ongoing basis to obtain reliable pricing information.”
gg p g


SEC Comment Letter
9

March 2008 letters
Specifies disclosures for MD&A, especially for any model‐
driven valuations
Notes that FAS 157 does not require mark to market if
“market” consists of forced or distressed sales
“Supporters of using fair value believe that investors and other users of
financial statements are better served by knowing, where possible, what
something is currently worth rather than relying on management
assumptions – which many experts deride as a rose‐tinted “yes, but it is going
assumptions which many experts deride as a rose tinted “yes but it is going
to go up again” approach. ‐ Financial Times, April 1, 2008
Lynne Turner: […] the notion that if you have a distressed asset, you can avoid
market prices, which is not the spirit or intention of this rule
market prices which is not the spirit or intention of this rule”. – FT April 1 08
FT, April 1, 08.


FSP 157‐3
10

FASB Staff Position: Fair Value in Inactive Markets
Warns against broker quotes, in particular.
Provides amendment to FAS 157 – new Example. p
Invested in AA tranche of CDO
Market increasingly inactive, widening bid‐ask spreads, volume
down
Few observable transactions, no current quotes, widely varying
quotes
Approach chosen: increase discount rate from when markets were
active, supplement with data from indicative quotes.
Supported by SEC September 30 release.
Supported by SEC September 30 release

DOL Letter (June 2008)
11

To pension plan investors in hedge funds.
“A process which merely uses the general partner’s
established value for all funds without additional analysis
may not insure … fair market value”
Plan administrators “must have a thorough knowledge of
the general partner’s valuation methodology”
th l t ’ l ti th d l ”


LP Interest Discounts?
12

Funds‐of‐funds, pension funds and other investors invest at
NAV: entry price.
Should the exit price be adjusted for lock‐ups?
If an LP investor wants to sell its interest, would buyers
If an LP investor wants to sell its interest would buyers
demand a haircut from NAV for a two‐year lockup?
In most situations, “issue went away”
Question: what happens when gates go up?
Often valuation uncertainty/volatility associated with gates.
Not a point where investors typically put new money in.
p yp yp y
Acceptable to value “liquidating” portfolio at different level
than ongoing portfolio?


Questions for Panel
13

Recent guidance – did any of that help?
g y p
Going from Level I to Level II – what rules or
standards can we rely on?
y
When, if ever, can we ignore market evidence?
Determining fair value when every sale is a fire
Determining fair value when every sale is a “fire
sale”
Broker quotes vs mark to model
Broker quotes vs “mark‐to‐model”
The LP valuation discount issue is back – and this
time for good?
time for good?

Specific Valuation Evidence
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‐ Restricted Stock Discounts
‐ Warrant Discounts
‐ Convertible Securities Valuation


Restricted Stock Discounts
15

70.0%

60.0%

50.0%
Discount

40.0%

30.0%
30 0%
D

20.0%

10.0%
10 0%

0.0%
0
0
0
0
0
0
0
0
0
0
0
0
0
10
30
50
70
90
11
13
15
17
19
21
23
25
27
29
31
33
35
Days of Illiquidity Remaining


Restricted Stock Discounts (ct)
16

Market Block Size Revenues Holding Market Volatility Discount
Cap ($ )
C ($m) ($m)
($ ) Period
P id Price
Pi
(Days)
293 450% 124 203 $7.89 86% 28.3%
Average

203 76 38 210 4.03 77 22.9
Median

407 35 48 227 13.11 81 12.8
1st Quintile

100 59 54 251 3.63 74 19.4
2nd Quintile

90 40 54 105 3.85 76 22.9
3rd Quintile

232 256 13 229 5.24
5 24 68 35.0
35 0
4th Q i til
Quintile

99 274 7 197 2.70 104 47.5
5th Quintile


Warrant Discounts
17
Market Stock Intrinsic Delta Money- Volatility Discount
Cap ($m) Price Value ness

231 $6.81 $2.31 0.817 0.202 86.3% 42.7%
Average

153 4.12 0.38 0.831 0.153 69 44.2
Median

229 7.66 2.16 0.903 0.471 52 15.3
1st Quintile

160 4.96 1.42 0.841 0.317 66 30.2
2nd Quintile

127 4.40 0.43 0.794 0.139 60 44.5
3rd Quintile

123 2.45 0.00 0.830 -0.058 83 56.8
4th Quintile

106 2.44 0.00 0.803 -0.184 90 66.9
5th Quintile


Basics of Convertible Valuations
18

Convertible valuations can be at a premium to “intrinsic”
or as‐if‐converted value.
Reflects the value of the “floor” downside protection to the equity
value of the instrument.
value of the instrument
Implies little or no illiquidity discount for the underlying shares –
effective registration statements and no “implied” blockage.
Valuations can be at a discount from face value.
Risky, highly illiquid positions in nano‐cap issuers.
Significant deterioration in the stock price.
Significant deterioration in the stock price
Usually “fallen angels” with or without floating conversion prices.
Severe illiquidity for the underlying convertible.
Most convertibles: value somewhere in‐between.

Questions for Panel
19

Convertible debt bifurcation analysis – models
y
or market data?
Valuation impact of shortening Rule 144 period.
p g p
How do agreement terms affect fair value?
Registration rights
Warrant call caps
Cashless exercise
Effect of going through the reverse merger
Effect of going through the reverse merger
process.


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