Within the framework of mark-to-market accounting, private equity funds are required to report their investments on their GAAP financial statements at fair value. Accounting Standards Codification 820, Fair Value Measurements and Disclosures (ASC 820), specifies that fair value is not an entity-specific value, rather it is a market participant-based measurement. Private equity fund managers should take care to ensure that the analyses they prepare in support of their upstream oil and gas investments’ fair value are based on market participant-derived assumptions so that their financial statements are GAAP compliant and their independent audit goes smoothly.
6 Considerations for Private Equity Fund Managers
The following are examples of matters that are commonly encountered in independent audit reviews of private equity valuations in the upstream sector, and how these matters may be addressed. Though this list is not exhaustive, private equity fund managers should be prepared to address these items, and discuss them with their auditors, before and during an independent audit:
- Commodity pricing – Internally-prepared price decks are often utilized, which may represent a company-specific view. For financial reporting purposes, independent auditors may expect to instead see commodity pricing based on a publicly available source that reflects market participant assumptions. Examples include the NYMEX strip or a forward-looking price deck based on independent analysts’ estimates.
- Risking adjustments – Internally developed risking estimates by reserve category are sometimes utilized in private equity valuations. However, independent auditors may expect to see risking that conforms to market participant standards, such as those set forth by the SEC.
- Income taxes – The assumption of whether to apply corporate level income taxes in a discounted cash flow analysis of reserves should be based on a market participant view and may depend on the asset profile of the company in question. For example, a tax-advantaged MLP assumption could be appropriate in cases where a large percentage of a company’s assets are mature, producing reserves.
- Discount rate – Independent auditors expect to see a discount rate based on a market participant-based weighted average cost of capital calculation. The income tax assumption should be consistent with the discount rate calculation and the discounted cash flow analysis (as discussed above).
- Trading multiples utilized – Such multiples (for example, enterprise value-to-daily production or enterprise value-to-proven reserves) should be obtained either from applicable guideline transactions or guideline publicly traded companies. The selection criteria for comparable transactions and companies, as well as the rationale for any adjustments to multiples, should be documented.
- Exclusion of certain asset classes – In some instances, undeveloped reserves are excluded from a company’s fair value analysis. However, this might not necessarily be reflective of a market participant view. For example, there may be upside value in PUD’s and unproven reserves that a particular company might not recognize, however, a market participant may recognize.
The preparation of a thorough, market participant-based valuation analysis may require greater up-front cost and effort. However, it will almost certainly lead to a smoother audit process.