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Lakin Spears, LLP

Portfolio Valuation

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What securities does Pluris typically value for portfolio valuation purposes?

We specialize in valuing illiquid and restricted securities, such as restricted (unregistered or affiliate) stock and warrants, equity units, convertible debt and convertible preferred shares. We also value more-complex and hard-to-value hybrid derivative securities as the need arises.

Does Pluris offer portfolio valuations for other assets?

Yes, we do. For example, we can value bank debt or other fixed-income instruments for hedge fund portfolios. We also value private equity investments.

How do investment firms such as hedge funds value illiquid assets and securities today?

There seems to be as many different ways to value portfolio securities as there are funds with restricted stock and warrants. Some funds appear to change from one method to another for random, or at least poorly understood, reasons. In ASR 113 (from 1969!), the SEC highlighted a number of valuation methods used for restricted stock and the problems it had with each method, including: applying zero discount, valuing the restricted stock at cost, using a constant discount, or starting with a set discount and "amortizing" it over time. We hear of even more inappropriate methods, including valuing all warrants held at a penny each or starting with a near-100 percent discount for newly acquired warrants.

Why not just use a flat discount for all the restricted shares in my portfolio?

Short answer: because it's probably wrong. It does not likely result in the fair value of individual securities or for the portfolio as a whole. When investors leave the fund and their interests are redeemed, they will be paid either too much or too little. Also, when the fund attempts to secure year-end financials from its auditors, under ASC 820 (FAS 157), the fund auditor may not be able to provide an unqualified opinion, because using a flat discount is not appropriate under Generally Accepted Accounting Principles (GAAP).

I have always just valued all my warrants at a penny each. Isn't that the most conservative and reasonable approach?

It is indeed highly conservative, but not reasonable by any definition of the term. Redeeming investors will likely be severely underpaid when this valuation policy is used. In addition, existing investors will be harmed every time new investors buy in, since the new investors will buy in at a too-low NAV, resulting in excessive dilution to the existing investors' shares.

Why not just put all illiquid assets in a side pocket? Wouldn't that solve the problem?

Putting restricted securities in a "side pocket" merely hides the problem. The longer highly illiquid investments remain in the side pocket, the more their true fair values will diverge from their stated values. Furthermore, as investors redeem or add to their investments in the fund, the accounting for side pockets, especially with illiquid securities, sometimes becomes increasingly complex.

What is ASC 820 (formerly FAS 157)?

Statement of Financial Accounting Standard No. 157, the "Fair Value" standard, was released by the FASB in September 2006. ASC 820 (FAS 157) does three things at once:

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    • It elevates the accounting standard setter's guidance for how to determine "fair value" to Level A GAAP.
    • It provides much more detailed instructions for how to determine fair value and what factors to consider.
    • It greatly expands the required disclosures for companies that rely on fair value estimates.

For more information, see our FAS 157 Handbook.

What does ASC 820 say about using a flat discount for all restricted shares?

ASC 820 (FAS 157) incorporates the guidance in ASR 113 on how to value restricted shares. Using a flat discount, regardless of investment quality and changing circumstances, is clearly rejected as an unreliable method. Basically, determining the discount is a question of fact, which can only be arrived at through careful analysis of all relevant drivers of the discount. Research has shown that the appropriate discount for lower-quality shares can be an order of magnitude greater than the discount for higher-quality shares.

Explain the distinction between "observable" and "unobservable" inputs in ASC 820?

"Observable" inputs reflect the assumptions market participants would use, based on market data obtained from sources that are independent of the reporting entity. "Unobservable" inputs should also reflect assumptions that market participants would use, but can be based on internally developed information. The standard states that valuation methods used "shall maximize the use of observable inputs and minimize the use of unobservable inputs." Observable inputs can be further divided into level 1 inputs (unadjusted prices in active markets for identical assets) and level 2 inputs (prices or statistics such as capitalization multiples for similar or comparable assets). Unobservable inputs are labeled level 3 inputs.

What is ASR 113 and how is this publication incorporated in ASC 820?

Accounting Series Release No. 113 was issued by the SEC in 1969. It outlines how investment companies are supposed to value restricted stock. While such ASRs only apply to companies subject to the Investment Company Act, ASR 113 provides a good overview of methods to use and, in particular, methods to avoid. ASC 820 (FAS 157), on the other hand, applies to all entities that prepare financial statements in accordance with GAAP. ASC 820 (FAS 157) specifically references ASR 113 as providing guidance relevant to the determination of fair value for restricted stock and notes that the discount varies "depending on the nature and duration of the restriction, the extent to which buyers are limited by the restriction …, and (qualitative and quantitative) factors specific to both the security and the issuer."

Our fund purchased restricted stock in a PIPE at a 30% discount. Isn't that the proper "exit price discount" for the stock?

That depends on whether or not the PIPE market would be considered the "exit market" for the stock. Most likely, auditors would not automatically accept PIPE market prices as exit prices for restricted stock. After the private placement, the holder cannot access this market again. Furthermore, as time passes from the date of the private placement, two things will happen: (1) the remaining holding period under Rule 144 will be reduced and (2) the characteristics of the issuer and the trading market for the stock may change. The magnitude of the discount may change due to either of these factors.

How does Pluris value restricted stock?

We use up to four different methods for valuing blocks of restricted stock. The first method is a valuation of the subject block through a direct comparison with trading data discount indications from the LiquiStat database. The second method is an analysis of the cost of borrowing the block of stock and selling it short, maintaining this borrowing/shorting position throughout the period of illiquidity. For blocks with unusually long periods of illiquidity, such as stock that is locked up through escrow agreements or similar long-term restrictions, a third method is based on an analysis of older restricted stock private placement studies (from when Rule 144 required a longer holding period than today). As a fourth method, Pluris sometimes uses certain theoretical discount models that are discussed in the financial literature. However, a comparison with the LiquiStat database will almost always be the method principally relied on.

How does Pluris value warrants?

Warrants are long-term call options issued on the issuer's own stock. The starting point will be the theoretical model (usually, the Black-Scholes model) price for the warrant. However, this model price does not factor in the illiquidity of the warrant. For non-traded warrants, therefore, a discount must be taken. To the best of our knowledge, there is no model or empirical study available for determining such discounts other than the LiquiStat database. Therefore, all of our valuation methods for warrants use the LiquiStat data to determine the proper discount for the warrant.

What does the final valuation report look like?

The valuation reports submitted are thorough, with a summary narrative and supporting exhibits. No black-box models are used: all valuation inputs are clearly identified, and the impact of each on the final value is disclosed. The emphasis is on the indications of our empirical data: if theoretical models are used, they are used only as supporting indications and only if they have been published in the peer-reviewed financial literature. The empirical data is thoroughly researched to establish which factors drive the valuation discounts -- and all valuation models derived are thoroughly back-tested against real-world transactions.

How many data-points are currently included in the LiquiStat database?

Currently, the LiquiStat database includes thousands of transactions and it is growing rapidly, with dozens of new transactions being added weekly. For the most up-to-date information, please check the LiquiStat page or our Press Room.

What are the most important conclusions from your analysis of the LiquiStat data?

The valuation discount applicable to any particular subject security will change from month to month, as more data is added to the database. However, in general, the discount is greater for riskier securities and larger blocks of more thinly traded securities. Thinly traded penny stocks with very high levels of stock price volatility would tend to have the highest discounts. The Press Room has articles with more information.

I am a hedge fund auditor. Why should I recommend Pluris to my clients?

Pluris will provide the best available support for the fair value of illiquid or hard-to-value securities at the lowest cost possible. If the client fund is already receiving outside appraisals of its restricted stock, warrants or other restricted securities, Pluris will likely be able to provide better solutions at a lower cost, using our internally-developed methods and proprietary LiquiStat data. If the client fund is currently valuing its own securities, Pluris will bring much-needed independence to the process and may save significant amounts of auditor time. Furthermore, with the significant additional scrutiny necessitated by ASC 820 (FAS 157), an outside appraisal may save a very significant number of auditor hours. This will go a long way to offsetting the additional cost of the valuation work.

How do you charge for portfolio valuation services?

We charge on a retainer basis for our valuation policy review services. The retainer is based on professional hours spent, depending on the scope of services, as determined by Pluris and our client together. Please e-mail us to receive a quote.

How do you charge for valuation policy review services?

We charge a simple, per-security fee. The fees are lower for more frequent valuations and for larger portfolios. Please e-mail us with information about your portfolio to receive a quote.

My fund specializes in buying and selling these type of securities. We have our own valuation model. Why isn't this model good enough?

The investment strategies of a hedge fund -- indeed, of most actively managed funds -- is to try to be smarter than the market in terms of how securities are valued. In other words, their internal valuation models identify the "true" investment values of securities and how those investment values diverge from the market values. But this has nothing to do with how your NAV is "marked to market." The fair values of your securities are what you could realize today if you had to sell them in the market, as that market is actually valuing the securities, not how it should be valuing the securities.

Our fund has decided never to reveal its valuation policies. Why should we? Revealing our valuation policies would give our strategies away.

Your policies for determining "fair value" should never be the same as the internal valuation models you use for investment decisions. Investment value does not equal "fair value." Therefore, disclosing your fair value determination policies can never jeopardize proprietary investment strategies or methods.

How can Pluris help my fund-of-funds?

The oversight role of the fund-of-funds is a very important part of its services, and an important differentiator between different funds-of-funds. If you refer Pluris to the funds you are invested in, this will go a long way toward ensuring that NAVs are consistent with market realities. Not only will the portfolios be fairly valued, but the volatility of the portfolios will be correctly calculated based on actual changes in the fair value of securities held and not "smoothed" or in any way manipulated by management.

With better investment performance information, the fund-of-funds' investment process is improved. In addition, for funds that cannot, or do not want to, pay for outside valuation work, Pluris offers funds-of-funds certain valuation policy review services. A valuation policy review may help you assess the adequacy of the valuation policy of funds you are invested in. In other words, how appropriate are these policies for determining fair value; how far from fair value may the stated portfolio values get under certain circumstances; and what are the circumstances that might cause the most significant overvaluation or undervaluation of the portfolios?