More than 100 CFOs, COOs and other private equity firm managers gathered in San Francisco at the PEI Strategic Financial Management (SFM) Conference last month to compare notes and share best practices on the increasingly complex job of running a private equity firm.
The conference was an off-the-record event, which encouraged a higher level of candor among participants, many of whom find themselves in highly stressful, key roles as they navigate their firms and portfolios through turbulent waters.
Waiting for a taxi to the airport at the end of the conference, one venture capital CFO said she was “relieved to discover that everyone else is having the same problems as me”. Below is a summary of the key issues and problems discussed at the West Coast SFM.
Core to the difficulties, as all finance professionals in private equity well know, is a nebulous, almost catch-22 dynamic between GPs and auditors
Fundraising challenges: The bulk of delegates at SFM disclosed (through an anonymous handheld voting system) that their firms were in fundraising mode. This fact may have contributed to the somewhat nervous energy in the room. What little capital is now available for re-ups is not being committed without requests for reams of data from the GPs. The task of collecting this data typically falls to the CFO. There was much discussion of how to maximise the efficiency of this process, with one venture capital CFO going as far as to say that his firm collected data-request forms from all its LPs in advance and acquired every type of information imaginable so as to merely copy and paste from these materials during fundraising due diligence.
LP defaults: Despite all the press regarding the fear of LP defaults, the participants at SFM were relatively sanguine about their own investor bases. Anonymous voting revealed that almost no one had experienced or was expecting material capital-call defaults.
Reporting season: One audit services partner said that the third quarter of 2008 had been the most difficult reporting season of his entire career. He added that yearend reports were probably going to be even harder. The unprecedented drop in the public equity markets, combined with a laser-focus on FAS 157, will mean that portfolios will be written down to a degree that many GPs will find nauseating. Core to the difficulties, as all finance professionals in private equity well know, is a nebulous, almost catch-22 dynamic between GPs and auditors. On the one hand, it is the responsibility of the managers themselves to assign fair values to their portfolio investments, with auditors providing blessings to the systems assigned to create said valuations. On the other hand, the auditors will take a zero-tolerance policy toward systems which to them seem arbitrary or not supported by documentation. This is creating an atmosphere in which the CFOs must coax from auditors suggested valuation methodologies that will get green lights, while the auditors continue to stress that as managers, the GPs themselves are the valuation experts.
Reasons to write up: On the sidelines of the conference, a number of participants debated key valuation metrics and how they should be applied to private equity portfolios. First was the issue of the control premium – the amount by which base fair value may be written up when the sponsor has control of a company. One participant said that the value of control had now increased, with a 40 percent to 50 percent premium seen on changeof-control transactions, whereas historically the premium has been around 30 percent. However a prominent valuation expert said of many GP decisions to write up otherwise impaired investments because of a control position: “I don't buy it.” The expert likewise took a dim view of another technique, particularly in buyout portfolios – the subtraction of debt at market value, as opposed to par. The expert said the problem with this method – which under today's conditions has the effect of inflating equity values – is that even if debt is sold at a discount it gets repaid at par. A more generally accepted valuation nuance had to do with the performance of the portfolio company itself. Regardless of public market comparables, if a portfolio company has shown strong underlying performance during the reporting period, managers have broader leeway to report them at a value that is well ahead of peers.
Of course, the trouble is that many portfolio companies are performing just about as poorly as their public market comparables, prompting the auditing partner to proclaim that Q4 would produce write-downs “not expected in our lives”.