Fair value is here to stay

Colin Blaydon is the William and Josephine Buchanan Professor of Management at the Tuck School of Business at Dartmouth University. Fred Wainwright is Adjunct Assistant Professor of Business Administration at Tuck. The authors are principals at the school's Center for Private Equity and Entrepreneurship. They can be contacted at www.tuck.dartmouth.edu/pecenter.

The adoption of valuation guidelines and their underlying principle of fair value has greatly increased, apparently driven by the accounting profession's focus on fair value and attention that private equity firms are receiving from their auditors. This is in spite of the fact that approximately half of US general partners have continued to express concerns about the usefulness and desirability of industry valuation guidelines since such guidelines were first being developed.

For the past three decades the venture and buyout industries have relied considerably on a cost basis or latest financing transaction methodology of valuing portfolio companies. However, global regulatory trends toward fair value accounting and the resulting auditor and LP attention are causing a sea change in how GPs assess their portfolios.

A new survey of 136 US GPs by the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth University shows that about 50 percent of GPs favor the development and use of industry valuation guidelines; about 20 percent are opposed. This is the same result observed in earlier surveys conducted by the Center in 2003 and 2005 (See Figure 1). However, the adoption of fair value based guidelines by firms has risen from 19 percent in 2005 to 42 percent of all survey respondents in 2007. Furthermore, a remarkable 86 percent of respondents are using or will consider using procedures that reflect fair value.

A recent conference held at Tuck (Private Equity Industry Summit: Valuation, June 21, 2007) brought together a diverse cross section of senior executives from GPs, LPs, accounting firms, valuation firms and regulatory representatives. The discussions confirmed that this dramatic shift in valuation principles and reporting are due to three main reasons: the further development of fair value concepts in the accounting industry, the impending effective date of FASB's Financial Accounting Standards No. 157, and the increasing attention paid by auditors of GPs and LPs to portfolio company valuations.

PEIGG guidelines and FAS 157
The Private Equity Industry Guidelines Group began its work in 2002 in the middle of the turmoil of falling values that followed the bursting of the internet and telecom bubble. PEIGG issued its initial guidelines in 2003 and revised them in 2004 and early 2007. The latest revision was undertaken to help private equity CFOs and senior partners to apply FAS 157. FAS 157 clarified the fair value definition and provided a framework for determining and reporting fair value. Fair value is defined as ?the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.?

FAS 157 indicates that it may be appropriate to use multiple methods of valuation and establishes a hierarchy of methodologies. The statement requires that managers take into account available information but without undue cost or effort so third party appraisals are not a requirement. FAS 157 becomes effective for fiscal years beginning after November 15, 2007. It is important to note that a private equity firm can follow FAS 157 but need not formally adopt PEIGG. PEIGG provides clarification and serves a useful purpose as an industry specific guideline.

Survey respondents
The survey was completed April through June of this year by 136 respondents representing a diverse set of fund sizes, number of funds under management and investment specialties. Sixty percent of respondents characterized the majority of their funds as venture capital, while thirty-one percent were buyout funds.

Adoption of guidelines
The major challenge for the adoption of the guidelines has been the issue of writing up valuations of portfolio companies in the absence of a financing event led by a new financier that ?sets the price.? This guidance was contained in Paragraph 30 of the PEIGG guidelines and 17 percent of the 2007 survey respondents cited this paragraph as a reason for not adopting the guidelines. However, the resistance to non-round write-ups is falling. Thirty-three percent of respondents in the 2007 survey preferred write-ups only after a new round of financing and this figure was down from 49 percent in 2005 (see Figure 2). In addition, 65 percent of respondents acknowledged having done non-round write-ups and an additional 21 percent indicated they may do so in the future. As one respondent noted, ?Paragraph 30 didn't stop us (from adopting fair value), but 157 will make us do it.?

This issue of non-round write-ups also affects the different rate of adoption of the guidelines by buyout firms relative to venture capital firms. VCs with portfolio companies that may not have positive cash flow or even sales are less comfortable with such write-ups than are buyout firms. As a result, 56 percent of buyout firms have adopted the guidelines versus only 35 percent of VCs.

Any change toward permitting non-round write-ups will affect portfolio valuations. In this most recent survey, 51 percent of respondents indicated that at least part of their portfolio would be written up compared to 69 percent in 2005. This decline is due to the number of GPs who have adopted fair value (non-round write-up) policies in the last two years. Over two thirds of those who have not yet adopted such a policy indicate that as much as 20 percent of their portfolio companies would be affected, but a sizeable minority (10 percent) says that over half of their portfolio company valuations would have to be written up. Not surprisingly, this is largely an issue among venture capitalists.

FAS 157's influence and auditors
Nearly three quarters of the respondents say they have received increased attention from their auditor regarding portfolio valuation. This is up from about half of the respondents saying the same thing two years ago.

Auditors have been shifting their emphasis to the issue of fair value (see Figure 3). Previously, nearly half of all respondents noted that their auditor thought it was more important to apply a valuation policy consistently regardless of what that policy was. Today only about a third believe that to be the case. In contrast, 13 percent say that their auditors tell them that they will have to shift from cost based valuations to fair value or risk a qualified opinion, up from only two percent in 2005.

GPs recognize that the major concern of LPs is fund performance. It was clear in the conference discussions that performance is no longer as strong a protection from LP concerns about qualified audit opinions. According to the survey, 48 percent of GPs believe today that LPs are less willing to overlook qualified opinions even if performance is strong. Two years ago, 60 percent of GPs thought LPs would take such a view.

In addition, GPs continue to be willing to change valuation policies to avoid a qualified opinion. Three quarters of respondents expressed such willingness in both of the last two surveys.

Exceptions for early stage?
Valuation presents particular challenges in early stage companies that may be without revenues or positive cash flows. First, it is certainly possible that cost or the value of the latest round of financing can reasonably be used in determining fair value in early stage companies in which there is a dearth of additional data.

Second, this challenge has given rise to some suggestions regarding the possibility of an exception to fair value (see Figure 4). Among survey respondents, there was greatest support for carrying companies at cost that have less than a year of revenues (39 percent). Twenty percent of respondents would adopt this approach only for companies without revenues and another seven percent would restrict this to companies without beta products or beta customers. One-fifth of respondents said there should be no exceptions to fair value.

International convergence
The International Private Equity and Venture Capital Valuation Guidelines were developed in 2005 through a combined effort of French, British and European industry associations (AFIC, BVCA and EVCA). Since then, these guidelines have been endorsed by 32 other private equity industry organizations. The international guidelines are considered more prescriptive than the PEIGG guidelines but conform to GAAP and International Financial Reporting Standards (IFRS). Seventy-nine percent of U.S. GPs expect that international and U.S. guidelines will converge but one quarter of respondents believe that it will take 5 to 10 years.

CONCLUSIONS
The origins of private equity industry guidelines lay in the concerns during the early part of this decade regarding lack of uniformity and consensus in portfolio company valuations in a down cycle in public and private markets. As markets and values recovered, the impetus for industry guidelines shifted to addressing accounting industry concerns about fair value within a principles-based GAAP structure.

As GPs, LPs and their auditors are coming to terms with the implications of the looming effective date of FAS 157, many GPs and LPs are turning to the new industry guidelines, either to be formally adopted or to be followed in principle as a visible indication of their adherence to the new fair value emphasis.