A review of the past 15 years reveals the slow-paced approach that has been taken towards the need for and development of valuation guidelines in the private equity industry. While there was an attempt by the National Venture Capital Association (NVCA) in the late 1980s to establish valuation guidelines, the primary catalyst for change was the technology implosion of 2000.
Many funds in the earliest phases of the private equity industry reported to investors using a tax-based system of accounting. Under this tax-based system, interim valuations were of less importance.
Over the past ten to fifteen years, and especially within the last five years, there have been a number of new entrants into the private equity asset class. These new investors include corporate and public pension funds, endowments, foundations and others. As a result, both the magnitude of amounts invested and the accompanying need for consistency and comparability in reporting has increased substantially.
As new investors entered the private equity market, language in limited partner agreements shifted to provisions that required fund financial statements be prepared in accordance with the US Generally Accepted Accounting Principles (GAAP). US GAAP does not provide specific guidance for the private equity industry. Within the US GAAP framework, the private equity asset class is combined with other investment entities, such as mutual funds, as outlined in the American Institute of Certified Public Accountant's (AICPA) Audit and Accounting Guide for Investment Companies.
Due to the specialized nature of private equity, which makes long-term investments in non-liquid securities of private companies, many private equity managers felt that additional guidance was needed on how to value their investments in portfolio companies. In the late 1980s, the NVCA established a committee to consider the question of valuation. While the NVCA never formally endorsed the guidelines prepared by the committee, the results became known and used in the private equity industry as the de facto NVCA Valuation Standards. These de facto standards were focused primarily on venture- backed enterprises, stating that investee companies should be valued at cost or at the latest round of financing. The de facto NVCA guidelines were not necessarily intended to comply with GAAP. They were designed to provide a conservative, consistent and comparable framework for reporting investments.
The de facto NVCAValuation Standards effectively became the industry standard over the following decade, especially for venture capital funds. As previously noted, during this time most funds were required to have financial statements prepared in accordance with GAAP. While GAAP required investments to be recorded at fair value, it did not specifically prescribe how fair value should be determined in the PE industry. Therefore, most funds continued to use the de facto NVCAValuation Standards as their basis for valuing investments. The overall sentiment within the PE industry was that the NVCA standards provided a framework for conservative valuations and offered an arguably good estimate of fair value.
The global impact of PEIGG
The burst of the technology bubble in the early 2000s impacted valuations more rapidly than many private equity managers acknowledged to their investors. Investors (limited partners) frequently expressed frustration with the slow reaction by funds (in particular venture funds) to the reduced valuation of their portfolio investments, whose value was impacted by overall market conditions. The Private Equity Industry Guidelines Group (PEIGG) was born as a response to such frustration. PEIGG's board took a very circumspect and thorough approach to developing valuation guidelines. After more than 18 months of work, PEIGG's valuation guidelines were released in December 2003, with minor modifications made to the guidelines in September 2004.
While not the only reason, PEIGG was a key catalyst in causing European venture capital associations to come together and to revisit their valuation guidelines. The PEIGG website (www.peigg.org), includes a frequently asked questions document for the PEIGG Valuation Guidelines. Question 18 reads: ?How do the PEIGG guidelines differ from the EVCAand BVCA guidelines? Answer: The PEIGG Guidelines are intended to be U.S. GAAP compliant. EVCA and BVCA Guidelines deviate from International or British Accounting standards in certain respects.?
The PEIGG guidelines caused the European Venture Capital Association (EVCA) to realize that it also needed to move its own guidelines into compliance with GAAP. As a result, the EVCA, BVCA (British Venture Capital Association) and AFIC (Association Francaise des Investisseurs en Capital) combined efforts to develop and release the International Private Equity and Venture Capital Valuation Guidelines in 2005. Subsequently, more than 20 venture capital associations (buyout funds are usually part of venture capital associations outside the United States) around the world have endorsed the new International Guidelines.
The value of fair value
The International Private Equity and Venture Capital Valuation Guidelines are in harmony with the PEIGG Valuation Guidelines. Both utilize a ?fair value? approach, which is intended to be compliant with relevant US GAAP and International Financial Reporting Standards (IFRSs).
The International Guidelines are more descriptive than the PEIGG guidelines. PEIGG's guidelines take more of a principle-based approach, while the international guidelines are slightly more rules-based. However, both reach the same goal of providing managers, who follow the guidelines, with the ability to use leading practice in determining the fair value of their investments. The conceptual differences between the PEIGG Valuation Guidelines and the International Guidelines are fairly minor and very technical in nature.
To ensure that the International Guidelines remain fresh and relevant, AFIC, BVCAand EVCAcreated an independent board (International Private Equity and Venture Capital Valuation Board – IPEVValuation Board) to manage the evolution of the guidelines going forward. PEIGG, as an ad hoc volunteer organization, relies upon its board and advisors for support in managing the evolution of its guidelines.
The Institutional Limited Partners Association (ILPA) has endorsed both sets of guidelines. This makes sense because the two sets of guidelines are identical in principle (e.g. fair value). The question, naturally, then arises: why not combine or harmonize the guidelines into one worldwide standard?
ILPA has commissioned a project, with the assistance of PEIGG, to identify any detailed differences between the guidelines as the first step to harmonization. The project is nearly complete, delayed only by the Financial Accounting Standards Board's (FASB) pending release of its new Standard on Measuring Fair Value. PEIGG wants to ensure that its guidelines are compliant with the new FASB Standard before finalizing the harmonization document. The IPEV will consider the ILPA/PEIGG assessment when it is completed.
Challenges facing a global standard
Utilizing fair value principles, with the intent to be GAAP compliant, has moved valuations in the private equity industry much closer to international harmony than could reasonably have been expected even three years ago. Complete harmonization is arguably dependent upon the evolution of private equity practices in various geographies as well as global standardization of GAAP.
Today there is collaboration between the International Accounting Standards Board (IASB) and the US FASB. Convergence of accounting standards is moving faster than most observers could have ever imagined. While there continue to be many differences, GAAP standards addressing the determination of fair value are substantially similar (based on the recent IASB Fair Value Standard and on the most recent draft of the FASB proposed standard).
One of the main conclusions of PEIGG and, subsequently, the European guidelines is that users of private equity information are best served when they have consistent, reliable, transparent information. Utilizing principles derived from accounting standard setters as a basis for valuation in private equity meets these guideline goals of consistent, reliable, transparent data. It also allows consistency between financial statements and information presented at annual meetings and in marketing materials. The Global Investment Performance Standards (GIPS), of course, also require fair value.
From a conceptual point of view, the global approach to private equity valuations has been harmonized. PEIGG, EVCA et.al, ILPA, GIPS, GAAP (US and International) all focus on fair value as the basis to record private equity investments. At a detailed level, a significant challenge preventing complete harmonization in private equity is agreement by all global private equity groups to cede authority to an international body responsible for overseeing implementation of one set of agreed-to guidelines.
many ways, this is less of an issue in the private equity market than in other areas. Private equity investors want to invest in the best funds. Investment decisions are better made when utilizing comparable information. PE investors must record information from their managers utilizing their relevant geographic accounting standards. At the same time, they want comparable information to assess relative performance among funds.
Prior to 2000, valuation of private equity assets, while important, was not deemed a significant issue. With the expansion of capital entering the private equity market, new entrants in the market, the burst of the technology bubble, and the resultant need for comparable, reliable, transparent information, private equity is becoming institutionalized. Valuing private equity assets using consistent methodologies based on the fair value principle is deemed the best way to serve private equity investors. In a 2005 survey by the Center for Private Equity and Entrepreneurship at the Tuck School of Businessat Dartmouth, 93 percent of respondents felt that global convergence of private equity standards was more than three years away. However, with the endorsement of the International Private Equity Guidelines by various bodies, increasing acceptance of PEIGG, and new standards recently introduced by IASBand proposed by FASB, the time for a harmonized global approach to private equity valuation may be now.
David L. Larsen is a partner in KPMGLLP's Transaction Services practice and leads the Institutional Investor segment of KPMG's Private Equity practice. He is based in San Francisco.