After a lengthy comment period in which it heard from a variety of sources including investors, general partners, accountants and regulators, the International Private Equity and Venture Capital Valuation (IPEV) board in September updated its private equity valuation guidelines.
The guidelines were originally launched in 2005 to improve consistency with the International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP). But as fair value accounting standards have evolved in the years since, so has the need for the IPEV guidelines to evolve as well. There are four principal changes to the guidelines intended to provide expanded guidance on valuing early stage investments, debt instruments, LP interests, as well as helping determine fair value at each reporting date and ensure that the illiquid nature of investments is appropriately considered.
Among the changes is extra guidance on how to include additional milestone analysis into the “Price of Recent Investment” concept. The guidelines state that the most appropriate approach to determining fair value is a methodology based on the price or a recent investment, but if such a price is no longer relevant – and there are no comparable companies or transactions from which to infer value – then it is appropriate to apply an enhanced assessment which can include a milestone analysis, including factors such as whether there has been any significant change in the market for the investee company or its products or potential products.
The guidelines also say that a valuer estimating the fair value of an interest in a fund should base their estimate on their attributable proportion of the reported fund net asset value, while clarifying that when marketability is appropriately considered when estimating fair value, there is no need for a second marketability discount on top. Finally the guidelines also eliminate any reference to the one-year period used in practice for retaining investments at the “Price of Recent Investments” concept, to ensure no conflicts with accounting rules.
But in addition to providing clarity, the board is also hoping the guidelines can influence behavior on both sides of the Atlantic. IPEV board member Katharina Lichtner, a managing director and head of research for Capital Dynamics, recently spoke with PEM on how the new changes to the guidelines came about and what IPEV is focusing on in the future:
How have the IPEV guidelines evolved since they were first put forth in 2005?
The IPEV guidelines evolved from the EVCA guidelines. The EVCA had issued a first set of guidelines on how private equity investments should be valued. However the EVCA alone was not the appropriate body to drive a globally accepted unified valuation standards. So out of that came the IPEV board and the IPEV guidelines to ensure alignment with US GAAP and IFRS.
The next evolution came to ensure alignment with the FAS 157 rules and further developments of IFRS and GAAP. For example, in older versions of the guidelines there was a possibility to hold investments at cost during the first year, which is not permitted under US GAAP as well as FAS 157. So the guidelines needed to reflect that fair market value needs to be applied for all companies at the time of valuing a portfolio, irrespective of whether a company is one year old or two months old. In the light of what happened last year that also makes conceptual and practical sense. It would be hard to justify June acquisition valuations in December after virtually all industries had substantially depreciated in October.
The availability of global guidelines will make it easier for investors as well, especially with respect to benchmarking. For younger funds much of the value is driven by the valuations of the unrealised portfolio. With strong differences in valuation practices, benchmarking has been challenging. With a more unified approach to valuing unrealised companies comparability between US and EU funds will become easier. This will make asset allocation and investment decisions easier.
One of the challenges for IPEV in the future is getting the guidelines to be more widely understood and used in the US. Why is there this lack of exposure in the US, and how is the IPEV board seeking to address this?
Several factors play into this.
Currently there is more weight given to the buyout aspect, but more consideration has to be given to the valuation aspects of venture investments. Furthermore, the Private Equity Industry Guidelines Group in the US issues their own guidelines and it takes time to bring the two guidelines together. Further work on the structure and creating a shorter, easier-to-use synopsis will aid acceptance. I believe content-wise the guidelines work well for US and EU funds now, which is also a result of having very strong contributors from the US as members of the board. Further consultation with a wide range of US practitioners will further support acceptance.
And lastly there has been much less publicity work in the US than in Europe. This is certainly an aspect the board is actively addressing. So the IPEV board welcomes any opportunity that helps making private equity practitioners aware of the guidelines and the work of the IPEV.
Anthony Cecil of KPMG has said that previously the guidelines seemed focused on impairments, missed budgets, downturns, etc. But are the guidelines as geared toward trying to encourage people to mark up as readily as they mark down?
From a fair market value point of view companies should be marked up just as they should be marked down as long there is a good reason for the change. It goes both ways. It is not in the interest of investors either to have an undervalued portfolio. Capital Dynamics prefers to receive valuations that adequately reflect the current value of a portfolio. We don’t want to see situations where a company is held at a value either too high or too low, and at an exit three months later the value changes drastically in either direction. So I think there will be increasing drive from the LPs for these guidelines to be used appropriately. There are some fears that valuing companies at fair market value can be misused by funds prior to fundraising. However, I think this will be calibrated by LPs.
At the end of the day any valuation implies judgment, and those GPs using the guidelines carefully will fair best in the long run. The guidelines provide a very good basis to achieve good valuation results. It is up to the LPs to understand the dynamic behind the valuations and to make sure they have the structures, processes and statutes in place to manage more volatile private equity portfolios adequately.
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