IPEVolution

After receiving feedback from general partners, investors and accountants, the International Private Equity and Venture Capital Valuation (IPEV) Board on 9 September released updated guidelines that are intended to provide more clarity and guidance to private equity valuations.

Several tweaks have been made to the Private Equity Valuation Guidelines, which were originally launched in 2005 to improve consistency with the International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP). The changes were prompted in part due to the evolution of fair value accounting requirements and the increasing use and knowledge of financial standards such as FAS 157 in the US.

“The updated guidelines now provide expanded guidance on valuing early stage investments, provide clarity in valuing debt instruments and provide guidance for valuing LP interests,” David Larsen, a member of the IPEV board and managing director at Duff & Phelps, said in a statement. “In addition, clarifications are incorporated to highlight the need to determine fair value at each reporting date and ensure that the illiquid nature of investments is appropriately considered.”

According to another IPEV board member, Anthony Cecil, a partner at KPMG, there are four principal changes to the guidelines.

1) 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 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. In such a case the valuer would assess whether there is an indication of change in fair value based on a consideration of the milestones, taking into account factors such as:

– Has there been any significant change in the results of the investee company compared to the budget plan or milestone?
– Has there been any changes in expectation that technical milestones will be achieved?
– Has there been any significant change in the market for the investee company or its products or potential products?
– Has there been any significant change in the global economy or the economic environment in which the investee company operates?
– Has there been any significant change in the observable performance of comparable companies, or in the valuations implied by the overall market?
– Are there any internal matters such as fraud, commercial disputes, litigation, changes in management or strategy?

“The milestone analysis is trying to give more guidance particularly for venture and development assets,” Cecil said. “It is not just, ‘I still own a good company, it's profitable, it must be worth a lot of money’. It’s ‘is the company on track to where I thought, has my money been well invested or well spent?’ and you’ll just continue to monitor that against whatever R&D milestones you have, testing milestones, budgets, sales targets, the lot. But it’s not trying to give concrete guidance, it’s really just saying these are the sort of things you might want to think about.”

2) Guidance on the valuation of interests in funds

In estimating the fair value of an interest in a fund, the valuer should base their estimate on their attributable proportion of the reported fund net asset value. In the event that the investor in a private equity fund has decided to sell their interest in that fund, then data from orderly secondary transaction prices is likely to be better evidence of fair value.

“We were getting a lot of pressure from one or two US audit firms saying that you should always value fund investments on the basis of secondary market prices,” Cecil said.  “And the problem that would give is, particularly in the current market, the secondary market players are offering 15 to 25 cents on the dollar maximum for any positions. So unless you want to sell your position, I don’t think that single opaque transaction is a sensible way for valuing your interests in a fund.”

Cecil continues: “So what we are saying is that the starting position is 'what is the underlying net asset value on a fair value basis of the fund you’ve invested in. But there are a lot of things you should think about or change: are you happy with the valuations, has it been three or four months since you got a valuation report, all those sorts of things. And we’re saying if there has been a secondary transaction, you should consider it as a data point about but be very careful as you rarely know all the terms of a secondary transaction.”

3) Clarification of how the marketability discount should be applied

The previous rules implied that once someone concluded a valuation assessment, they needed to add on top of that a top marketability discount because the company was not liquid. The new rules clarify that when marketability is appropriately considered when estimating fair value, there is no need for a second marketability discount on top.

“What it used to have was a straightforward discount applied at the last stages of calculation,” Cecil said. “So the way it has been changed is really taking out the way it is calculated, and it's now something which the valuers should consider as a part of their initial multiple and points of difference assessment. The concept is still there and I would not expect that change to change the valuations people come up with. It's merely a different way of thinking about it and calculating it.”

4) Elimination of 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

The erasing of this concept stems from a misinterpretation that has taken hold in retaining investments.

“The guidelines always used to say that you have to decide how long cost is an appropriate reflection of fair value, and in practice valuers often used one year,” Cecil said. “That was translated as the so-called ‘one-year-at-cost rule’, which meant that if you held it at cost for a year no one would challenge it. And that was a misinterpretation, so we have taken out all references to one year, saying that it is up to you how long it will be, because there never has been a one-year-at-cost rule.”