David Larsen, a managing director in the San Francisco office of Duff & Phelps, is well known to private equity CFOs as being a leading expert on private equity valuation and accounting methodology. He is a board member to the Private Equity Industry Guidelines Group (PEIGG) as well as an author of the soon-to-be-released The Definitive Guide to Private Equity Valuation, published by PEI Media (click here to learn more http://www.peimedia.com/Product.aspx?cID=&pID=204686 )
Larsen spoke recently with Private Equity Manager about what to look for in yearend valuations.
PEM: What should the private equity market expect to see when the yearend numbers are released?
There are three things in play all at once, so part of this is trying to divine which one will win out, or whether there will be an impact of all three together.
Clearly the overall market has come back from where we bottomed out at Q1 2009, and many managers took some hits in their portfolio at 31 December 2008 and at 31 March 2009. You have the psyche of investors who don’t like bad news more than once, and you’ve got that human nature that is fighting to some extent against the facts of the marketplace that shows that value has come back. The desire to not want bad news twice leads to a thought process of, “Okay, I’ve already written it down, if I write it back up and something bad happens again, if we have a W-shaped recession, then I have to write it down again, and that is bad news twice”.
So you have this kind of human nature that is reluctant to move back in the direction where the market is going, kind of at loggerheads with the need to say, “Well okay, multiples are expanding a bit, my EBITA is strong or I have a positive outlook on it, I’ve made it through the worst of the difficult times and there is starting to be some light at the end of the tunnel”. [That is] combined with the pure market facts, that, at least on the surface, give a tendency to say that you would expect values to come back up to some extent.
You have all of that and in the backdrop is the fact that the world of the limited partners is changing with the impact of the new accounting guidance on validating net asset value.
And the LPs haven’t fully comprehended that piece yet, and the auditors haven’t fully comprehended it, and when the auditors realise what the new pronouncements from FASB mean and the upcoming pronouncement from the American Institute of Certified Public Accountants (AICPA), which could come any day, that will put a lot more things in the tool kit for the auditors, which will then put pressure on the limited partners, which will then put pressure on the GPs.
When they are released, what will the new AICPA guidelines generally mean for auditors and LPs?
The AICPA guidance is really an interpretation of the FASB guidance that came out in September, so it will provide more practical help for auditors and for limited partners on using net asset value. But in a nutshell what we’ve been saying even before the AICPA guidance is that limited partners can’t blindly take net asset value. LPs have to do something more, they have to ensure that the GPs have a robust valuation process such as using a third party, they have to do their due diligence, they have to have procedures to ensure that the valuation of the general partners is rigorous.
All of this is kind of converging together. We have the bottoming of the market in March. Things are coming back. Do people allow the facts to trump the emotion [and] to write things up, which the accounting would require given the market conditions?
According to recent State Street Private Equity Index numbers about Q2 2009, we will likely see the same type of W-style valuation trend as was seen following the dotcom crash. How does the current situation compare to 2001 to 2002?
What we saw in the dotcom crash, in private equity, was stair-step write downs, because the managers really didn’t believe things were as bad as they were. That gave rise to limited partners saying this just doesn’t work, and that was what gave rise to the the Private Equity Industry Guidelines Group valuation guidelines in 2003.
In the current situation you had a very steep fall off a cliff. Everyone kind of went splat on 31 December 2008 or 31 March 2009. And now it’s a question of, “Okay, we are walking, but are we walking in the valley or are we starting up the next mountain?” And again from an overall economy point of view there are indications we are in positive territory. So all that says is that we shouldn’t be in that valley, we should be walking up the next mountain. The question is no one can see whether or not there is a cliff on the other side of the next mountain, which there may be. However, should we welcome the chance to climb the next mountain, recognise the fact that conditions are improving and that values are going up. Or do managers keep valuations flat, effectively saying they are happy to stay at the valley floor?
Emotions always have an impact on valuation estimates, but in particular I think some will argue that keeping valuations flat – in the valley floor, so to speak – is conservative. However, we learned through Enron and other problems of the last decade that conservative is not necessarily a good thing. Conservative has come to mean purposefully understating, and the whole premise we have for governance, for financial statements, for asset allocation is that a prudently determined fair value is necessary.
How will the numbers be rolled out?
Limited partners need [the 12/31 numbers] as of their reporting dates, for example corporate pension plans need them in January. Other limited partners, depending on what type of entity they are, may not need final 31 December valuation estimates for several months. Usually the general partner has 90 to 120 days after yearend to report.
So we may not see too much until next April or so. However, a preliminary indicator will be the corporate pension plans, because the sponsors of corporate pension plans must provide new disclosure in their 10Ks for 31 December. So when 10ks are released in Feb and March, they have to list by asset category the pension assets in which they have invested, so we’ll at least see at that point in time some of the movements in their pension assets, including their alternative assets. So that is where there will be a leading indicator. Whether that be IBM, Boeing, GE, any public company sponsor of a pension plan has brand new disclosures required as of 12/31 that we will see in the 10Ks coming in January, February, March.