Earlier this year, the International Private Equity and Venture Capital Valuation board (IPEV) proposed a number of technical updates to its valuation guidelines, which many private equity CFOs see as their bible for valuation best practices.
Some of the updates being proposed are simple tweaks made to improve reader friendliness and the logical ordering of how the guidelines are presented.
But others – which are largely the result of important developments and trends in accounting and valuation circles – deserve careful consideration when forming an opinion on whether the proposed changes should be adopted. Here’s a rundown on the proposed changes we think you should be paying attention to:
Further commentary on “unit of account” (Contents section): Determining what “unit of account” to use when valuing a portfolio company is not straightforward. CFOs could value a portfolio company by multiplying the price of an individual share by the amount of shares held (PxQ), but that ignores the value associated with the entire interest in the portfolio company. FASB and the IASB, the two main accounting standard setters, offer limited guidance on determining unit of account for the private equity industry. In the proposal, IPEV wants to clarify that the unit of account should be determined by the approach that a hypothetical buyer and seller would use when transacting under normal market conditions.
New guidance on reporting across funds (Section 1.6): Private equity firms that split an investment across multiple funds will sometimes use one fund as the basis for estimating the fair value of each fund’s interest in the company. Despite the convenience of this, IPEV is recommending a fund’s fair value estimate to be independent from other funds and reporting entities. Trouble can arise, for instance, if one fund holds a combination of both debt and equity in the same company partially owned by a second fund under management with only an equity interest.
Clarification on how debt impacts equity valuations (Section 2.4): CFOs sometimes question how debt holdings could impact the value of equity in a company. For instance, if debt carries a prepayment penalty, should a CFO subtract the amount of that penalty from the company’s enterprise value if the measurement date was before the penalty no longer applies? In this instance, IPEV argues that the reasonable assumption would be that GPs normally transact before the penalty applies, meaning the fair value estimate may not consider the penalty price.
New language on back-testing (Section 2.7): Under this proposal, IPEV is asking CFOs to better understand “the substantive differences that legitimately occur between the exit price and the previous fair value assessment.” Also known as back-testing, the principle requires GPs to review their previous valuation estimates with a company’s actual exit price, and determine if any improvements could be made when conducting future valuation estimates. Following concerns that some GPs may have inflated valuation estimates ahead of a fundraise, back-testing has become a focus area for regulators and investors alike, which IPEV may have considered when adding the new section.
Revised guidance on the DCF model (Section 3.8): There is no technical requirement that CFOs use multiple valuation techniques when valuing assets, but auditors expect it nonetheless. Accordingly, IPEV wanted to remove any negative bias towards CFOs using the Discounted Cash Flows (DCF) technique. Even though the DCF method relies on a heavy degree of subjective judgement, it seems that IPEV wanted to legitimize it as one of several valuation techniques for CFOs to consider.
IPEV is in the process of finalizing the guidelines now. Pfm will, of course, provide an update on the finalized changes once available.