Until 2008, ‘standard’ valuation practice in the industry was a misnomer. Though the National Venture Capital Association (NVCA) in the US had standards in place for venture capital that were followed by their members, GPs in other sectors did not have definitive standards. Certain GPs held valuations at basically ‘lower of cost or market’, others followed something akin to NVCA guidelines, while still others were more aggressive in writing up valuations in the light of changing purchase price multiples or cap rates. These processes made it difficult to compare performance across GPs early in the life of a fund, when unrealised investments comprised the bulk of portfolios. It could even be difficult to compare returns across funds that may have participated in a few significant investment syndicates, where a number of key investments overlapped but the valuation policies of the two funds differed completely.
LPs hoped for some level of consistency across GPs that would give them greater confidence in the valuations numbers they used for internal analysis and for reporting to their investment committees and boards.
Devil in the details
FASB ASC 820 was meant in part to address some of these concerns. However, throughout 2008, as various GPs began to implement the changed accounting methodologies, the practicalities of implementation became clearer as did their impact on the desires of LPs.
- • Valuation metrics and consistency of methodology: The accounting guidelines were meant to ensure that a particular GP utilized a consistent valuation methodology to estimate the fair value of the underlying investments in a fund, both across investments and through time. However, GPs were allowed to select a methodology that they felt made sense for them with the concurrence of their auditors. For example, the two most common methodologies used in buyouts are price to earnings (P/E) multiple comparisons and net present value cash flow analysis. These methodologies can generate widely divergent results, as evidenced in the cases of investment syndicates, where widely different valuations between GPs are in part driven by these differences.
- • Valuation metrics and consistency of assumptions: Even in the case where two managers are using roughly the same valuation model, different assumptions on key model inputs can generate wide disparities in value as well. Those assumptions are also key to how the GPs oversee and manage their investments and are difficult to compromise merely for consistency’s sake.
- • Fair value in a distressed environment: The implementation period for the new regulations overlapped one of the worst market environments in history. All illiquid investments are difficult to value, but as the markets fell apart in late 2008, two major issues emerged:
- – During periods of distress, valuation can be nearly impossible: Though more evident in the exotic end of the asset-backed securities market, there has been tremendous dislocation in private equity and real estate as well. For example, buyout market activity has been so low that current private market purchase price earnings multiples were simply not available – though these are key at the small end of the market where public market values are often not appropriate. Forced to provide valuations, GPs’ assumptions can become increasingly intangible, as evidenced by the continuing debate on Level 3 assets.
- – Timing of valuations: Fair value forces a valuation at period end based upon current market conditions, even in an environment where no rational private investor would sell and nothing would necessarily force a sale. Even without an impending financial crisis that would push a portfolio company into bankruptcy, valuation metrics could imply a wipeout of equity.
- • Stale pricing – estimating allocations and returns: Though the changed regulations regarding fair value require quarterly re-pricing, those valuations are still stale when compared to other assets in an institutional portfolio. Depending upon where one stands in a reporting cycle, fair values of privately held assets can be four or five months out of sync with assets that are truly marked to market. In periods of dramatic change, these numbers over the short term can be as badly flawed as they were previously.
This passage is excerpted from The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media. Primarily written by valuation experts Duff & Phelps LLC, this guide provides investors and fund managers with valuable tools and practical guides to fairly value nuances and scenarios, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/pevaluation.