When is fair value not fair value?

Earlier this year, the American Institute of CPAs (AICPA), the main professional body for US accountants, created a taskforce to develop valuation guidelines more tailored to the needs of private equity and venture capital firms – the idea being to give fund managers a clearer and more consistent set of rules to follow when valuing hard-to-price non-quoted companies.

The industry has already developed its own extensive set of valuation guidelines to this very end: last December, the International Private Equity and Venture Capital Valuation Association (IPEV) released an updated set of rules (developed by both GPs and LPs) for private equity to follow.

But auditors say the IPEV guidelines aren't granular enough, which means that private fund managers sometimes end up taking different approaches when valuing certain types of securities. That sort of inconsistency can make auditors nervous, especially now that the Securities and Exchange Commission has oversight of the private equity industry and has highlighted portfolio valuations as an area of importance.

That's why accountants want to develop their own valuation playbook for the private equity and venture capital community to follow. With their own guidelines, they suggest, auditors could provide examples or hypothetical scenarios of how GPs should value certain assets – thus eliminating some of the inconsistencies seen in market practice.

It's a nice theory. But will these guidelines actually reflect market practice?

Of course it's easier for auditors to justify to their oversight bodies that protocol has been followed when everyone else is using the same rulebook. But in private equity and venture capital, a portfolio company’s fair value is ultimately determined by what price it would sell for in the marketplace at that time. And that's an incredibly subjective exercise. Having GPs run extra models, following a fixed methodology, to find an exit price that fits into a neat accounting box might not actually be terribly helpful in terms of evaluating a private company’s growth.  

Auditors probably have a point that a percentage of private fund advisors are not currently doing enough to determine the fair value of portfolio companies. The concept of 'calibration' (where fund managers track the growth of comparable public companies to help determine the value of their own portfolio companies) is a good example of this: it seems an obvious valuation tool for GPs to utilize, but some don't bother on convenience grounds. AICPA has already promised to discuss calibration in 2014; it seems safe to say it will make it a priority in its own guidance.

The trouble is, however, that if the taskforce goes too far in its efforts to shake fund managers out of their comfort zone, it may be left with a set of guidelines that do not actually reflect how valuation is done in this industry. And if that happens, GPs may start keeping two sets of books – one for the auditors to check, and one for LPs who want to know what their managers actually think the portfolio is worth in any given quarter.

Sources tell PE Manager the AICPA taskforce won’t unveil a draft of their guidelines until sometime in 2016. Until then, private equity and venture capital managers need to keep making their case to auditors: that trying to establish a completely uniform set of valuation rules for companies whose worth is always open to debate until the time of sale is a very big ask.