Audit wars

GPs are reporting an increased tension between private equity firms and their auditors as fair-value pressure builds. By David Snow.

Increasingly, the often idiosyncratic approaches to valuing private equity portfolio companies are not receiving the blessing of the auditor community.

Especially in the US, where venture capital and buyout firms have long prided themselves at their “conservative” approach to valuation, GPs are privately reporting increased pressure from their own auditors to be more proactive at applying fair-value methodologies in accounting.

Thanks to the increased scrutiny of private company accounting methods, auditors are less willing to risk their own practices by giving an opinion on private equity portfolios where they cannot discern a reasonable effort to determine fair value.

“For years, the GPs somehow got the auditors comfortable and to accept that cost or another round of financing is representative of fair value,” says an auditor with private equity clients. “But now there’s more pressure on GPs to do more robust valuation and documentation.”

The fair value approach requires a GP to approximate what price a portfolio item would fetch if sold today. Many GPs are resisting the push to fair value because they feel it assigns an arbitrary and perhaps overly optimistic value to portfolio companies. This is especially the case with early stage venture capital investments, many of which have negative cash flow and little by way of comparable public positions against which to mark a valuation.

GPs also know it is an expensive hassle to assign quarterly fair values to portfolio investments. Many also complain that while some LPs are pressuring for a move to fair value, these same LPs may balk at the value fluctuations that may be the result of such a move.

One small-buyout GP says he recently rejected a demand from his auditor to write up the values of certain investments. As a result, he issued a 2005 report to LPs that did not have an auditor opinion.

“It’s strange to me that an auditor would be arguing to write up an asset,” the GP says. “It’s completely upside down.”

The stepped-up tension also comes amid a push on both sides of the Atlantic for private equity firms to adopt valuation standards, issued by various industry trade associations, that are based on fair value methodology.

At the 2006 European Private Equity COOs and CFOs Forum today in London, an anonymous audience poll revealed that roughly 45 percent of the firms represented at the event have adopted the fair-value-based International Private Equity and Venture Capital Valuation Guidelines, developed by the Association Française des Investisseurs en Capital (AFIC), the British Venture Capital Association (BVCA) and the European Private Equity and Venture Capital Association (EVCA).

A more extensive article on this topic appears in the current issue of Private Equity Manager.