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Friday Letter Fiduciary Duty

Adhering to clear valuation guidelines will strengthen the bond between investors and managers when the going gets tough.  

At the European Venture Capital Association’s annual investor forum in Geneva earlier this year, a row started brewing between investors and general partners about the valuation of portfolio companies. The investors argued valuations provided by their GPs were too often lacking in realism. Continuing to hold some of their investments at cost was not tenable in a deteriorating economy, they said. It did not describe fair value.

Since then the debate around fair value accounting has intensified. It's a discussion that managers cannot ignore. It is also an opportunity for managers to get on the front foot in the broader debate about greater transparency in private equity. To this end, various industry bodies including EVCA have developed guidelines to help their members value their investors consistently.

Neither is it surprising that quoted private equity is in the vanguard here too. For instance: in its most recent results announcement 3i, the FTSE-listed private equity firm, spelled out its valuation criteria in language accessible to all.

The firm explained a number of valuation techniques dependent on the stage of the portfolio company in the lifecycle of 3i’s ownership. For the first year most investments are held at cost. Thereafter they are valued on an earnings basis before moving to an imminent sale basis. It also took its 50 largest investments and explained which valuation basis applied.

Now clearly valuing illiquid investments is both an art and a science and most practitioners will say they can offer a point in a range of values, but it is important to remember it is a range.

But what 3i’s guidelines establish is a valuation policy for write-downs as well as write-ups. The policy is externally audited, which means it meets the highest governance standards. And while it won’t kill the debate about contentious valuations, it will provide a framework for discussion.

This will be helpful, especially if the doomsayers are proved right and aggressively leveraged portfolio businesses come under pressure in the coming months making write-downs inevitable. Investors in private equity funds deserve a consistent set of standards for valuation, and a consistent, clear methodology approved by a third party. The Geneva quarrelling served as a reminder that even though various sets of valuation guidelines have been in place for some time, the ambiguities they are designed to eliminate still exist.