Friday Letter: The long and short of standards

The private equity industry is blessed to be inherently long-term in investment outlook, but rather cursed to find itself increasingly dependent on a broader investment market that is built around short-term performance measurement.    

Two observations from the third annual European Private Equity International COOs and CFOs Forum, concluded yesterday in London, highlighted this contradictory phenomenon, which finds our long-term asset class increasingly adopting the valuation standards of the short-term asset classes, as it were.

On Wednesday, during a panel on regulation and self-regulation in the private equity market, Javier Echarri, secretary general of the EVCA, said his association was in the process of promoting the adoption of the recently released EVCA/BVCA/AFIC valuation guidelines to European and UK general partners. While there will certainly be some holdouts, it appears the voluntary guidelines have already made great headway. A poll of the audience – the bulk of them private equity firm CFOs – found that more than half had already adopted the guidelines.

At the core of the European valuation guidelines, as well as similar efforts from the PEIGG and CVCA (Canada) in North America, is the concept of fair value, which, put simply, asks what a portfolio company would be worth if sold today. Traditionally, of course, private equity GPs and LPs have not been interested in this question as they did not plan to sell the company for several years, and in the meantime had no reliable way to value the company, such is an illiquid market.

If most GPs had their druthers, they would hold a portfolio company at cost until some material event, like a new round of financing or public listing, forced a change in valuation. Not only is this easier and more conservative, but the hold-at-cost method creates some advantageous mystery in the event of a sale. In other words, a buyer can’t ask: “Why are you attempting to sell this company for €1 billion when just last quarter you attached to it a fair-market value of €750 million?”

Alas, the barbarians of public market accounting have broken through the gates of private equity. An institutional investor that sizes all other assets at fair value now has a hard time explaining to his or her superiors why private equity doesn’t act like the others.

As a result, private equity practitioners far and wide accept that the gradual adoption of valuation standards is a positive development for the industry and one that will get private equity broader acceptance among investing institutions. However, the industry is less enamoured with the notion that fair value as the basis for such standards should be best suited to private equity.

General partner resistance to fair value has been fiercest in the US venture community. But fair value and clear standards is desired by the customers, by international accounting bodies and by regulators worldwide. And if private equity GPs don’t adapt and adopt, they may find outside parties seeking to force standards upon them.