Mark Twain once said, “there are three kinds of lies: lies, damn lies and statistics.”
It might also be said of private equity portfolio company valuations that there are three kinds: valuations in financial statements, valuation projections at annual meetings and valuation estimates in Private Placement Memoranda (PPMs).
“Around here we call them PPM valuations,” shrugs a portfolio manager at a major US endowment, referring to the third, most aggressive, flavour of valuation.
As the struggle for valuation standards continues (see accompanying article), its proponents remain all too aware of the varying methodologies (and motives) being applied by general partners to their investments. Much, for instance, has been made of the different methods used by different private equity firms to value the same company in their respective financial statements. Divergent numbers here have invited some to rail against what they see as the habitual inconsistencies of private equity managers. But it is also the case that some private equity firms value their own portfolio companies differently depending on the occasion and audience. Some market professionals are increasingly worried that this common practice will further undermine investor confidence in the credibility of the asset class.
For example, a number of market participants who work with large numbers of financial statements from different GP groups note a disconcerting practice that many firms follow when fundraising. “You see a draft of the PPM come out, but the valuations are different from what was reported in their financial documents,” says one such practitioner, who adds he has seen this practice ‘increasingly’ in the market. “The GPs want to project their exit values and get people a little bit excited about a new fund launch. But I don't understand how these can be different. There needs to be conformity of valuations.”
The endowment portfolio manager says ‘PPM valuations’ are sufficiently dubious that he and his team often don't even bother reading performance figures in marketing materials, instead focusing on biographies, strategy and other qualitative attributes. “If the qualitative stuff warrants a meeting, we'll have a meeting and then go through the deals,” he says.
“It's no surprise that there's a big discrepancy,” the portfolio manager adds. “GPs are playing the game that there's so many funds in the market, they're hoping a prospective LP will see a big IRR and that will get them in the door.”
Specifically, industry participants note that private equity firms will frequently present their own version of ‘fair value’ in a PPM – in other words, what the various portfolio companies could be sold for if exited today – while at the same time holding at cost the value of these same portfolio companies in the financial statements they send to investors.
In addition, some market professionals note a third circumstance to which yet another type of valuation convention is applied. If quarterly reports to existing investors are where more conservative valuations reside, and PPMs, designed as they are to attract new investors, are the place for more aggressive numbers, so annual investor meetings seem to sit in the middle ground.
These meetings are often forums where GPs speak candidly to their investors about the state of the various portfolio companies, and in many cases forward-looking exit valuations are offered, if unofficially. According to the endowment professional, these projected valuations are often delivered orally, or are in a slideshow presentation – nothing that leaves a paper trail.
People want to know what something can be sold for
“This happens more often on the buyout side than on the venture side,” he says. “They might say, ‘An exit is imminent and we expect 3x.’ [As an LP] you can generally feel pretty good about [these valuations]. The last thing a GP wants to do is give the expectation of a certain number they can't deliver.”
In other words, what might be termed annual-meeting valuations tend to be conservative but forward-looking, and designed to indicate to a fund's investors what they might reasonably expect by way of distributions in the near future. “I personally find this extremely helpful,” says the endowment professional.
THE CASE FOR CONSERVATIVISM
Many limited partners wish that their GPs would be as helpful more often. Proponents of a move to fair-value accounting standards in private equity note the PPM versus quarterly report discrepancy with some chagrin. After all, many general partners claim that fair value is an inappropriate accounting method for private equity, but find it entirely appropriate when the approach serves their own purposes, such as when they are raising a fund.
In the meantime, many limited partners find it increasingly necessary to integrate their regular private equity partnership reports into a broader portfolio that includes other asset classes, most of which are based on fair-value accounting.
General partners have many good reasons for opposing a shift to delivering fair valuations on a regular basis. Philosophically, many GPs worry that a shift to fair value may give a false impression that estimated interim valuations are reliable performance indicators. If a portfolio company is valued one quarter at $200 million and later sold for $150 million, will the GP group be called to the carpet to explain the drop?
Strategically, general partners also worry about letting a host of proverbial genies out of their bottles with frequent and accurate valuations. Private equity is a market where non-transparency and illiquidity are often a key advantage over the public market. GPs worry that pinning an “official” value to a company – especially an impaired business – will lead to a weak hand at the negotiating table when it comes time for an exit. A potential buyer who learns that a private equity firm has, one quarter earlier say, valued an asset at below cost is far less likely to offer anything higher. “The buyers will know exactly what they can get away with,” acknowledges the endowment professional. “It lays the cards on the table.”
More practically, the reluctance of many GPs to move toward consistent fair value reporting has much to do with resources, or rather, the lack thereof. Put simply, it requires a great deal of work to establish ‘if-sold-today’ valuations every quarter for a cluster of portfolio companies. And the work can come to seem a bit pointless considering the extreme illiquidity of the assets in question. Why not just save everyone a lot of trouble and keep things at cost until some material event, such as a sale, comes along?
This issue of the amount of work and resources required for constant valuations seems to be a subtext to many of the other debates taking place in the private equity market. In the US venture capital world, the NVCA's opposition to the expensing of stock options has partly to do with its fear that expensing stock options would also mean an exponential increase in the amount of valuation work to be done, with all the same philosophical as well as practical pitfalls described above.
To be sure, general partners are caught between two often-conflicting sentiments among investors. Most LPs prize conservativism in their GPs, and like to see evidence of cautious optimism and carefully managed expectations – both signs of a responsible fiduciary. At the same time, LPs want to know what their portfolio is really worth. A New York-based placement agent says her GP clients are usually conservative in presenting valuations, and that inquiries as to fair value, or projected exit values, come from potential LPs. “People want to know what something can be sold for,” the placement agent says.
But perhaps an overriding consideration should be consistency. Steven Millner, a managing director for BISYS Private Equity Services, an accounting services firm, says that PPM numbers should match financial reporting numbers if private equity is to increase its appeal to institutional investors. “I think GPs are more aware now that valuations need to be consistent among marketing documents and financial statements,” Millner says. “It provides more credibility to the track record.”
That said, many LPs would still be more than happy to see this consistency and credibility revolve around the fair-value standard. It's just that the responsibility for this resides with the GPs.