A year ago we predicted in an article in this journal that 2003 would be remembered as “The Year of Valuation Guidelines.” At the time two industry task forces were working on developing new guidelines for valuation practices for private equity funds: the British Venture Capital Association (BVCA) task force in the UK and the Private Equity Industry Guidelines Group (PEIGG), a group of 18 professionals representing most segments of the US private equity industry.
BVCA, PEIGG AND OTHERS
The BVCA group arguably had the easier task in that their assignment was to update and improve on an already existing set of guidelines that were actually in use. In the US, by contrast, there were no official guidelines in existence, and there was no single private equity industry association that was the obvious entity to promulgate any such rules. Thus the PEIGG group not only had to develop the guidelines themselves, but it also needed to be recognised by the industry as a sufficiently authoritative voice to merit attention.
However, PEIGG was not writing on an entirely blank slate. US practitioners were already using valuation principals that were based on a set of guidelines that had been proposed to the National Venture Capital Association (NVCA) at the start of the 1990s. Although the NVCA never formally adopted these proposals, they had become a de facto standard in the industry. They were seen as appropriately conservative, as they emphasised carrying investments at cost unless 1) material impairment indicated a write-down in value or 2) a financing round with new investors supported a write-up in value. It was widely believed that any new PEIGG guidelines would be a fairly simple and straightforward codification and update of this widespread approach.
Nevertheless PEIGG's was a serious task. Many thoughtful observers had come to believe that a codified and widely adopted valuation standard was important for the US industry at that time. This consensus developed in the wake of the widespread corporate financial reporting scandals as well as the difficult private equity reporting and clawback issues caused by an extremely harsh down market. Still, as we found out in an industry survey that Tuck's Center for Private Equity and Entrepreneurship conducted in 2002, there was no agreement of what these standards should be; in fact, there even was even some opposition to the development of any standards at all. Still, most of those polled agreed that an industry association would be the appropriate body to develop guidelines, but even that presented a problem as the NVCA, the only industry association in the US, does not represent the US buyout industry. PEIGG's foray was a solution to this particular difficulty.
In addition to the work of the BVCA and PEIGG task forces, there were related activities underway that could impact both their efforts and the industry as a whole. The Association for Investment Management Research (AIMR) was updating its Global Investment Performance Standards (GIPS), which focused on standards to be used when reporting historical fund performance. More importantly, the US accounting industry was moving toward greater emphasis on fair value assessments of assets as reflected in the Fair Value Project of the Financial Accounting Standards Board (FASB). In fact, FASB intends to issue an exposure draft of its proposed statement “Fair Value Measurements” in June of this year. All of this was also being done in the context of the development of International Accounting Standards (IAS) and the discussion of the conformance by US entities to those standards.
NO MORE DELIBERATE UNDERSTATEMENT
The first task force to present results in 2003 was the BVCA, which published its “Reporting and Valuation Guidelines” in June that year. The key feature of this framework was an explicit reliance on the principle of “fair value”, defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction. This principle was viewed as an important objective to make the guidelines conform to International Accounting Standards. In particular, the guidelines relied on the draft IAS Standard 39 “Financial Instruments: Recognition and Measurement.”
At about that same time, Tuck hosted a valuation conference to bring together leading industry practitioners who were involved in the various task forces and initiatives. There were two major conclusions that emerged from the discussions at that conference.
First, there was broad consensus that valuation assessments are the responsibility of GPs and that LPs expect their GPs to exercise their best judgment in estimating values based on the valuation policies as set forth in the limited partnership agreement.
Second, it became clear that if any new guidelines were to conform to accounting standards in the future, they would have to be acceptable under the fair value principles purported by international and US accounting authorities. This meant that any new valuation standards that continued to reflect the old concepts of “conservatism” would not conform with accounting standards. One member of an accounting body at the conference stated that accountants defined conservatism as “the deliberate and consistent understatement of assets or income or both.” There was broad agreement at the conference that care and caution should govern fair value assessments and that these assessments should be “prudent” even if they could not be explicitly conservative.
PEIGG issued its valuation guidelines last December, acknowledging and supporting the fair value concept.
The most dramatic contrast with past practices in the US was the now infamous “Paragraph 30”, in which PEIGG would allow write-ups based on portfolio company performance rather than just a third-party financing transaction. Although this reflected the guideline's underlying principle of fair value, some LPs and some GPs expressed a concern that such practices would lead to increased volatility in portfolio valuations as well as possible abuse. Some observers say that volatility is already present in any cost-based valuation policy. They point to the prominent example of Google, which will soon be one of the biggest IPOs ever (possibly over $10 billion), but is probably still carried on its investors' books at early round valuations that are much lower. This IPO will introduce its own type of volatility, albeit of a very pleasant sort for some parties. In addition, there was a concern that a mark-up without a financing might be abused, particularly by GPs in fundraising mode. Some LPs are already seeing evidence of this, and hearing the PEIGG guidelines cited as justification.
PEIGG's guidelines further encourage firms to report quarterly to LPs and to use valuation policy committees to help establish valuation practices for the fund. The GP will retain ultimate say in the actual valuation. Firms that co-invest in a single portfolio company are also encouraged to confer among each other.
Initial responses by the media were critical. Some commentators pointed to skepticism among industry players that the guidelines were insufficiently prescriptive to ever achieve the goal of consistency. Others viewed the retreat from conservatism and from reliance on cost-basis as dangerous. To date, few GP members of the NVCA have adopted the guidelines.
The industry is in the process of absorbing and understanding the PEIGG guidelines. The reactions of the major associations representing GP and LP interests are being watched carefully.
The NVCA has specifically encouraged its members to review the PEIGG guidelines when evaluating procedures or developing new approaches. NVCA also commends PEIGG for its efforts. However, endorsement has not yet emerged. The Institutional Limited Partners Association (ILPA) on the other hand endorsed both the PEIGG efforts and the NVCA's support of PEIGG.
INTERNATIONAL VALUATION GUIDELINES
|Underlying Principles||Prudence, disclosure, fair value||Fair value, consistency||Cost with modifications||Fair value, GAAP,|
|based on circumstances||consistency, transparency,|
|Periodicity of Valuation||Twice a year||Annually||Annually||Quarterly|
|Use of Cost Basis||As long as no profits or||First year||Ongoing||Cost may approximate fair|
|cash flow||value for some time|
|Early Stage||Follow-on Round /||Material investment by||Significant investment by||Sophisticated unrelated||Sophisticated unrelated new|
|Write-ups||3rd party||independent 3rd party||new investor (if strategic,||investor|
|apply 50% discount)|
|Write-downs||25% bands as needed||Impairment||Significant deterioration||Change in circumstances|
|Revaluation||After 1 year||3rd party investment,||After 2 years of self-|
|Private /||performance, adverse||financing and 1 year of||Change in circumstances|
|Mature /||change, market conditions||positive cash flow|
|Methodology||Comparable multiples (P/E,||Comparable multiples (P/E,||Comparable multiples (P/E,||Comparable multiples|
|P/CF, EV/EBIT, EV/EBITDA)||EV/EBIT, EV/EBITDA)||cash flow)|
|Illiquidity Discount||>25%||10% – 30%||>30%||Manager's judgment, may be >30%|
|Public||Discount for||Minimum 25%, increasing if||0% to 25% discount||30% discount, reduced as||0% to 30%|
|Restricted Shares||lock-up period is significant||lock-up expiration|
WHAT REMAINS TO BE DONE
In the US, as public employee pension plans increase their allocations to private equity, accurate valuation becomes more critical to asset managers who need to report to their boards and key constituents such as employee contributors and retiree beneficiaries. This is also occurring within the context of a supratrend of globalisation and convergence of all types of laws, standards, guidelines, and practices, most notably in accounting, banking and trade. Similar pressures are facing fiduciaries around the world.
IAS is moving toward common cross-border accounting practices. There will doubtless be regional adjustments, but transparency will certainly be enhanced. FASB is integrally involved in the development of IAS.
Accurate valuation becomes more critical to asset managers who need to report to their boards and key constituents”
Basel I was a 1998 agreement among the Group of 10 (G-10) central banks to apply common minimum capital standards and credit risk measurement frameworks to their banking industries by 1992. When finalised in 2004, Basel II will in essence force major banking institutions in the US and Europe to implement by 2007 more robust risk management programs and increase capital reserve requirements. Those banks in the US that have invested heavily in private equity in the past already are reducing their exposure to the sector. The EVCA is working closely with policymakers to ensure Basel II does not reduce European competitiveness by hampering private capital funding for innovative growth companies and for the restructuring of existing industries.
The EVCA leadership has been instrumental in defining the framework for debate. In addition to advocating harmonised practices, the EVCA conducts regular reviews of its valuation and reporting guidelines, and is engaged with the ongoing development of International Accounting Standards. Upon assuming the association's chairmanship, Jean-Bernard Schmidt went so far as to call for a single fund structure to attract new investors and increase the amount of capital available to promising innovations.
It is fairly easy to envision ultimate convergence of valuation and reporting guidelines, but the timing is considerably more difficult to estimate. There are a several milestones and future developments that will continue to foster the move to international convergence on valuation practices in private equity. Among them:
Colin Blaydon is the William and Josephine Buchanan Professor of Management at the Tuck School of Business at Dartmouth. Fred Wainwright is Adjunct Assistant Professor of Business Administration at the Tuck School of Business. The authors are principals at the Center for Private Equity and Entrepreneurship at Tuck. This article was developed with the assistance of Erick DeOliveira, Research Fellow of the Center. For more information, go to www.tuck.dartmouth.edu/pecenter.