The hold-at-cost effect

Private equity general partners have been hearing an earful about fair value in recent years, and many have found it hard to get enthusiastic about embracing this accounting standard.

A new academic study may make fair value even more essential. Ludovic Phalippou, an associate professor of finance at the University of Amsterdam Business School, argues that historic GP conservatism on valuation, mixed with commonly used “end-to-end” performance benchmarking, often has the effect of exaggerating average IRRs delivered by private equity funds over specified time horizons.

Phalippou’s research adds to the growing body of research suggesting that average private equity is not something to get excited about (but top-quartile private equity is).

Before understanding Phalippou’s math, you need to understand the history of GPs and valuation. Private equity investments are inherently hard to place a value on. A fund manager invests equity in a private company and hopes to grow the value of that equity over a years-long holding period, but in the meantime has no way of accurately measuring its value. Because unrealised valuation exercises can produce such a diversity of marks, many GPs have opted simply to “hold at cost”, meaning they declare the value of the equity invested to remain the same until some significant event occurs (the company goes public, it reaches a business milestone, it is partially sold, etc.)

Many GPs took great pride in their hold-at-cost stubbornness, believing that it indicated a culture of not counting chickens before they hatch. In other words, these GPs never wanted to be accused by their investors of overpromising the performance of a particular portfolio investment. Better to downplay expectations and then knock LP socks off with a huge exit.

But fair value is now the accounting law of the land, meaning that every quarter GPs need to determine what their equity stakes would be worth if sold in an orderly fashion at the measurement date, aka right now. A GP might still hold an investment at cost, but he’d have to explain to his auditors that cost equals fair value; if the portfolio company were sold today, the GP would get back only the equity invested, he’d have to prove.

Gradually, the old days of hold-at-cost are giving way to the more rigorous and volatile world of private equity fair value accounting. But according to Prof. Phalippou, the legacy of hold-at-cost lives on when private equity performance is measured using the end-to-end method.

In a forthcoming book, Phalippou demonstrates the numbers trick that takes place in a conservatively valued pool of investments that is measured over a five-year period. He assumes a vehicle that invests in one deal every year, investing $1 in each deal. After holding each investment for five years, each deal turns the $1 invested into $2, for a 15 percent annual rate of return. But when an end-to-end performance evaluation is taken over the most recent five-year period, the IRR is calculated at 20 percent. Indeed, after a few years, there are always five non-exited investments, making the initial NAV $5. Every year $2 is distributed and $1 is invested, making a yearly cash flow of $1. The final NAV is again $5 because there are still five unexited investments. In effect, this performance measurement exercise undervalues the initial NAV, and hence exaggerates the end-to-end return.

The same “hold-at-cost effect” is at play in the creation of asset-class benchmarks, says Phalippou. These end-to-end performance averages measure backwards over a specified time span to starting points populated by funds that are understating the fair value of their portfolio companies. The further back you go, the more pronounced the effect is.

This problem goes away when viewing private equity fund performance through the prism of vintage years, which have long been thought of as the most useful way to think about returns. But in seeking to compare private equity to other asset classes, the time-horizon approach has frequently been used, often with the result of private equity appearing to be quite attractive indeed.

As institutional investors learn more about how private equity has truly behaved over the years as an asset class, they won’t necessarily fall out of love with it, but they will likely wake up to the realisation that it’s harder work than anyone heretofore led them to believe.