Once Upon a Time...
I have a seventeen-year-old Lexus with 185,000 miles on it. I bought it used when it was 4 years old for $17,000, which I considered quite a bargain. I recently looked up its residual value because I want to trade it in. Although I’m a bit of a finance geek and should adjust the value of the car periodically, the value of my car wasn’t important to me as long as it ran. Why would anyone need to know how much it was worth on a regular basis? The car loan has been paid off for a while, so until I got ready to sell or trade-in, did it really matter?
Once upon a time, the private equity and venture capital industry operated in much the same way. Sponsors who invested in a company kept the value of the company on the books at the original purchase price and didn’t adjust it until there was another financing transaction, an exit or some impairment that would make it prudent to update their investors. There wasn’t a secondary market at that time—valuations were typically important only when the company was ready to be recapitalized, sold, restructured or taken public. In those days it didn’t matter to many limited partners. Investors in private equity funds didn’t have sophisticated portfolio management systems, and investment committees were content with far less information with respect to their PE investments.
Fast forward to the present. In late 2011, the SEC sent letters to several GPs as part of an “informal inquiry” into private equity valuation practices. While there was speculation among industry insiders as to what the SEC was really investigating, the SEC’s letters led to much introspection and discussion about standard industry practices, the effect of the financial meltdown, and the moves to standardize, regulate, codify, and promulgate valuation standards. From the outside, the SEC concern appears to focus on whether private equity funds use inflated valuations to report an enhanced performance record during fundraising (which is, after all, a securities offering in which misleading information is problematic).
Understanding the route from a conservative or even laissez-faire approach towards valuation to an SEC inquiry into valuation of investments requires a bit of a historical redux.
Traditional Cost-Based Valuation
For much of its history, the private equity industry was dominated by a “lower of cost or market” valuation approach. This was generally thought to be in the investor’s best interest. Private equity investment was dominated by venture capital in its early years and those investments were typically pre-revenue companies and there was little tangible input available for re-valuation. Therefore, valuations held at lower-of-cost-or-market was considered a conservative approach that minimized the risk of premature overvaluation and the attendant fear of misleading calculations of interim performance of a fund. All industry players seemed to be content with this valuation premise.
Once performance metrics such as the internal rate of return (IRR) became the standard performance metric for the industry, valuation becomes more important since the unrealized value of investments, i.e. the net asset value, was a significant component in performance measurement.
Once private equity became a mainstream asset class, appropriate comparisons to the public markets and other asset classes became critical. If a significant portion of an investment was tied up in the unrealized portion of a private equity portfolio, having accurate estimates of valuation became critical to contemporaneous performance metrics. Otherwise, performance measurement based on stale or attenuated valuation due to industry practice could under-value private equity investments and thus make them seem to underperform the public markets. In addition, asset allocation models are typically driven by performance metrics and portfolio values, so contemporaneous valuations in a fast-changing market are critical.
Investors felt that buyout investments, which typically involved companies with revenues/profits and free cashflow, demanded more contemporaneous valuations. At a conference in the late 90s, one LP noted: “if they can value a company [with enough rigor] to invest in it, why can’t they perform the same process three years later?”
The Push for Standards
There were several attempts in the industry to guide valuation policies. In the late 1980s there was an attempt by several prominent members of the National Venture Capital Association (NVCA) to provide a series of guidelines for their members to follow in reporting the value their venture capital investments. The membership overwhelmingly defeated the proposal, but, ironically, the proposed guidelines were known for years as the “NVCA Valuation Guidelines„ notwithstanding the fact that they didn’t formally exist.
In the early 2000s, the U.S. PE industry finally created a guidelines group (the Private equity Investors Guidelines Group or PEIGG) made up of LPs, GPs and service providers to address valuation guidelines and standards, among other issues. The mandate was to move the industry to a fair value standard instead of the ubiquitous lower-of-cost-or-market approach.
Unlike their U.S. counterparts, industry associations in Europe, which had a more aggressive and rigid regulatory framework, such as the British Venture Capital Association (BVCA) and the European Venture Capital and Private Equity Association (EVCA) were fairly aggressive in trying to codify valuation standards starting in the mid-90s. The European associations operated independently, but eventually the EVCA, BVCA and AFIC (the French Venture Capital Association) together created the International Private Equity Valuations Board (IPEV) which harmonized the various European valuation guidelines with U.S. GAAP and the IFRS. These IPEV guidelines have been “adopted” and endorsed by virtually every country-specific and regional venture capital and private equity, association in the world.
Fair Value Is Here
The move to “fair value” was as contentious in the 2000s as it was in the late 1980s. The U.S. PE industry had to comply with U.S. GAAP, which required that private equity funds report the value of their funds on a “fair value” basis. But there were few real procedures under GAAP as how to determine fair value. At the time, fair value (in a definition an accountant at a conference described as “old as dirt”) was defined as:
The amount at which an investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.
The procedures that the industry adopted as a result of the PEIGG guidelines used the original investment or most recent transaction as the basis for the valuation of an investment, but also required quarterly estimated valuations that required a contemporaneous valuation. That contemporaneous valuation necessitated using comparable investments, performance multiples, discounted cashflows or industry-specific benchmarking.
Independent of the industry efforts, financial reporting organizations embraced fair value by the mid 2000s, making it all but inevitable that private equity would have to face fair value no matter where they turned. The primary difference between the historical private equity practice and the fair value approach is that the former focused on the “entry” price, while the latter focused on “exit” price.
Enter FAS 157 (ASC Topic 820)
The lack of clear procedures to determine fair value, plus the extreme volatility in the markets during the dot.com era forced the accounting profession to revisit fair value. The result of that review was the accounting standard put forth by FAS 157—which provided a more rigorous framework and guidance on techniques and application for determining fair value.
FAS 157 also brought a refined definition of fair value:
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The new standard focused on orderly transactions in “most advantageous” markets with assets being held to their “highest and best use.” This provided a very precise syntax, but many claimed it was an even more ambiguous framework. As an example of this perceived ambiguity, one interpretative note pointed out that contrary to prior practice, “value” might not necessarily be the same as “price” under the new standard—because price is sometimes determined under duress, and can differ depending on the particular market which may or may not represent the principal market, or the “most advantageous” market.
Remember that prior to FAS 157, the primary difference between PE practice and fair value was the focus on exit versus entry price. FAS 157 created a more problematic distinction for private equity investors. The accounting standard focused on a market-based approach to determining fair value for an investment rather than an entity or company-specific approach. To many professionals, particularly venture investors this distinction led to a concern that these new fair value standards might be wielded like the proverbial hammer where everything looked like a nail. To its credit, FAS 157 also provided detailed guidance and a framework as to where and how to apply the guidelines. Most significantly, it stratified assets and liabilities into three buckets—so-called levels:
- Level 1 are those that have an observable input such as a traded market price.
- Level 2 are those that may not have a direct observable input such as a market price, but have inputs that are based on observable inputs such as market prices.
- Level 3 (and most applicable to private equity) are those that have no observable inputs.
In addition, there were extremely prescriptive techniques, matrices, and rules on how to apply techniques to determine fair value. PEIGG revised its guidelines to comply with the new FASB 157 guidelines, which were to go into effect on November 15, 2007.
The timing could not have been more auspicious. It was at the very beginning of the financial crisis, and in some circles the financial crisis and its focus on the value of “unvalue-able” assets, such as mortgages, was exacerbated by FAS 157, the fair value premise and its close conceptual cousin “marked-to-market.” There was considerable consternation that one unintended effect of FAS 157 was to exacerbate the downward spiraling of Level 3 asset values. Compounding the problem was that analysts, pundits and investors started to view the Level 3 assets as all being bad simply because there was no transparency—thus everything from mortgages, derivatives and other alternatives were painted with the same brush—”problematic,” “toxic,” “hiding something.” Level 3 assets were viewed with suspicion.
The move to fair value has been contentious, not because of the concept but because of the unintended consequences and the difficulty of applying a rigorous technique to what some would suggest is art rather than science. In 2009, FASB made an expedient change to FAS 157 that allowed Net Asset Value (NAV) to be used as a basis for Fair Value. To some it appeared to be an acquiescence to the notion that FAS 157 had unintended consequences. Others viewed it as giving bad actors a pass. Still others viewed it as a realization that fair value was a work-in-progress.
As of this writing, FAS 157 has been subsumed within FASB ASC Topic 820. As mentioned above, the timing of the introduction of FAS 157 coincided with the financial crisis, and whether or not there was a casual link, FAS 157 became a polarizing issue. The unheralded renaming of FAS 157 into Topic 820 was observed by some as a simple recognition that fair value was now a fait accompli and it was time to move on. Others quipped that renaming it was just a way of removing it from headlines.
What Can Go Wrong?
GPs making “club” investments in a company agree on a valuation of that company when they make the investment. Post-investment, however, the value each investor places on that company may well diverge until there is another arm’s-length transaction implying a market value. If the divergence is small, there is no issue, but a material divergence may draw scrutiny from investors. This divergence in valuation has also piqued the interest of the press as it may not make intuitive sense to the casual observer. It may also be this divergence that has attracted the interest of regulators even if it is a natural artifact of independent evaluations.
Fair value assessments in venture investing have a self-correcting mechanism since there may be multiple arm’s-length transactions over the life of an investment. Buyout investments, however, generally have only one such transaction, the initial investment, and thus only one real reference point to validate a valuation. Any valuation after that initial transaction involves a subjective appraisal by the general partner. Although buyout transactions have more observable inputs, buyouts have been just as resistant to fair value as their venture counterparts. A GP once responded when pressed on using cost as current value: “we’ve got to eventually sell this company, why would we telegraph what we think this investment is worth to a buyer? Let them tell us.” Whether that is actual policy or not, it does reflect the hands-off approach that GPs sometimes feel is in both their own and their investors’ best interests.
To go full circle, the irony in the recent SEC interest in overstated valuation is that it is in direct contrast to the accounting and financial reporting industry’s concern for the last couple of decades that the private equity industry’s historically conservative legacy practice was understating valuations.
In any case, since the financial crisis, there has a been a dramatic change in attitude and widespread adoption of fair value among private equity firms. Between the requirements of the various U.S. and international accounting, industry, and financial performance reporting standards, there is little escape from the fair value regime. In recent years, coordination and sharing of best practices among PE firms, their valuation consultants and auditors have made the process more institutionalized. Many firms appear to be performing valuations on a quarterly basis rather than just at the annual audit and the industry has become more comfortable with the language of fair value—notwithstanding some lingering suspicion of its unintended consequences.
The move to fair value has had many fits and starts, but it is an evolutionary step that is probably necessary in order for investors to have the transparency they require in an era when there is tremendous transparency in other financial markets. That said, some claim that too much transparency in the private equity context is much like killing the goose that laid the golden egg: because performance in alternative asset classes is often attained through inefficiencies in market information. They suggest that too much transparency destroys those inefficiencies in ways that will ultimately penalize the investor. Another danger is that GPs may begin to focus too much on short-term performance, a common criticism of the public company structure. In any event, like all evolutionary processes, valuation will continue to be refined with both intended and unintended consequences.
Co-Founder of QuartileOne