Buyout Firms Finally Confront Fair Value

Unfortunately, it could take quite a long time. Many buyout firms still hold investments at cost for at least a year or more unless a subsequent financial transaction justifies a change. The approach has big flaws. One is that in a bull market, quarterly reports tend to understate the actual performance of their portfolios; in a bear market they tend to overstate performance.

A bigger problem is that holding investments at cost, even for a short period of time, fails to meet generally accepted accounting principles, or GAAP. To comply with GAAP, buyout firms must use “fair value” to assess portfolio companies. One of the principles of fair value, when applied to illiquid assets, is the requirement to regularly assess valuations and adjust them should conditions warrant. Holding investments at cost, regardless of how a company’s performing, and regardless of how exit multiples are changing, doesn’t cut it.

Five or 10 years ago, LBO firms and their auditors could reasonably argue that holding investments at cost approximated fair value. For one thing, the Financial Accounting Standards Board didn’t provide a whole lot of guidance on how to determine fair value. But a confluence of factors has torn that argument to shreds:

• In the wake of the venture bubble, LPs upset with how long it took for firms to write down their portfolios helped launch the Private Equity Industry Guidelines Group. PEIGG released GAAP-consistent valuation guidelines in December 2003 (and revised guidelines in March). It also sounded the alarm that industry practice—holding investments at cost in the absence of a subsequent transaction—was out of step with GAAP.

• That same year, the American Institute of Certified Public Accountants issued guidance calling for auditors to take a rigorous approach to ensuring clients use true fair value to value illiquid and other assets. Last year, according to David Larsen, managing director at Duff & Phelps LLC and a member of the PEIGG board, the institute issued similar guidance for auditors of LPs.

• Last September, the Financial Accounting Standards Board issued FAS 157, providing guidance on how buyout firms and others must determine fair value, and what they need to disclose to investors about the process. Buyout firms using the calendar year as their fiscal year must follow the new rules starting with their 2007 audited statements, released in early 2008.

How rapidly the buyout market is making the shift to fair value remains a mystery. James Clarke, investment manager-private equity and energy at the Ewing Marion Kauffman Foundation, said that fewer than half of the dozen or so U.S. buyout firms in his portfolio have switched from holding investments at cost to using fair value. Those that have made the switch, he said, still hold investments at cost for at least a year, suggesting they are in transition. “This is a real problem because LPs have few good options to systematically and independently value hundreds or even thousands of underlying portfolio companies,” said Clarke. “Everyone’s got to get there,” he added. “The accountants are all over LPs to do something in this area.”

The accountants are also all over the buyout firms. Howard Weiss, chief financial and administrative officer at Castle Harlan Inc. and a member of the PEIGG board, said his firm went through a far more rigorous examination of valuations in its latest audit than ever before. What used to take two hours now took three to four weeks, he said. Part of the push came from the firm’s auditor, Deloitte. “It was the first time they literally did a full audit on our valuations,” Weiss said. “They wanted fair value. That was their goal.” (In the past, Castle Harlan would typically hold investments at cost for a year before beginning regular assessments.) In addition, two corporate pension funds on Castle Harlan’s review board asked for more documentation than usual to support their own valuation audits. “That’s a whole new dimension that we’ve never heard before,” Weiss said.

One of the most shameful episodes in the venture capital market took place in the early 2000s when firms failed to write down their investments in a timely fashion after the Internet bubble burst. It took years for the full impact of that debacle to flow through to the quarterly and annual financial statements of limited partners.

Buyout firms have a chance to avoid repeating history when the next downturn hits. It’s time to move to fair value.

Reach Larsen of Duff & Phelps at 415-693-5330.