Limited Partners Gird For Volatility

Are limited partners ready to see some volatility hit their portfolios? We’re about to find out.

For years, private equity firms made an accounting habit of holding their portfolio companies at cost, unless a subsequent transaction justified a change. The reported value of those companies, in other words, remained static regardless of market conditions, on the theory that the true value would be revealed only upon exit. Until the early 2000s, many private equity firms felt that this was an admirably conservative approach to reporting results that would limit downside surprises for LPs. For their part, investors often agreed.

But when the Internet bubble burst earlier this decade, the pop took a lot of things down with it. The stock market swooned, capital for start-ups dried up, and it stopped being cool to ride a scooter to work.

In the world of private equity, the usually amicable relationships between general partners and their investors grew tense. A big reason was that it took years for venture capitalists (along with the handful of buyout firms who got caught up in the Internet craze) to write down the value of their illiquid holdings. Consequently, LPs didn’t learn the full extent of the damage until long after. In the annals of private equity investor relations, this was a particularly bleak moment.

In response, a group of general partners and LPs in 2002 formed the Private Equity Industry Guidelines Group. One of its goals was to draft a blueprint for using “fair value” to evaluate portfolio companies, and to convince the industry to adopt it. A requirement of Generally Accepted Accounting Principles, fair value essentially represents the price a portfolio company would fetch if it were sold on the open market. Rather than holding a company at a fixed point, fair value undulates with market conditions.

For LPs, the need for continuously updated valuations is clear, said David Larsen, managing director at valuation firm Duff & Phelps in San Francisco and a lead author of PEIGG’s guidelines. For starters, the financial statements they produce often must be GAAP-compliant, since many are publicly traded corporations or government institutions. Second, it’s impossible to evaluate the performance of fund managers if LPs don’t know how well they’re doing along the way. For the same reason, LPs can’t establish effective incentive programs for employees since it’s impossible to establish how well their investment choices have panned out.

Perhaps most important, LPs can’t make allocations to buyout funds with the right kind of assurance or accuracy if they don’t know the interim value of their present investments, Larsen said. It’s critical that LPs rebalance their portfolios often, and interim valuations will allow them to know early on whether their exposure to buyouts, for instance, has climbed above the targeted maximum. And that would lead them to slow their pace of commitments. “That was not an accounting-driven [issue], it was an LP-GP relations issue,” said Lee Mitchell, managing partner of Chicago LBO firm Thoma Cressey Bravo.

As more GPs move to fair value over the next several months, investors will begin to begin to experience the volatility that has been masked by at-cost accounting. It’s not clear yet whether, as a community, buyout firms have been too conservative or too aggressive in holding investments at cost. But it seems reasonable to predict that investors will be getting some surprises. And that could translate into shifts in the pace of their LBO fund commitments, as they make adjustments to hit their long-range allocation targets.

New Guidelines

In 2003, PEIGG released a set of GAAP-consistent guidelines for assessing the fair value of portfolio companies, calling on fund managers to provide regular updates that mirrored changing market conditions. PEIGG got a boost in 2003 when the American Institute of Certified Public Accountants released its own guidelines urging members to use fair value. Last year, the AICPA also issued a set of fair-value guidelines for auditors of LPs.

The final push came in September 2006 when the Financial Accounting Standards Board, which hadn’t before issued clear guidance on the matter, published FAS 157. That directive tells buyout firms and others how to determine fair value and what they need to disclose to investors about how they’re doing it. Fund managers are required to adhere to FAS 157 for their 2007 audited statements, due in early 2008. (In March, PEIGG refined its guidelines to include FAS 157.)

The message seems to be catching on—sort of. The Tuck School of Business at Dartmouth University has been polling the industry on the issue of fair value for years. A Tuck survey taken in 2005 found that only 30 percent of LBO and venture capital firms had adopted PEIGG’s fair value guidelines. By 2007, that figure had risen to nearly 70 percent, according to subsequent survey. That said, VC firms accounted for 61 percent of respondents, while buyout firms comprised 28 percent of respondents, and buyout firms have historically shown greater reluctance to embrace fair value. Indeed, seasoned LPs report that barely half of the buyout firms they’ve backed have made the switch to fair value.

“They may not like it because it’s difficult, it will take more time, and there will be more volatility,” said Lisa Filomia-Aktas, partner at Ernst & Young.

Nonetheless, boilerplate language in every LP agreement requires firms to provide GAAP-compliant financial reports. What’s more, compared with venture capital portfolios, buyout portfolios are far simpler to value on an interim basis, since portfolio companies have products, sales, EBITDA and other easy-to-comprehend measurements, Larsen said.

Inertia explains some of the reluctance, as does a belief that valuations of illiquid assets aren’t particularly meaningful. But there’s also an element of gamesmanship at work because holding portfolio companies at cost can allow buyout firms to manage LP expectations. Every buyout firm has at least one dog in every fund—whether because a company or an industry sector is struggling—and holding investments at cost can buy them time to work through problems before having to reflect them in valuations. And many LBO firm principals believe that illiquid assets can’t be valued in real time—that estimating an exit cost amounts to guesswork, pure and simple.

LPs, too, haven’t terribly minded the status quo, since switching to fair value could turn private equity investing into a roller-coaster ride. “Life may be easier if they didn’t have to record the results of volatility,” Larsen said.

That said, CFOs at buyout firms and the boards of many institutional investors tend to be fans of fair value. In addition, accountants at every level—portfolio companies, LBO firms and institutional investors—have started making a lot of noise about meeting GAAP requirements, since those are the rules that the profession lives by. The pushback that sometimes comes from the deal makers has sparked low-level conflict, Larsen said. “As private equity has grown as a percentage of limited partner portfolios, it deserves more attention from the auditor,” he added.

This is borne out by the most recent Tuck survey, which found that nearly 80 percent of GPs said their accountants paid more attention to valuations with their latest round of audits. That’s up from 53 percent two years ago.