New draft reporting and new valuation guidelines were issued by the British Venture Capital Association this week. “This is part of the wider debate about transparency, clarity and consistency and we hope it is another step forward in that process,” says John Mackie, chief executive officer of the British Venture Capital Association. Clarity, consistency and transparency are seen by many investors in private equity and the venture capitalists themselves as important factors in moving private equity into the arena of a mainstream asset class. Clearly the mainstream asset class label would widen funding sources for the industry, which is currently viewed by the many institutional investors, particularly in Europe, as somewhat exotic.
The reporting guidelines, issued for the first time by the association, borrow, with the exception of a few small tweaks, in full from level one of those published by its European counterpart, the European Venture Capital & Private Equity Association (EVCA). The valuation guidelines, however, have undergone an extensive change and review process that has thus far been a year in the making. The year-long timetable was necessitated by the nature of the changes under review and the fact that around 150 parties were involved in the consultation that led to the publication of the draft guidelines this week.
The BVCA document, titled Reporting and Valuation Guidelines’, invites comments to be made by industry participants and interested parties by January 31, 2003 and expects both sets of criteria to be in use by the middle of next year.
BVCA valuation guidelines first came into being in 1991 and have been updated in 1993 and 1997 and their present proposed update is driven by a number of changes in the market, the most pressing being the proposed changes to the International Accounting Standard 39 Financial Instruments: Recognition and Measurement (IAS 39). This new accounting standard has driven the BVCA valuation guidelines towards a fair value approach. Fair value is defined as “the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.”
Fair value has a fair number of ways of being interpreted – precisely 16 pages worth in the BVCA’s documentation – and keen readers should refer to www.bvca.co.uk for the full breakdown.
Present BVCA valuation guidelines recommend that the overriding principle should be to represent fair value. However, presently early stage investments are recommended to be valued at cost until they cease to be viewed as early stage. “The only exception to this principle is where a significant transaction involving an independent third party at arms-length values the investment at a materially different value.” As too many institutional investors in private equity are now aware arms length third parties can lead to large upwards valuations as during the dot.com boom.
Those investments not in the early stage remit, which is categorised as “until they case to be viewed as early stage” can be valued according to cost (less any provision required), third party valuation, earnings multiple and net assets. An earnings multiple basis was deemed to be the most commonly used method.
EVCA valuation guidelines, last updated in March 2001 (updating those published in 1993), noted the motivation behind the guidelines. It said: “…investors in private equity would like to see two separate valuations a conservative valuation (based on cost or the last round of financing) which would be applied in their capital account, and a fair market value, which would be used to assess the prospective value of their portfolio.”
Suggested areas of comment in respect of the BVCA’s draft reporting guidelines include additional items of information to those specified in the proposed guidelines that should be disclosed in reports to investors, and any items of information specified in the guidelines that should not be required to be disclosed in reports to investors. In addition, the BVCA has asked for opinions on the proposed internal rate of return disclosures advocated by the guidelines and whether the guidelines should additionally specify the format of reports to investors.
For the valuation guidelines the BVCA asks whether there is agreement about the use of fair value as the overall basis of valuation, the use of primary and secondary categorisations for the various methodologies with the corresponding obligation to justify the use of a secondary methodology (and should methodologies be categorised differently), and the use of a marketability discount for unquoted investments and more specifically with its application at the gross attributable enterprise value level. Marketability discount is defined as “the return market participants demand to compensate for the risk that they may not be able to sell an asset immediately.”
The document also seeks to find out if the level of disclosure specified is sufficient or excessive and whether discounting is required in certain circumstances in order to arrive at the fair value of a quoted investment, bearing in mind that the proposed changes to IAS 39 contain an apparent prohibition on the use of discounts to market prices in valuing quoted investments.
Both the BVCA, and for that matter the EVCA, guidelines on valuation and reporting are deemed to be a recommendation of current best practice for venture capital and private equity firms in reporting to their institutional investors. The nature of private equity investment (typically as part of a fund lasting ten years) means that investors in those funds that don’t participate can’t do much more than refuse to commit to future, follow-on funds. Interestingly institutional investors that have invested in this asset class are increasingly saying that meaningful and timely reporting and disclosure do form a significant part of their decision making process when choosing whether or not to commit to a follow-on fund.