The recent effort by the investment industry to create a level of consistency for the valuation and performance measurement of private equity and venture capital investments has resulted in two separate valuation guidelines released over the last two months. The ultimate goal of both is to create consensus among private equity professionals who must reflect the value of investments recorded on their financial statements, and who need to report investment performance to their investors.
On Dec. 2, 2003, the Private Equity Industry Guidelines Group (PEIGG), a volunteer committee comprised of industry-wide representatives, issued its U.S. Private Equity Valuation Guidelines in an attempt to establish a set of industry standards aimed at reporting fair value of private equity investments on a “consistent, transparent, and prudent” basis.
The Association for Investment Management and Research (AIMR), a global industry association made up of 68,000 investment professionals and financial analysts, followed with the release of its own guidelines on Jan. 6, 2004. The guidelines represent AIMR’s effort to bring private equity investments under the umbrella of the association’s broad Global Investment Performance Standards (GIPS). Established in 1999, GIPS comprise AIMR’s voluntary set of global investment performance reporting standards, which are currently the most widely accepted standardized guidelines for investment performance reporting.
Both pairs of guidelines endorse the concept of fair value, generally defined as an amount at which an investment could be exchanged in a current transaction between willing parties, other than in a forced liquidation or sale. Since private equity investments are essentially in non-public companies, the determination of fair value is left to the discretion of investment managers, often resulting in wide ranging variances in methodologies and/or results, even in cases where different investors hold investments in the same company.
Although the basic recommendations of the two sets of guidelines are consistent, they emphasize different focus areas. PEIGG’s guidelines address when and how to perform periodic valuations, while AIMR focuses more on creating performance measurement consistency by offering guidance on calculations of internal rates of return and calling for the establishment of investment fund “composites” to simplify cross-firm return comparisons. More specifically, PEIGG’s guidelines look to move investment managers away from the traditional practice of relying on original investment cost as an estimate of fair value. PEIGG recognizes that managers consider near-term company performance at the time of an investment, and so permits the use of original investment cost or the latest round of financing as an approximation of fair value for “some period of time” after the investment is made.
Under what circumstances should investors deviate from original cost or the latest round of financing to value investments? No hard and fast rules are offered, but the PEIGG plan outlines examples of changes in company or market circumstances that would lead to either a positive or negative adjustment in value. For example, a red flag is raised if the current performance of a subject company is significantly above or below expectations at the time of the original investment as measured by the company’s success or failure in reaching certain milestones, achieving technology breakthroughs or significantly exceeding or failing to meet budgets. In addition to company targets, the guidelines also direct managers to examine if market, economic or company-specific conditions have improved or deteriorated since the time of the original investment. Examples given are broad changes in economic climate, changes in financial markets or the legal/regulatory environment, or shifts in the company’s cost structure. A final example of a change in circumstances indicating a potential change in carrying value of an investment is the observation of any substantial decrease in the value of quoted, more senior securities of the company, such as public debt.
Once the decision is made to adjust investment-carrying values, both the PEIGG and AIMR offer suggestions of which specific valuation methodologies to use. The preferred methodology is the use of relevant public data, including comparable company transactions or trading multiples. Other approaches, including the discounted cash flow method, have been cited for use only under certain circumstances, although no details are provided. In addition to a hierarchy of valuation methodologies, the PEIGG also stipulates that each firm establish a Valuation Policy Committee and recommends that valuations be performed on a quarterly basis with rigorous reviews of valuations to be performed annually.
While the guidelines are an attempt to provide structure in an industry where formal valuation guidance does not exist, the PEIGG and AIMR do not wield any real enforcement powers within the private equity arena. There is currently no industry regulatory body to enforce disclosure and presentation standards. Although AIMR is the leading industry association for more traditional investment managers such as buy side and sell side equity analysts and mutual fund managers, from our vantage point they have less influence in the private equity world.
In addition, little direct GAAP guidance exists for value disclosure. The Financial Accounting Standards Board, which in recent years has embraced the virtues of fair value accounting in several of its pronouncements, continues to strive for clarification and codification of fair-value principles. In the second quarter of 2004, the FASB is expected to release a long awaited exposure draft, which will provide overarching guidance for applying fair value to GAAP. Indications are that the FASB’s recommendations for valuation approaches will be more or less consistent with those outlined in the PEIGG and AIMR guidelines.
The current environment has given rise to the broad array of valuation approaches practiced by managers. As a result, some managers are disposed to perform discounted cash flow and trading multiple analysis for their investments, where others leave carrying values at investment cost, citing the challenges inherent in a rigorous valuation analysis.
What is the impact of the guidelines on how firms will value their investments going forward? If accepted industry-wide, the proposed guidelines would be expected to affect private equity firms differently, depending on factors such as size and funding stage preferences. Some of the largest private equity funds are managed by bank holding companies, which already operate under strict compliance guidelines imposed by the Federal Reserve, and so find themselves already in tune with many of the PEIGG’s and AIMR’s tenets. For the most part, the larger LBO funds currently report, or at least track, fair values based on in-house valuation analyses or third-party valuations. (Firms such as Texas Pacific Group, the Blackstone Group, and HarbourVest Partners, LLC are represented on the PEIGG board.) Thus the larger firms would be expected to more readily comply with such guidelines, if adopted, although valuations on a quarterly basis may require additional effort for many. Additionally, while there is still a tendency for firms to be conservative with fair value adjustments, required quarterly valuations may lead to increased volatility in carrying values.
Those likely to be most impacted by the proposed guidelines are smaller, early stage venture capital firms. The worst-case scenario is illustrated by a firm with a large number of minority investments in startup companies for which the firm has no board representation (and therefore possibly very limited information with which to perform valuations). For venture capital firms, the carrying forward of investments at cost is still a common practice due to practical and financial constraints. For example, finding public companies to use in a market comparable analysis for an early stage company with little operating history can be difficult at best. DCF methods present their own challenge, as the required detailed information needed may be unavailable. In addition, projections are often optimistic or not current, making their use problematic. Cost adds yet another constraint for firms with fewer resources as quarterly and annual valuation work would be expected to add extra administrative or consulting expenses, in addition to the cost of diverting other resources.
The PEIGG’s proposed guidelines may be seen as a preemptive move against regulatory watchdogs that have focused their attention on disclosure requirements in alternative investment areas in recent years. For example, in response to the meteoric growth of loosely regulated hedge fund investing, the U.S. Securities and Exchange Commission launched a “fact finding mission” into the industry in 2002 and recently concluded its investigation. Their recommendations, which include suggestions for fund disclosure and valuation, are expected to become new rules in 2004. Some may see this as a harbinger of things to come for the private equity industry, unless action is taken to demonstrate that the industry can regulate itself.
Despite the market pullback starting in 2000, investment in private equity and venture capital in North America totaled over $43.9 billion in 2003. It is estimated that currently more than 50% of investment in private equity funds is contributed by corporate or public pension fund sources, an increase from approximately 40% in 1994. As such, some of the more influential investor fiduciaries have already taken action. As the nation’s largest public pension fund with $19 billion invested in private equity funds alone, the California Public Employees Retirement System is leading its own charge to improve disclosure of its “alternative investments.” In March 2003, CalPERS announced a comprehensive performance disclosure policy for private equity investments whereby it will publish, on a quarterly basis, internal rates of return, amounts of cash invested, and profits realized from cash invested.
Neither the PEIGG nor AIMR valuation guidelines are going to serve as a panacea for private equity valuation issues, but, if adopted, would provide a common valuation framework. Equally important, professional judgment would continue to play a significant role in the valuation process, and it would still be possible for investors in the same company to have different perspectives on value, based on consistent and supportable methodologies.
P.J. Viscio is a managing director and John Walsh is a manager in the Private Equity practice of Standard & Poor’s Corporate Value Consulting. Corporate Value Consulting has advised clients on valuation and corporate finance issues for more than 30 years.