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Fair value reporting for illiquid investments: ready or not
(here it comes)12/12/2007. Source: Dechert. Roger Mulvihill 
 For many years, private equity funds (both venture and buy-out) carried illiquid portfolio companies at cost for at
least a year or more unless a subsequent financial transaction supported a different valuation, says Roger Mulvihill, a partner at law firm Dechert.
In some cases, cost basis valuations continued until liquidity. This approach, often justified as conservative, tended to understate the actual performance of privately held portfolio companies in strong markets and overstate performance in weak markets. In the most extreme example, it took some years for the full impact of the internet bubble collapse to flow through to the financial statements of some limited partners.
Although generally accepted accounting principles require that investments be valued at “fair value”, and most general partners are required to furnish GAAP financials to their limited partners, private equity funds and their auditors could plausibly argue for many years that cost
approximated fair value for many private companies, partly because there was little guidance from the Financial Accounting Standards Board. In September 2006, the FASB issued FAS #157, which outlined specific methodologies for valuing illiquid investments and the accompanying
required disclosures. Compliance with FAS #157, which is generally effective for financial statements issued for fiscal years beginning after November 2007 and interim periods within those years, could lead to much greater volatility in reported results of private equity funds and,
at a minimum, will require significantly more attention to valuations by general partners.
Background
For some time, the private equity industry has struggled with the appropriate valuation of private companies in private equity fund portfolios. While general partners were obligated to report to their limited partners on the valuation of the fund holdings on at least an annual basis, and usually more frequently, there was a wide divergence in
the application of valuation methodologies, even in funds that were contractually obligated to report on a fair value basis. As a result, the performance of similar funds (in style or vintage) was often difficult to compare. It was not unheard of for limited partners to receive different valuations from several funds that held similar interests in the same portfolio company.
Many general partners preferred relatively conservative valuation techniques, content to ride with the principle of “under promising and over delivering.” Others wished to avoid the volatility in reported performance which a more comprehensive fair value reporting approach might encourage. As a result, a common conservative practice was to carry investments at cost for at least a year, unless an unrelated third-party financing clearly demonstrated a higher (or lower) value.
Partly in response to concerns by limited partners over the delays in writing down investments in the wake of the internet bubble, a volunteer group of industry-wide representatives (including general partners, limited partners, and service providers in the private equity industry in the U.S. and abroad) organized the Private Equity Industry Guidelines Group (“PEIGG”) in 2002. PEIGG sought to develop greater reporting consistency and transparency in portfolio valuations through the development of Guidelines for valuing investments in portfolio companies at fair value based on a more comprehensive approach to
valuation. Although not binding on private equity funds, the PEIGG Guidelines were supported (but not endorsed) by the National Venture Capital Association, and endorsed by the Institutional Limited Partners Association.
While recognizing the role of the managers’ “best judgment” in determining value, the Guidelines emphasized the importance of considering other methodologies, such as comparable company transactions and performance multiples, particularly when recent third party financings were nonexistent or stale. The Guidelines also endorsed
the formation of Valuation Committees in private equity funds to review (but not determine) valuation methodologies and reported values. In 2003, the American Institute of Certified Public Accountants urged auditors to take a rigorous approach to ensuring client use of fair value in
valuing illiquid assets.
The PEIGG Guidelines were not greeted with unrestrained enthusiasm. According to a 2005 survey of 102 private equity funds by the Tuck School of Business at Dartmouth College, only 19% of respondents formally adopted the Guidelines. A significant number of respondents who did not adopt the Guidelines cited their preference for write ups only if a new round of financing had occurred, an implicit recognition of the potential volatility and other drawbacks of the fair value approach. The study also found that, although all of the respondents prepared audited fund financial statements for 2004, fewer than 1% had been issued a qualified opinion for not using fair value methodologies, and only 1% had been warned to expect a qualification going forward if fair value standards were not explicitly adopted. Interestingly, nearly 70% of the respondents said that they would write up their portfolios by some percentage if they were to apply fair value principles.
In September 2006, the Financial Accounting Standards Board adopted FAS #157 (“Fair Value Measurements”) for all fiscal years beginning after November 2007 (although earlier application was encouraged). FAS #157, which requires investments to be reported at fair value, set up a comprehensive three level scheme for determining fair value, and PEIGG in March 2007 issued its own report, which is intended to assist managers of private equity funds in applying FAS #157 to their specific circumstances.
In general, FAS #157 and the Updated PEIGG Guidelines seek to have all portfolio investments reported at fair value on a consistent, transparent, and prudent basis. Fair value is defined as “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 objective is to estimate the price at which a hypothetical willing marketplace participant would agree to transact in the principal market or, lacking a principal market, the most advantageous market.
At each valuation date, including periodic reporting dates within the fiscal year, the managers must make a determination of fair value for each investment that takes into consideration all relevant factors (i.e., all reasonably available information about the business and all assumptions that market participants would normally use in their
estimates of value). Accordingly, the managers cannot simply rely on cost or the value of the latest round of financing as an approximation of fair value without taking into consideration other facts and circumstances.
Other Measures of Value
Both FAS #157 and the Updated PEIGG Guidelines recognize that cost or latest round financing will still be useful benchmarks, and in some instances, such as early stage venture companies whose promise is still largely unfulfilled, may be determinative. In other situations, where such measures of value become less reliable as an approximation of fair value over time, the Updated Guidelines require a careful consideration of other factors.
Where more reliable indicators of value are not available, the Updated PEIGG Guidelines encourage managers to look at third party investments in equity securities of comparable companies, adjusted for any control premiums or unique synergistic benefits or detriments. However, the Updated Guidelines recognize that comparable companies
may be difficult to identify until the portfolio company has achieved marketplace acceptance for its products or services.
Under such circumstances, the Updated PEIGG Guidelines encourage the use of a performance multiple methodology to derive the value of the portfolio company. An “appropriate and reasonable” multiple is obtained from reference to market based conditions of quoted companies or recent private transactions, and adjusted to reflect differences in growth prospects and risk attributes.
Dechert is an international law firm with over 700 attorneys. It provides practical business solutions to a diverse client base. For more information please visit www.dechert.com.
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