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Feature: Tracking Fair Value

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By: Ken MacFadyen | March 11, 2007
Private equity's debate over fair value accounting refuses to die. It was sparked anew last September, when the Financial Accounting Standards Board (FASB) issued SFAS 157, clarifying its definition and how the rule is applied to generally accepted accounting principles (GAAP). But even as most observers recognize that fair value is here to stay, there's still some argument about how much progress has been made.

"The FASB statement doesn't change GAAP, but it does increase the intensity of the light bulb that is focused on fair-value issues," says David Larsen, a managing director in Duff & Phelps' transaction advisory services practice.

Larsen is also an adviser to the Institutional Limited Partner Association (ILPA) and a board member of the Private Equity Industry Guidelines Group (PEIGG), two industry trade groups whose focus in recent years has been to push for a boilerplate method that would take the guesswork out of assigning value to private holdings. The goal of the initiative has been to spur industrywide adoption of PEIGG valuation guidelines across the entire private equity universe, which would theoretically remove conjecture from the assessment of unrealized private equity funds and make the process an apples-to-apples evaluation.

As it currently stands, firms continue to use diverging metrics in valuing their portfolio holdings. Some will write up investments, while others won't; some firms account for an illiquidity discount, whereas others do not. But despite the incongruities, industry pros feel the band of disparity has narrowed. The FASB ruling, which gave a concrete definition to "fair value" and added new disclosure requirements, should only add more thrust to the movement, but there is still a way to go.

"I'm seeing more firms use fair value, no question, but I would still say it's very sporadic," says Erik Hirsch, chief investment officer at Hamilton Lane Advisors, an asset management advisory firm. He notes that the intention is there, but it can become misconstrued when varying constituencies go about it in different ways. "What they're trying to do is put an interim valuation on something that won't really have an actual value until it's sold. So there's really no right answer. Because of that, everyone has his own opinion on how it's done, which is where the difficulties [in creating one industry standard] arise."

Conservative bent

The divergence among fair-value proponents usually occurs in the application of write-ups. If a particular holding is given an arbitrarily high valuation, it could create the impression that a firm is overvaluing an investment. Back in 2000, before the tech implosion, a number of venture capital firms registered to float portfolio companies at valuations that, in hindsight, appeared puffed up. In a matter of months, some of those investments became complete write-offs.

In order to remove the appearance of impropriety, or simply to use the one sure method available, many in the venture capital community will simply keep their investments at cost, and adjust the appraisals whenever there is a follow-up round. This is also the case in the buyout realm, where write-ups tend to occur alongside refinancings.

While investors appreciate the concept of mark-to-market appraisals, the gripe is that the idea is not practical when dealing with private companies, especially the nascent ventures that, in the words of John Taylor, a research and financial affairs executive at the National Venture Capital Association, may outwardly appear to be "two guys and a dog in a garage."

"Until these companies find some level of success," Taylor says, "how can they really know their value?"

The kind of volatility Taylor refers to can be seen in buyout investments, as well, although not in as extreme a form. When Thomas H. Lee Partners acquired an 80% stake in ethanol producer Hawkeye Holdings last June, the company was valued at approximately $1 billion, according to company filings. Three weeks later, TH Lee registered to take the company public in a $350 million IPO. By August, it had boosted the size of its planned IPO to $523 million, although it didn't disclose how many shares it would be selling. In September, however, the offering was lowered to $421 million, and a couple of months later, it was put on hold indefinitely. While this example doesn't definitively point to valuation volatility, it backs up the sentiment that assigning values to illiquid securities is still more of an art than a science.

Yet another example that many venture capitalists point to is the case of YouTube, which Google bought last year for $1.65 billion, a price tag that is effectively around 100 times the company's annual revenue. "Could you expect YouTube's investors to write it up to that kind of valuation? The universal answer is no," Taylor says.

But the complexity surrounding valuations does not excuse investors from putting forth their best efforts, especially now that FASB has made fair value part of GAAP requirements. And if private equity investors count pensions or endowments among their LP base, there's a good chance they'll insist on GAAP.

Duff & Phelps' Larsen argues that YouTube and other outliers make more of a case for fair value than if investors were to hold those properties at cost. "I agree it can be difficult to come up with an estimate, but those kinds of examples clearly indicate that the value is above cost," he says, adding that sometimes GPs will miss the mark, but as long as they're arriving at valuations "in a consistent manner," that's progress over past efforts.

Meanwhile, Larsen is not buying the argument that it's better to be overly cautious than to overstate a company's value. "Prior to Enron, many people would define conservatism as purposely understating their value. That doesn't fly in today's world," he adds. "If you have objective evidence saying something has increased in value, you have to write it up."

In addition to getting everyone on the same page, the proposed valuation guidelines take on added importance when considering the increased secondary activity in the industry, which in some ways removes the cash in/cash out mentality that has been typical of private equity. LPs need a mark-to-market estimation in order to get full value for their yet-to-be-realized positions in funds. Moreover, anecdotally, the compensation of limited partners is not necessarily derived using the cash in/cash out model, so some money managers need a more real-time approach to value their own performance.

The third-party conundrum

To be sure, most industry pros are on board with fair value at this point. But what worries some is that the development may eventually require third-party evaluators, or worse (though unlikely), government regulation.

Jeremy Coller, who heads UK secondaries firm Coller Capital, voiced such concerns two years ago at an industry event when he reportedly told the audience that the "benign climate" the industry currently operates in must not "blind [the industry] to the possibility of heavy-handed regulation."

The solution, he said, was to embrace corporate governance standards, noting that one of the "minimum conditions" for a true asset class is "comparable performance" measurements.

Most of the sources IDD spoke with believe government regulation is still a long shot, but they do see a need for independent evaluators as a distinct possibility. Coller did not return an e-mail seeking comment.

"The FASB statement did not make it a requirement, but I've heard that the LP community is feeling more pressure to assure that valuations are more robust," says Larsen.

Adds Espen Robak, president of Pluris Valuation Advisors: "The disclosure requirements as spelled out by the FASB statement will lead to a greater need on the part of hedge funds and private equity for outside valuations."

Already, a number of firms have begun tapping third parties to correlate their own numbers. This need is underscored for particular vehicles, such as business development companies, that are easy targets for short sellers. Allied Capital, for example, has fought off a number of attacks by short sellers who called into question the firm's valuations of particular holdings. Allied, according to its most recent 10K, disclosed that it had hired Duff & Phelps and Houlihan Lokey Howard & Zukin for valuation assistance.

However, just as public companies grieve about the lack of value added by SarbanesOxley, requiring third-party assistance would probably provoke a similar outcry.

"It's important to remember that all of this has to do with interim financial statements. At the end of the day, the actual results and benefits come from cash going in and the cash going out. All this is just about keeping score along the way," Taylor says.

He adds that the added costs wouldn't occur in a vacuum. They'd be felt directly in the returns. And as in the case of SarbOx, smaller groups would feel the pain most acutely. "If you're investing $10 million in a company and have to perform $5 million worth of oversight, that affects your IRR," Taylor notes.

Consider Adoption

In spite of the headwinds fair-value proponents have faced, progress has indeed been made. Anecdotally, Larsen notes that at recent private equity conferences, he has polled the audiences and estimates that around 85% of investors report using fair-value metrics. Four years ago, he says, that number would've been around 40%.

Peter Linthwaite, CEO of the British Venture Capital Association, points out that adoption of fair value has become a global trend and that the valuation guidelines set forth by the BVCA, which are similar to the PEIGG guidelines, have become standard in LP documents throughout much of Europe. "Without question, as an industry, we're moving toward having a greater ability to compare performance across funds," he says.

And even Hamilton Lane's Hirsch, who calls the progress "sporadic," says that his criticism is not for lack of effort. He says that many of the discrepancies come from the accounting firms, which have not standardized among themselves how they account for fair value. But, Hirsch notes, "the gap is narrowing, and reporting is not nearly as divergent as it once was."

Many still recognize there's work ahead, though. As Jeremy Coller reportedly told an audience two years ago: "If we don't do corporate governance, corporate governance will be done to us."