Fair value explained

01 January 2010

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Fair value is the market price of an asset if you were to sell to today. It was incorporated into the private equity industry by the European trade associations in 2005, to comply with the US GAAP. Yet, for illiquid private equity assets it remains a difficult concept, particularly in the recent environment. The International Private Equity Valuations Board (IPEV) has provided guidelines - here three Nordic advisers help you detangle the issue

1. How did the crisis affect the fair value debate for the private equity industry?

BJORN GUSTAFSSON - PARTNER, ERNEST & YOUNG

Estimating fair value for portfolio companies has become more complex during the crisis due to the volatile financial markets and the lack of relevant comparable transactions. In addition, maintainable earnings are more difficult to estimate, for example because of uncertain market demand and restructuring plans.

TAUS WOLFSBERG - PARTNER, KPMG

In the third quarter of 2008 there was a marked increase in demand from investors for fair value information and supporting data. This appeared to support the argument that investors are demanding fair value, rather than the "old school" view that investors really want cost-based accounting, no sudden downward surprises and certainly no volatility.

I think that the crisis also highlighted the debate over the quality of fair value estimates. Most private equity houses fell into two camps last year. Those that savagely wrote down their portfolios in line with the decrease in quoted comparables and those who appeared to say that the market was distressed and that their view of value was a more valid measure.

PETER LUNDBLAD - PARTNER, PRICEWATERHOUSE COOPERS

There was much more focus on the valuation process. Investment managers were uncertain on how to tackle the challenges relating to the dramatic down-turn in the stock markets and lack of liquidity and transactions, and sought information about how others handled the situation. Also, investors in private equity limited partnerships showed much more interest in questioning the valuations and in wanting to understand the process applied to arrive at conclusions.

2. In September 2009 the International Private Equity Valuation Board (IPEV) published updated guidelines - what are the main concerns?

BJORN GUSTAFSSON - PARTNER, ERNEST & YOUNG

Generally, I think the updated guidelines provide useful clarifications, for example on the use of distressed market transaction data. IPEV has also eliminated the requirement to apply a marketability discount, and the one year cut-off period applied to observed prices from recent investments. This will allow for more qualitative analyses based on facts and circumstances. Of course, to make sense, these changes demand that valuers make the necessary analytical effort.

TAUS WOLFSBERG - PARTNER, KPMG

I have not noticed anything that gives me any major concerns and the updated guidelines are seemingly being well-received in the market and widely-used.

PETER LUNDBLAD - PARTNER, PRICEWATERHOUSE COOPERS

I don't believe there are any main concerns. The focus in discussions on valuation procedures among the Nordic private equity houses have been on the marketability discount, which was previously applied very explicitly. The risks associated with lack of marketability of an unquoted investment and any impact from control, should now be incorporated through an appropriate adjustment to the multiple. Many private equity houses seeks further advice and understanding in relation to this change.

3. What is the impact of the updated guidelines for LPs?

BJORN GUSTAFSSON - PARTNER, ERNEST & YOUNG

Although the new guidelines stress that fair value is the best measure of valuing portfolio companies, the old guidelines were also focused on fair value. From that perspective there should be no material impact as long as fair value is, and has been, the applied premise of value.

TAUS WOLFSBERG - PARTNER, KPMG

Importantly, nothing in the updated version should change the fair value estimate. The guidelines provide a framework within which the valuer is encouraged to use their professional judgement. The updated version particularly encourages the investors to understand, assess or challenge the values reported to them. The update also balances the language used to be neutral, rather than negative with a hope to prompt valuers to mark investments up as readily as they write them down.

PETER LUNDBLAD - PARTNER, PRICEWATERHOUSE COOPERS

I don't see any impact for the LPs from the new guidelines. Assessment of fair value is still the riding principle defined as the expected price at which an orderly transaction would take place among market participants at the reporting date. LPs have in general shown an increased interest in understanding the valuation process applied by the private equity houses and the main considerations and assessment that have been made.

For more information, see Rikke Eckhoff's in-depth interview with Nick Rea, a partner with PricewaterhouseCoopers in London on unquote"s Media Centre: www.unquote.com.