The value of 'fair value'

With 'fair value' reporting being increasingly demanded by auditors and regulators alike, private equity firms are preparing for what is likely to be a challenging year-end accounting process. As a recent report produced by PricewaterhouseCoopers (PwC) - Fair Value Challenges in the Current Environment - suggests, the problem centres around the fact that the current economic crisis has eroded many of the metrics on which such objective valuations are based. "It has never been more difficult to value companies as this is usually based on comparables, which are hard to come by at the moment as there are few transactions occurring, more distressed sales and the public markets are very volatile," Nick Rea, partner at PwC, explains. Indeed in a recent article published in trade magazine Accountancy Age, senior industry figure John Moulton claimed many firms will subsequently be forced to make 'spectacular writedowns' against their investments, especially in the buyout space.

Strong principles
However, many continue to question the validity of fair value procedures which, even despite the current difficulties with finding reliable comparisons, are limited by the fact that they are, by their nature, subjective. The guidelines put forward by the BVCA and EVCA, which were the first to attempt to replace the traditional method of fund managers holding an investment at cost, were particularly problematic in this sense. "Though they largely promoted the same ideals, the two methodologies differed slightly in approach and this merely served to compound the underlying fact that valuation is judgemental," says Rea.

In recent years these guidelines have been superseded by the accounting requirements of US generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS), which are being increasingly applied under the International Private Equity and Venture Capital Guidelines (IPEVCG) and US Private Equity and Investment Guidelines (PEIG). Although these principles cannot fully eradicate the problem of valuations being subjective, they do advocate the adoption of a consistent approach and this is extremely helpful to LPs attempting to benchmark the market value of their portfolio.

Investor demand
Indeed it is largely in response to demand from investors that these procedures are being so widely incorporated across the industry. "People are centralising under these guidelines -as opposed to holding an investment at cost - which used to be the case in LP agreements," Rea confirms. This stands in contrast to the view of some fund managers who, understandably, argue that as many portfolios are held in closed-ended funds it is only cash at exit that really matters. This holds true in terms of the reasons why investors initially decide to commit to a given fund, with PwC data revealing that 72% of surveyed LPs highlighted performance as a criteria for investment, compared to just 33% for quality of reporting.

However, this view changed dramatically when LPs were asked why they would cease to commit to a particular fund manager, where these criteria were deemed to be of equal importance with 41% and 40% respectively. Furthermore, with only 22% of respondents stating that they found the quality of reporting from private equity firms to be either 'good' or 'very good' (see chart), improving the standard of valuation methodologies could become crucially important to fund managers in order to retain a committed LP base. This is particularly relevant for fund-of-funds, which are also under pressure to appease their own investors, as Rea explains: "Fund-of-funds need to get information on their underlying portfolios of assets and we are going to see managers pushing more for better information."

Fair value in practice
There are, then, significant commercial incentives for private equity houses to successfully adapt to the requirements of fair value reporting. Indeed, Rea notes that this is an area where firms are becoming increasingly differentiated: "Some have adapted very well but others have not and we see some inconsistencies and errors in how the approach is being implemented." He suggests that the key is to take the time to develop a robust approach, through consultation both with the investment managers (as opposed to merely keeping it within the finance team) and outside advisers, and then to be consistent. He also advocates the importance of documenting the process to show transparency: "Valuation is always, in the end, judgemental but there is a need to come to a number for the accounts. Extensive documentation of the process is therefore essential in order to properly show the rationale behind your decisions," he explains.

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