Limited Partners' reactions to the new valuation guidelines

The paper, International Private Equity and Venture Capital Guidelines, sets out recommendations for private equity managers on how to value their companies on a ‘Fair Market Value’ basis and comes hot on the heels of the new International Financial Reporting Standard (IFRS), which was introduced in January this year. The principle behind Fair Value is that private equity portfolio companies should usually be valued as though they were being sold to ‘knowledgeable, willing parties in an arm’s length transaction’. However, the new guidelines have been drafted against a backdrop of much uncertainty. Most of the confusion revolves around IAS 27, an aspect of IFRS, which deals with consolidation and may require some private equity funds to report the sales and earnings of portfolio companies into their accounts. It is widely thought that the IASB (International Accounting Standards Board) may take a similar view of private equity to its counterpart in the US, allowing private equity firms to opt either for full consolidation of investments or to adopt Fair Market Valuation in most cases. The International Private Equity and Venture Capital Guidelines therefore recommend that European private equity players adopt a Fair Market approach (also recommended by IAS 39, another area of the new Standard that causes uncertainty for the private equity industry), while the IASB re-thinks IAS 27. It is expected that a revised article will be published in the second half of 2005, which clarifies its implications for private equity firms, although many industry players doubt that the situation will even then be cut and dried.

So what is the reaction to the new guidelines from Europe’s LP community? Unsurprisingly, many have yet to see the full report, although most committed investors we spoke to on the subject have a fairly clear idea about the main thrust of the recommendations, since they were well publicised during the lead up to publication. In principle, most limited partners believe that it is too early to tell if the move towards Fair Market Value will benefit them. As one Dutch pension fund manager pointed out; ‘The venture capital associations had no option but to go the Fair Market way, but this may not provide investors with what they need. There is a danger that marking to market will result in much more volatility than the current methods used and this would act to the detriment of limited partners. In practice, you will only know the true value of your investment when it is sold.’ Concerns about volatility are also expressed by other investors: if a company shows a big increase in its valuation, limited partners tend to disregard this anyway.

Under the new guidelines, private equity fund managers are discouraged from valuing their investments at cost later than one year after the investment took place because of the obvious erosion on value over time. But for the time being this is the method used by many private equity fund managers and some estimates suggest that it will be up to ten years before all European players move fully to Fair Market Value. In the meantime, some limited partners point to the increased burden on private equity fund managers as they adopt the new methods and deal with issues raised by investors. The last set of valuation guidelines was published only in 2002, also recommending a move to Fair Market Value, and many private equity professionals have yet to take on board the implications of these. Many experienced limited partners would rather GPs were allowed to focus on deal-doing and management of investee companies.

Do the Guidelines go far enough? Some limited partners with large portfolios would like to see more standardised reporting, however, and feel that the guidelines could have gone further. One UK fund manager comments;: ‘Even under the new guidelines there will be a wide range of different methods being used by general partners to calculate valuations, including EBIT, EBITDA and discounted cashflows. In some cases there is good reason for selecting one method over another, but in many instances, it is just down to the subjective judgement of the GP. In club deals, for example, we may have exposure to a portfolio company through two or more funds and the valuations ascribed by each fund are different, leading to inconsistencies across our portfolio and raising questions about what the Fair Value actually is.’ It has been argued that the valuation guidelines could resolve such an issue by requiring funds involved in club deals to agree a valuation methodology between themselves, in order that they value their holdings on a consistent basis when they report to LPs. This would still allow them to determine the appropriate fair value methodology they use. Most investors appreciate, though, that in order for valuation methods to work, there needs to be a high level of take-up by general partners and that the more prescriptive valuation guidelines are, the less appealing they will be to the private equity community.

Many experienced LPs that have long-term relationships with the general partner community, tend to focus less on valuation methods and more on the overall reporting by general partners. As Gillian Brown of Hermes points out; ‘It is not possible to determine the true value of a private equity investment by use of a formula.’ Many investors support the use of conservative valuations and a subjective assessment by the GP of how a portfolio company is doing. The new guidelines, however, favour accuracy over conservatism. But it is questionable whether accurate valuations can ever really be arrived at in a hypothetical scenario where an investment is sold. The question arises whether the new methods are really going to answer the needs of investors. For some limited partners, however, their interpretation of IFRS means that they already require Fair Value assessments, including profit and debt figures for portfolio companies, something GPs are usually ill prepared to provide.

The full implications of IFRS for the private equity industry in Europe are unlikely to be understood for some time, but will be felt first by the limited partner community. Even if many limited partners do not, at present, appreciate the benefits of Fair Market valuations, they are likely to be under pressure eventually to demand them from GPs. However, most limited partners are satisfied that GPs do value their companies fairly according to the current methods. The challenge for private equity fund managers will be to interpret and implement the new Guidelines in order to reassure limited partners that his valuations are still meaningful.

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