June, 2007 | Issue 20
Introduction
The Private Equity Industry Guidelines Group (PEIGG) recently issued a revised version of its U. S. Private Equity Valuation Guidelines. The revised Guidelines, issued in March 2007, provide guidance to private equity funds on how to value their portfolio investments. A copy of the Guidelines can be found here.
GAAP Requires Fair Value
Generally accepted accounting principles (GAAP) require private equity funds to report portfolio investments on their financial statements at “fair value.” Until recently, however, there was no authoritative guidance on how to determine the fair value of an investment. The PEIGG was formed in February 2002, and is comprised of a volunteer group of private equity industry representatives who came together to establish a set of reporting guidelines for the industry. The Group is a broad-based alliance, consisting of general partners (managers), limited partners (investors) and service providers from both the venture and buyout segments of the private equity industry. It issued its initial Private Equity Valuation Guidelines in 2003.
The recent revision to the Guidelines was prompted in large measure by the issuance in September 2006 by the Financial Accounting Standards Board (FASB) of Statement No. 157. The purpose of FASB 157 was to clarify the meaning of “fair value” for GAAP financial reporting purposes. PEIGG felt it appropriate to make modifications to its guidelines to ensure compliance with FASB 157.
Definition of Fair Value
The new PEIGG Guidelines have adopted the GAAP definition of fair value, viz. “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.” Further elaboration is provided by the Guidelines as follows: “The objective is to estimate the exchange price at which hypothetical willing marketplace participants would agree to transact in the principal market, or lacking a principal market, the most advantageous market. No matter which market is deemed most appropriate, fair value is the estimated ‘exit price’ in that market.”
The exit value emphasis of FASB 157 is of particular interest to the private equity industry because private equity funds have traditionally tended to value investments at cost and make adjustments only in connection with subsequent financing rounds or achievement of milestones. The revised Guidelines stress that the initial cost of the investment and the price of the most recent round of financing are factors that may be considered, but they lose reliability over time and must be evaluated in connection with other factors.
Guideline Recommendations
Unrestricted actively-traded public securities are required, in general, to be valued at the closing price or bid price. Discounts for blockage for unrestricted securities owing to the size of the holding are prohibited.
A discount from actively-traded values should be taken for securities which are subject to a formal restriction that limits their sale. Examples of such restrictions would include Rule 144 holding periods and underwriter’s lockups. Such discounts typically range from 0% to 30%. The size of the discount will vary depending, among other things, on the length of the holding period.
Limitations on sale based on Rule 144’s volume test or based on a closed trading window for board members do not qualify as formal restrictions related to the security itself. Therefore, discounts are not allowed in these situations.
In valuing non-actively-traded securities, the Guidelines encourage the use of a market approach in most situations, utilizing comparable company transactions or performance multiple inputs as the primary technique.
The Guidelines concede that there are other valuation methodologies that may be appropriate in certain circumstances, including discounting cash flow, valuing net assets, and industry-specific benchmarking.
The Guidelines recommend that valuations be conducted or updated on a (typically) quarterly basis, subject to written parameters established in consultation with a Valuation Policy Committee composed of fund investors.
Finally, the Guidelines point out that they are not intended to eliminate all subjectivity. They are designed to provide a valuation framework while allowing a manager to exercise his best judgment in applying it.
