Private equity’s debate over fair value was sparked anew last fall when the FASB issued SFAS 157, which provides a concrete definition of “fair value” and enhanced guidance for using fair value to assign values to assets and liabilities. In accordance with SFAS 157, private equity firms’ portfolio companies must be reported at fair value, which is defined as “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.” This definition, which focuses on exit values rather than entrance values, is new to the private equity community. Most observers recognize that fair value is here to stay, but questions remain as to how much progress has been made. “The FASB statement doesn’t change GAAP, but it does increase the intensity of the light bulb that’s 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 boiler-plate method that would take the guesswork out of assigning value to private holdings. The goal of the initiative has been to spur industry-wide adoption of PEIGG valuation guidelines in the private equity community, which theoretically take the conjecture out of assessing various unrealized funds and make the evaluation exercise an apples-to-apples comparison process. Firms have been using varying metrics to value their portfolio holdings. Some write up investments, while others don’t; some account for an illiquidity discount, while others don’t. But despite the incongruities, industry pros universally believe that the band of disparity has narrowed. The FASB ruling should add more thrust to the movement, but there is still a ways to go. “I’m seeing more firms use fair value, but it’s very sporadic,” says Hamilton Lane’s Chief Investment Officer, Erik Hirsch. 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 their own opinions on how it’s done, which is where the difficulties arise.” 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. In 2000, before the tech implosion, there was a number of venture capital firms that had 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 VC community will simply keep their investments at cost, and maneuver 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 new financing arrangements. While investors appreciate the concept of mark-to-market appraisals, the gripe is that it’s not practical when dealing with private companies, especially nascent businesses, that in the words of John Taylor, Research & Financial Affairs Executive at the National Venture Capital Association, may outwardly appear to be “two guys and a dog in a garage.” Taylor adds, “Until these companies find some level of success, how can they really know their value?” The kind of volatility that Taylor refers to can be seen in buyout investments as well, although it’s not as extreme as what is typical in venture capital. When Thomas H. Lee Partners acquired an 80% stake in Hawkeye Holdings last June, the company was valued at approximately $1 billion, according to company filings. Three weeks later, the buyer 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 didn’t disclose how many shares it would be selling. In September, however, the offering was lowered to $421 million, and a couple months later it was put on hold indefinitely. While it doesn’t definitively point to valuation volatility, it backs up the sentiment that assigning values to illiquid securities is still more art than science. Another example is the case of YouTube, which Google acquired last year for nearly $1.7 billion, a price tag that is about 100 times its revenues. “Could you expect YouTube’s investors to write it up to that kind of valuation? The universal answer is, no,'” Taylor says. But 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. If PE investors count pensions or endowments among their limited-partner base, there’s a good chance that they will insist on GAAP. Larsen even 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 that 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 general partners will miss the mark, but as long as they’re arriving at valuations “in a consistent manner” it represents progress over past efforts. Larsen doesn’t buy the argument that it’s better to be 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. If you have objective evidence saying that something has increased in value, you have to write it up.” In addition to getting everyone on the same page, the valuation guidelines take on added importance when considering the secondary activity in the industry, which in some ways removes the “cash in/cash out” mentality that has been typical among private equity firms. Limited partners need a mark-to-market estimation in order to get full value for their yet-to-realized positions. (c) 2007 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com

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