A 2018 investor survey by eVestment found that 60% of private equity investors are skeptical of private equity valuations, and 61% of respondents still have trouble comparing the performance of one fund manager to another. Despite this fact, more than 20% of those surveyed still expected to increase their PE investment allocations.
Why the uncertainty?
Private equity funds have historically been exempt from registering with the SEC as an “investment company” under the Investment Company Act of 1940. By stating that the fund only offers “shares” to 100 or fewer accredited investors, the fund does not have to comply with certain SEC reporting rules. However, since 2010, the Dodd-Frank Act has required private equity advisors to register with the SEC (provided they advise funds with less than $150 million in assets), which requires general reporting on the private equity fund that they advise. However, advisers often get around this with exemptions.
So, with limited information and SEC exemptions, how do investors know that a private equity valuation is reliable?
In December of 2018, the updated International Private Equity and Venture Capital Valuation Guidelines were released by the American Institute of CPAs (AICPA) to further encourage transparency and adherence to GAAP reporting principles for PE funds in 2019. Will this have any effect on valuation reliability?
All private equity valuations aim to present a fair value measurement of the PE firm’s investments. According to the valuation guidelines of the FASB ASC 820-10-05-1B, “the objective of a fair value measurement … is … to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions.”
For investors, market information is not made public for many private companies, and it can be difficult to determine the true value of the PE fund and make an allocation.
While PE firms do not want to be accused of inflating valuations, not all PE funds use the same valuation methods, and funds are responsible for creating their own valuations. Investors look at the net asset value (NAV) to determine portfolio value, but PE funds use a number of methods to determine value, including discounted cash flow (DCF), market comparables and more. In many situations, a fund may use a third-party valuer, which can help provide better accuracy and objectivity.
Unfortunately, transparency can still be an issue as, one major study suggests.
A study by three authors at the University of Oxford, published in February 2013, concluded that investors in new PE funds “should be extremely wary of basing investment decisions on the [reported] returns…of the current fund.”
The study of 761 fund investments made by CalPERS (the largest U.S. investor in PE) found that PE fund managers tend to inflate the valuations of current funds during fundraising for follow-on funds, so that “the performance figures reported by funds during fund-raising have little power to predict ultimate returns,” especially when performance is measured by internal rate of return (IRR).
In their paper titled “How Fair are the Valuations of Private Equity Funds?” the authors, Tim Jenkinson, Miguel Sours and Rudiger Stucke, said:
“The ultimate performance of private equity funds is only known once all investments have been sold, and the cash returned to investors. This typically takes over a decade. In the meantime, the reported performance depends on the [interim] valuation of the remaining portfolio companies. Private equity houses market their next fund on the basis of these interim valuations of their current fund.”
Jenkinson, Sours and Stucke concluded that these interim valuations tend to be conservative and “fair,” until they start raising money for the next fund and are once again inflated.
The good news? A 2018 study by Peter Easton, Stephannie Larocque and Jennifer Stevens of the University of Notre Dame and Ohio University, respectively, found that the Accounting Standards Codification 820 of 2008, which offered enhanced guidance on fair value accounting, did in fact improve the information environment across financial markets.
Further guidelines have since been published, specifically the International Private Equity and Venture Capital Valuation Guidelines.
The new International Private Equity and Venture Capital Valuation Guidelines, mentioned earlier in the article, were released last year. Though it is not an enforceable set of rules, it serves to clarify certain issues concerning fair value.
According to the document, the guidelines are meant to encourage:
There is extra consideration for other topics as well, including debt investments, investment structure and other components that can affect fair value.
Not all market participants are optimistic that the guidelines will have a significant impact on private equity valuations and their reliability. Funds that use independent valuation experts and abide by GAAP accounting principles have already been following these guidelines, so the information is not necessarily new. However, it does help standardize certain language and may enhance the valuation process by emphasizing backtesting and other methodologies.
Portfolio valuation is still murky, but with rising concerns regarding PE fund valuations, the industry is continuing to take steps in the right direction.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Selecting the Right Valuation Expert and Advanced Topics: Public Company Reporting. This is an updated version of an article that was originally published on March 21, 2013.]
David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…
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