International Private Equity and Venture Capital recently released an updated guideline in which it removed the use of the price of a recent investment as a technique to calculate fair value, saying that it wasn’t consistent with accounting standards.
IPEV, a trade group that sets valuation practices for private funds, released its latest valuation guidelines in late December. The change was made in order to reinforce the idea that fair value should be estimated at each reporting date. Some valuation users had misinterpreted previous guidelines and “blindly used their recent investment as an indicator of fair value without doing any further analysis,” according to the report. IPEV added that such “blind acceptance” of including a recent investment’s price wasn’t consistent with accounting standards on fair value calculations.
“There was some confusion among some who believed you could just hold an investment at its historical cost or the value of the last round of financing and not have to think about it until the next round of financing,” David Larsen, managing director at Duff & Phelps, told pfm. “That was never part of the guideline and that was never intended, but some people interpreted the 2015 and prior guidelines to think that was allowed.”
He added that if a fund calculates its fair value only by its most recent investment, it could lead to misleading reports to its investors.
Larsen gave an example of a fund that invests $100 for 100 percent of a private company based on EBITDA of $10 at a multiple of 10. Three months down the line, the EBITDA of the company increases to $11, and assuming the multiple stays the same, that makes the fair value of the investment at $110. However, if the fund reports the value based on the original investment cost then general partners wouldn’t be reporting a true fair value to their investors.
Larsen said that incorrect reporting of valuation could lead to bad investment decisions for limited partners. At the same time, investments that are subject to regulation and use this incorrect method for fair value could come under the scrutiny of the Securities and Exchange Commission.
Recently the SEC has been cracking down on fees and expenses. In late December, Lightyear Capital paid $400,000 in settlements over claims that the firm overcharged its investors.