When US accounting standard setters released FAS 157 in the fall of 2006, finance professionals in private equity and venture capital didn’t think much of it. After all, the new rules (now known as Topic 820) created guidance on something the industry already felt it had a handle on: reporting hard-to-price assets at fair value. Groups like the US-centric Private Equity Industry Guidelines Group (PEIGG) and more EU-focused International Private Equity Valuation Board (IPEV) had been providing a framework for this for years.
But as Duff & Phelps managing director and IPEV board member David Larsen admits: “Thinking that the new FAS 157 would have little or no impact was a mistake.”
Auditors’ strict interpretation of FAS 157 didn’t exactly synchronise with industry practice, meaning that valuation guidelines CFOs had been using for some time were suddenly inadequate. The PEIGG and IPEV responded by tweaking their guidelines to comply with the new standards. But many private equity CFOs accept now that the inadequacy of the industry’s reaction to FAS 157 meant it missed out on an opportunity to show auditors how fair value reporting was already being accomplished in practice.
What’s happening now, it seems, is that the industry is attempting to correct that mistake. At a scale not seen before, private equity and venture capital trade associations worldwide are coming together to promote a single set of valuation guidelines. The hope is that auditors will be more comfortable with valuation practices that are being applied consistently at an industry-wide level.
It also explains why last year the Private Equity Growth Capital Council (PEGCC) and the National Venture Capital Association (NVCA), the private equity and venture capital industries’ respective US trade associations, went beyond their normal remit and endorsed the IPEV guidelines. The two trade bodies, which have historically limited their input to public policy and regulatory matters, joined 40 of their worldwide counterparts – including the China Venture Capital Association, the European Private Equity and Venture Capital Association (EVCA) and the Latin American Private Equity and Venture Capital Association – to promote IPEV as the industry’s global framework for valuing private equity assets.
(And now that the industry is rallying behind it, IPEV intends to strengthen its North American ties by offering its US endorsing members a more formal seat on its governing board, PE Manager has exclusively learned.)
TOGETHER WE STAND
So why now? Sources say the US trade associations felt compelled to act after witnessing their member firms undergo steadily more grueling audits.
In 2012, the US Securities and Exchange Commission was granted formal oversight of the private equity industry, and quickly sent a signal that valuations would be a priority during inspections. Auditors, hearing that message, began forcing CFOs to run more models (of arguably limited benefit) to justify their fair value marks, mindful that the SEC was now looking over their shoulders.
Auditors themselves tell PEM that the problem stems from a lack of guidance. Asking GPs for more data and calculations allows auditors to show their overseers that GPs’ valuations were adequately stress-tested. Consequently, fund managers are being asked to generate complex option pricing models and include complicated graphs in their financial statement footnotes that (for example) detail when an asset becomes harder to price because of its illiquidity.
Aware that audits have become more laborious and time-intensive, the American Institute of CPAs (AICPA), the main professional body for US accountants, recently assembled a taskforce to create bespoke guidelines for private equity and venture capital valuation estimates.
However, the industry is questioning the need for this taskforce, arguing that IPEV’s valuation guidelines offer everything auditors need to prove that CFOs are sending financial statements in accordance with official accounting standards.
In a statement released shortly after the NVCA endorsed IPEV’s standards, the group’s president Mark Heesen seemed to be saying as much to auditors when he noted that IPEV guidelines “are consistent with US GAAP, which specifies that fair value be determined using market participant assumptions”.
For their part, auditors counter that IPEV’s guidelines don’t provide enough instruction on certain areas where they’ve encountered inconsistences in the field.
But critics say the taskforce’s mission is really to push more valuation work on CFOs, regardless of its benefit, so that auditors can sleep easier at night.
“Auditors are prone to using models and tools that market participants aren’t actually using,” said one US-based private equity CFO. “They’re pushing these models on us, and we say: ‘Wait a minute, we looked at the definition of fair value and agreed as an industry – both GPs and LPs, working through IPEV – that what we have works’.”
Auditors’ tough approach to fair value estimates also has LPs worried that their fund managers are spending too much time and resources on portfolio valuations.
“I’m hearing from some GPs that they’ve spent seven figures on valuation work. Well, those costs are passed down. That hurts our return,” says one LP from a university endowment.
LOOKING AHEAD
To address industry concerns, AICPA senior technical manager Yelena Mishkevich says the taskforce features “strong industry representation”. And while any final guidelines are still years out, Mishkevich says the taskforce will release a working draft of the guide for feedback and plans “to be receptive to industry concerns by taking into account how industry participants typically price investments”.
It’s still early days yet in terms of knowing what approach the AICPA taskforce will ultimately take. On the one hand, CFOs stress that valuation is both art and science – meaning that any set of valuation guidelines needs to contain a certain degree of flexibility, especially ones designed for an industry dealing in illiquid assets primarily traded by a limited universe of buyers and sellers.
On the other hand, auditors are desperate for a document that can provide a ‘by the book’ feel to their audits now that the SEC and PCAOB are taking a closer look into their work files. So the big question 2014 and the years ahead is: can a unified front behind IPEV help to influence the debate?
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