Compliance & Regulation

Standard 157

PEIGG has released updated guidelines on fair market valuation for the private equity industry in accordance with FASB 157. Some practitioners question the value of more stringent standards.

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ByWanching Leong In response to the Financial Accounting Standards Board's ?enhanced guidelines? for applying fair value accounting standards to assets and liabilities announced in September 2006, an industry group has updated its valuation guidelines for the US private equity industry.

The Private Equity Industry Guidelines Group, formed in 2002 by a group of general partners, limited partners and service providers in the US and overseas, has tailored its guidelines to help the industry understand and implement FASB Statement No. 157 ?Fair Value Measurements? for private equity and venture capital investments. The updated US private equity guidelines are intended to be consistent with US generally accepted accounting principles (GAAP).

David Larsen, managing director at Duff & Phelps and PEIGG member says, ?I've described FASB 157 as it increases the wattage of the light bulb shining on the fair value issue. It doesn't change the need for fair value, but it will increase the visibility that fair value receives from private equity managers, investors and auditors.?

Fair value, defined by FASB 157 and in accordance with GAAP, is ?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.?

Although the FASB 157 doesn't come into effect until November 15, 2007, private equity firms are already feeling the effects of having to revalue their investments regularly. Traditionally, private equity firms do not revalue investments until they are sold or are faced with an economic event. Now they are coming under pressure to revalue their companies more frequently.

A finance professional at a private equity firm says, ?We revalue our portfolio companies only once a year because it's so time consuming. At the end of the day, I don't know what the general guidelines provide the LP in terms of what the capital balance is at any point in time. Until a company is sold, you don't know what the value is because some of these companies are very slow moving and illiquid.?

The biggest pressure for fair value adoption is coming from auditors. FASB's revision of 157 in September, the first time the board had ever discussed fair value comprehensively in one statement, is believed to be a trickle down effect of the Sarbanes-Oxley Act, which in itself was created in the aftermath of accounting scandals at Enron and WorldCom.

FASB 157's impact on the private equity world will largely depend on how robust the GP's existing accounting procedures are, says Larsen. According to him, ?the nuances of the updated PEIGG guidelines driven by FASB Statement No. 157 could be significant for some. These include the elimination of a bias to write things down more quickly than up, the fact that inside rounds of financing need to be taken into account in fair value determinations, a prohibition on liquidity or blockage discounts and a prohibition on including transaction expenses in the determination of fair value.?

The additional work required to comply with the updated guidelines will likely have the biggest impact on small private equity firms. ?It's a challenge as far as it's laborious and detail oriented,? says the finance professional. ?At the end of the day it's realized or unrealized gain or loss on your books which does not amount to a hill of beans until there's an economic event. There are no tax or financial consequences. All it is is this hypothetical ?what if? at a given date. You should have some process in place, but to get so granular, I question it.?

Fair value valuation
Below are excerpts from PEIGG's Updated US Private Equity Guidelines

  • ? Securities of private companies, by definition, will not have quoted market prices available. However, private companies at times engage in arm's-length transactions for issuances of their equity or debt securities. The value of these transactions could serve as an observable market price similar to a quoted market price if the transaction is both recent and between willing parties for the same securities as those for which the fair value determination is being made (deemed a level 2 input by FASB Statement No. 157), and could therefore be used as an estimate of the theoretical exit price.
  • ? When quoted market prices or arm's-length transaction prices as described above are not available, the estimate of fair value should incorporate all reasonably available information about the business and utilize assumptions that market participants would normally use in their estimates of value. The estimate of fair value should seek to best replicate the amount at which the investment could be sold in a current transaction between willing parties.
  • ? In determining the fair value of individual investments using these Guidelines, managers are expected to use their judgment. In utilizing judgment, substance takes precedence over form. For example, when a manager's past experience indicates that liquidation preferences will likely be renegotiated or may not be fully enforced at the time of liquidation, the manager is strongly encouraged to use the expected results rather than the form of the agreement.
  • ? Valuations should be updated on each measurement, generally on a quarterly basis. Of course, valuations used for annual and quarterly performance reporting should be used in private placement memorandums and other marketing materials.