Defining Fair Value

Editor: For the benefit of our readers, please tell us about the roles Duff & Phelps plays in assisting players in the private equity arena.

Larsen: Duff & Phelps is an independent financial advisory firm, serving client needs in the areas of valuation, investment banking, transaction advice and dispute consulting. In the private equity area we provide a number of services to private equity investors, in particular general partners of private equity funds. We also work directly with portfolio companies.

For example, when a private equity fund is buying a company, we provide financial accounting, tax, IT and commercial due diligence and other services to assist them in evaluating all of the factors in connection with their potential investment. We also focus on portfolio evaluation, helping large private equity funds on a quarterly basis in giving an independent view as to the value of their portfolios. We work with investee companies on a myriad of valuation issues in looking at purchase price allocations, goodwill issues, valuing complex securities such as derivatives or stock options, etc.

We have an investment banking practice that assists private equity funds both with identifying and helping to facilitate buying and selling portfolio companies. In the unlikely event that a private equity fund has a company that is not doing well, we have a restructuring group that focuses on advising companies, creditors and stakeholders in distressed situations. We also help with financial modeling and dispute resolution as needed. We play in a myriad of places in the private equity arena. We also have a specialty tax practice that focuses on matters like business incentives, gives guidance on transfer pricing issues, etc.

All of these services are tailored from an industry-needs perspective. As an independent financial advisory firm, we are not constricted to a narrow range of services as are the independent accounting firms. We cover the whole spectrum of providing service for a transaction.

Editor: What is your particular area of expertise?

Larsen: My area of expertise is in financial due diligence and focusing on issues in private equity. I am relatively new to Duff & Phelps, having joined the firm in October 2006. Previously I spent 22 years in the Big Four environment with KPMG where in the last nine years of my career I focused on financial due diligence and private equity issues in particular, specifically on limited partner issues. I am the drafter of the Private Equity Industry Guidelines Group (PEIGG) valuation guidelines and have been an advisor to PEIGG's board for several years. I am also an advisor to the Institutional Limited Partners Association, helping them with their various research projects. I have worked with some of the largest investors in private equity and have spoken widely on these topics.

Editor: How would you define private equity?

Larsen: Generally, it is an investment fund with a general partner and various limited partners focused on private investments. In particular, it includes buyout, venture capital, mezzanine financing and in some cases, hedge funds, depending on their focus.

Editor: What is the history and primary focus of PEIGG?

Larsen: PEIGG started in 2002 as an ad hoc group of industry participants, including general partners, limited partners and industry advisors because in the U.S. there was no group who could speak for and focus on private equity issues and develop a code of best practices. In 2001 and 2002 with the bursting of the technology bubble there was a large concern with valuation in the private equity area, especially owing to the perception that a number of private equity funds had overvalued investments. In 2003 and 2004 PEIGG introduced valuation guidelines as well as reporting guidelines to assist limited partners in providing consistency and transparency on the reporting side. The guidelines issued by PEIGG are not required by GAAP, but they have positively impacted the industry, particularly in the area of valuation. We are in the process of updating the valuation guidelines to ensure that they are consistent with FASB Statement 157, a method for determining valuation, which becomes effective in 2008.

Editor: Describe the work of PEIGG?

Larsen: PEIGG is made up of volunteer representatives from the private equity community who work together to establish a set of reporting guidelines for the industry. Its mission is to promote increased reporting consistency and transparency while at the same time improving operating efficiency in the transfer of information among market participants by establishing a set of standard guidelines for the content, formatting and delivery of information.

Editor: What do you see as the greatest challenges in the private equity industry?

Larsen: The greatest challenges today can be split into two areas - one from a limited partner's perspective and the other from the general partner's perspective. For the limited partners it is identifying and selecting general partners that have superior performance records whose funds they can gain access to on reasonable terms. On the general partner's side the challenge is effectively putting all their available money to work in a market where they can at least maintain historic returns, given that there is an ever-increasing amount of competition and a lot of liquidity in the market. All of that should be done in a fashion that provides transparency and good governance to both parties.

Editor: Why is it necessary to ascribe fair value to an investment portfolio?

Larsen: It is necessary from several different points of view. In today's environment, the vast majority of limited partner agreements require that the funds prepare financial statements in accordance with GAAP. GAAP requires fair value. Also, the limited partners report their financial information for their organizations using GAAP which requires fair value information for their own financial statements. To be able to monitor and evaluate interim performance of a manager, the limited partner has to have a consistent methodology and ability to evaluate what is happening over time. Fair value has been determined as the basis that allows one to evaluate private equity results on a comparable basis.

Editor: Please describe for our readers the new framework for measuring fair value that was created with the issuance of FASB 157.

Larsen: FASB 157 provides disclosure requirements and calculation requirements for the use of fair value wherever fair value is used in GAAP. FASB 157 was not specifically prepared for private equity and in many cases touches other areas of accounting to a greater extent. In principle, it does not change anything from a private equity fair value point of view. Before FASB 157, private equity funds were required to report on a fair value basis and they are still required to report on this basis. Conceptually nothing has changed - only the means for deriving fair value.

FASB 157 has increased the wattage of the light bulb shining on the fair value issue in private equity. Preparers of financial statements realize that FASB 157 is focused on fair value so they need to focus more keenly on how it is derived. In the future once a fund adopts FASB 157, there will be additional disclosure as to how the fund came to its fair value assessment for each of its investments. FASB 157 goes through a hierarchy of inputs to get these values. You then have to disclose the level of input used so that the reader of the financial statement can then assess the overall quality of the fair value determination.

Editor: What is the preferred methodology?

Larsen: There are several criteria: (1) if the company is a public company, quoted prices in active markets; for non-public companies: (2) cost or the latest round of financing may be appropriate to measure fair value for some period of time; thereafter (3) comparable company transactions; (4) performance multiples; (5) other relevant information. The technique least likely to be used and with caution is discounted cash flow.

Editor: Could you give an example of how a fund might value an investment?

Larsen: You have to look at it from two perspectives. If a company is in a buyout portfolio (usually meaning that it has earnings and is growing), in order to value that company you should first ask if it is publicly traded. If it is, you take the market price of its shares times the number of shares to get fair value. If it is not publicly traded, you look for a comparable company that gives an indication of value. You look at the market multiple for the comparable company, and if that multiple makes sense for your company, you use it in order to get a value - always in the context of the overall market and economy.

A venture-backed company that does not have earnings should be viewed in the same way. Is the company still on plan? Is the cash burn what was expected? You look at the goals and expectations set by the investor. You then look at similar companies and factor in the value of the market for that type of company and its product(s). Taking all of that into account, you make a determination of fair value. Often this is evaluated in the context of what was paid or the value of the last round of financing.

Editor: Are there additional regulatory challenges for private equity funds or companies seeking private equity financing?

Larsen: At this point there are not any direct regulatory challenges, but that is not to say that regulation might not come in the future, given the large amount of capital that has come into this market, in particular from pension funds. Recently some of the large buyout funds have established a lobbying group because they do not feel that their story has been told well on the political side. The venture capital funds have the NVCA as their lobbying body.

Editor: Do you see eventual harmonization of the various valuation standards used throughout the world?

Larsen: At the end of 2005 the British Venture Capital Association, European Venture Capital Association and AFIC, the French Venture Capital Association, got together and came up with new international valuation guidelines. This came about in part because of PEIGG's website, where among frequently asked questions dealing with valuation guidelines, there was a question as to whether the prior international guidelines complied with GAAP. The answer on the website was "no." That caused the Europeans to go back and evaluate their guidelines and issue new ones at the end of 2005. In concept they are 90 percent plus consistent with the PEIGG guidelines prior to the issuance of FASB 157. However, keep in mind that FASB 157 will cause a revision to the PEIGG guidelines and likely will cause a need to revise the international valuation guidelines. Harmonization between PEIGG and the international guidelines is a possibility in the future.

Editor: What are the consequences for companies that do not adhere to the new fair value requirements?

Larsen: The biggest consequences are that they could receive a qualified audit opinion since their financial statements are not in accordance with GAAP. Without fair value information from their general partners, limited partners may find it very difficult to provide fair value information in their own financial statements. There has been some recent audit guidance, in particular, for auditors of entities such as foundations and pension funds who now push harder on the limited partner side to make sure that the investments are at fair value. In addition, private equity funds have an exemption from consolidation rules established post Enron (FIN 46) because it is presumed that private equity records their investments at fair value.

Editor: What advice do you have for private equity funds to ensure that their portfolio assets are valued correctly?

Larsen: They need to make sure that they have a robust process internally for coming up with fair value. Using PEIGGs valuation guidelines, once harmonized with FASB 157, is one way to do that. PEIGG and GAAP says that you should consistently use your methodology and if you make a change in it, you need to disclose that to investors.

For a long time the private equity industry had a tendency to talk about valuation at cost or the latest round of financing as fair value. This approach is no longer consistent with the concept of fair value. Managers must evaluate all relevant information in coming to their fair value determination. However, particularly in the venture capital space it is reasonable that fair value, after analysis, may be the value of the last round of financing at least for some short period of time.