Age-old private equity valuation debate re-ignited by new accounting rules
Jul 15th, 2009 | Filed under: Private Equity, Today's Post
(By: Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board)
Private Equity valuations have received a great deal of attention recently because of FAS 157, a new accounting standard that requires firms to use exit prices when calculating the fair market value of portfolio companies. The new calculation methodology is markedly different from the previously accepted practice of valuing portfolio companies at the purchase price, and has revived the timeless Private Equity “Valuation Debate”.
On Another Level…
In a recently released paper, Espen Robak discusses the intent and implications of FAS 157 for reporting firms. The most fundamental change resulting from the adoption of the standard is that the definition of fair value is no longer the entry or purchase price, but rather the exit price of an investment. The standard creates a valuation hierarchy rating system, which places a greater emphasis on observable market inputs versus assumption based methods:
- Level I – the inputs used are actual active market prices
- Level II - the inputs used are quoted prices for similar assets in active/inactive markets, or other observable/derived market inputs
- Level III – no observable inputs are available
Firms should, in theory, feel pressured to avoid Level III classifications, because these will require increased disclosure as well as the least credibility with investors. The standard also states that firms can’t ignore available market data, even if the market is not perfectly liquid. (For an additional discussion of FAS 157, see Kalin Kolev’s paper.)
The Valuation Debate
Many GPs simply don’t see the point; they argue that private equity is a long-term investment and that interim valuations mean little in the context of actual long-term results. Why should investors be concerned with a current exit price for an investment that is 5 or 10 years away from being exited? More…
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