Langham Hall Autumn 2011: Impact of Policy Changes on Private Equity Valuations

Welcome to our Autumn 2011 newsletter

The Asian private equity markets seem to be weathering the autumnal storms in Europe and around the world rather well. Fund-raising markets remain open for business, and some fund-raising efforts are actually ahead of schedule right now. Is this a rush to close funds before a much anticipated big freeze sets in, or are the Asian PE markets simply now waterproofed against downpours on the other side of the world? Hard to tell, but by Chinese New Year I think we will know.

Of course the true perfomance of a market is measured in investment returns rather than fund raising results, and to that end Brett Shadbolt and Jean-Baptise Roy from Censere Group comment on the impact of coming policy changes in the valuation of private equity fund investments, with a focus on buyout funds.

Impact of Policy Changes on Private Equity Valuations

Current policies allow buyout funds to report in either of:

1) US GAAP – Showing a fair value measurement per investment, reflecting the current fair value of each investment; or

2) IFRS – Full consolidation with purchase price allocation (PPA) and impairment testing of controlled investments, and hence minimal indication of the fair value of the investment. 

The first option is the most widely adopted solution for PE funds making controlling investments given the IFRS status quo. The second option can be tedious due to the requirements of PPA and impairment testing, and it does not communicate the performance of the fund to investors.

“The objective of the new IFRS 10 policy draft: The investment entity would be required to measure the fair value of all investments through profit or loss.”

The proposed standard is a step forward for an increasingly important industry. It would reduce the compliance overhead for PE funds and allow LP’s/investors to more clearly see and understand the true performance of their investments. The newly-released policy draft does leave many important questions unanswered, especially with regard to implementation. In particular, the draft does not specify:

  • Whether the new standard will require DCF valuations, or whether market multiples be accepted where appropriate?
  • Whether there different reporting requirements for various investment thresholds?
  • Who can do the work: independent valuation firms, in-house staff, audit firms?

At Censere we predict that firms and regulators may struggle with several requirements of the proposed policy. Below, we highlight two anticipated problems and potential solutions:

Problem: Firms may struggle to meet independence and objectivity requirements

Solution: Independence in the fair valuation calculation of current holdings by the fund manager. LP’s want to see more transparency in valuation of investments – pragmatic solution might be involving an independent third party to do the valuation.

Problem: It is hard to obtain adequate financial and operational information from investees

Solution: Transparency issues in Asia make data collection from investee companies an arduous process. The new standards will not necessarily make this any easier. Investors can begin to change this by upgrading their requirements during the due diligence and data collection period prior to making an investment, supplemented by ongoing independent monitoring of this data over the life of the investment through a third-party. Alternatively, multiple and market comparables could be used approximate the value of the investment.

***

Instead of viewing the proposed policy as a hurdle, we at Censere see it as a potential opportunity for all stakeholders to benefit. For fund mangers, the proposed standard will provide impetus to transmit more meaningful information to their investors, and incorporate regular valuations into their investor reporting mechanism – while simultaneously removing the time-consuming and largely pointless requirement of PPA and impairment testing.

Many leading fund managers have already voluntarily adopted this type of reporting mechanism in addition to existing IFRS requirements. For LP’s, the level of transparency they have long sought will finally be achieved, helping them screen funds and GP’s for potential second-round funding in earlier stages of investment cycles.

Ongoing monitoring of investee companies and regular investor reporting are a basic facet of fund management. However, best-practice suggests that using an independent service provider to either review or conduct portfolio assessments and provide independent monitoring of investments will ensure that corporate governance and transparency objectives are met. Censere’s portfolio monitoring services plug directly into the fund accounting function, giving the GP's greater confidence in the results and providing an additional layer of comfort for limited partners.

This article was contributed by Brett Shadbolt (CEO) and Jean-Baptiste Roy (Senior Manager) of Censere Group, HK.