In a recent study, partially funded by a CIV Research Grant (2014), Kelvin Law and I delve into the impact of fair value accounting—one of the hallmark accounting standards in recent decades—on the valuation of individual private equity investments. Under fair value, fund quarterly reports must include the fund manager’s best estimate of the market price they would receive for exiting each portfolio company. In short, we find the implementation of fair value accounting standards resulted in a significant improvement in the quality of portfolio company valuations. In this blog post, I want to take the opportunity to boil down some of the key findings.
For many years, investors in venture capital and private equity funds paid relatively little attention to the valuation of active portfolio company investments. In principle. these valuations would help investors decide how to rebalance their portfolio. However, the valuations were not seen as reliable enough to be of much use. Without public markets to aid in price discovery, private equity funds value their portfolio companies by marking to a valuation model. This requires subjective judgments by fund managers on which model to apply, and which inputs to use for each investment.
This has led to some concerns that fund managers might take advantage of the discretion afforded to them. For example, a common critique is that fund managers have incentives to choose a low discount rate or a set of favorable comparable firms, so they could produce high valuations for their portfolio companies. Surprisingly, our discussions with both investors and fund manager suggest the opposite. Worried about investors reactions if portfolio companies are eventually realized for less than they were valued, fund managers tended to be conservative.
A large shift in valuation practice occurred as fair value standards were first implemented among European funds in 2005 and subsequently among US funds in 2008. The implementation forced the industry to be more formal about valuation, with more scrutiny provided by end-of-year auditors. This staggered implementation was fortunate for researchers interested in private equity because we can apply difference-in-differences estimation, a common statistical technique, to tease out the causal impacts of fair value accounting. This is especially helpful in answering our research question. Had we simply examined the change in valuation among US funds in 2008, it is impossible to ascertain whether changes we observed in valuations were driven by the implementation of fair value accounting or the 2008 financial crisis.
We find that the implementation of fair value accounting standards is associated with a large improvement in both the bias and accuracy of valuations for buyout fund portfolio companies. Prior to implementation of fair value accounting, the discounted value of cash flows from realized portfolio companies exceeded their valuation by roughly 26%, suggesting that managers were being conservative, which is consistent with our conversations with investors and fund managers. Implementation of fair value accounting appears to eliminate nearly half of this bias. We observe a similar effect on accuracy. Controlling for the average tendency to undervalue companies, valuations under fair value tend to be closer to the cash flows eventually realized from each investment.
One limitation in our sample is that it does not have enough European venture capital funds to apply the difference-in-difference technique described above. We are left to speculate a bit on the effects on venture capital valuations. In unreported results, we find that US venture capital funds saw improvements in valuation bias and accuracy around the implementation of FAS-157 that were similar in magnitude to what we observe for US buyout funds. This suggests the improvement in venture capital may be similar to what we document for buyout funds, with the caveat that we cannot rule out that some of this change was due to the effects of the 2008 financial crisis.
Investors who have not taken private equity valuations seriously in the past are likely to benefit from revisiting how these valuations are used to rebalance their portfolio, make follow-on investment decisions, evaluate their investment staff, etc.
Nicholas G. Crain is an Assistant Professor of Finance at the Owen Graduate School of Management, Vanderbilt University in Nashville, TN. His research interests include Private Equity, Venture Capital and Corporate Finance. The guest post above is the summary of a research partially funded by a 2014 CIV Research Grant.