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Portfolio Company Valuation Guidelines

Over the past few years, much attention has been paid to the development of guidelines and standards by various groups. These reporting standards and guidelines generally fall into two categories: (a) performance presentation formats and (b) portfolio company valuation guidelines.

An example of the former is the Private Equity Provisions of the Global Investment Performance Standards (GIPS). This was developed by the CFA Institute (formerly known as AIMR). While many of the specifications and terminology line up with current practice in the United States, the NVCA has not endorsed or otherwise commented on these standards. Neither NVCA nor Thomson Financial has determined how widespread the adoption of those standards is or will likely be. This document and accompanying guidance can be currently found at http://www.cfainstitute.org/centre/ips/gips/.

Much more attention is being paid to the other category: portfolio company valuation guidelines. The chronology and sections below refer to this category. Suffice it to say for now that portfolio valuation guidelines developed by the Private Equity Industry Guidelines Group (PEIGG), most recently revised in March 2007, are the most commonly referred to in the US. An unrelated European consortium has created “international” guideline which they intend to conform to IASB rules. That version has received little attention in the US.

Why Valuation Guidelines Matter

What ultimately matters to the investors and private equity practitioners is the cash which has been distributed to the investors during the life of the fund compared with the original money put in. However, the life of a typical venture fund is at least 10 years, longer in the life sciences arena. During that period the venture capital fund reports progress to the limited partners. In many cases, this means quarterly portfolio updates and a complete audited annual financial statement. For a typical venture fund, very little money is paid out in the first four or five years. Also, while every portfolio company receives funding with high expectations, it can take several years to determine if a particular company is a likely winner. Therefore, understanding progress in the portfolio requires some estimate of the success of the investee companies by the venture capital or private equity firm. While many investors and fund managers agree that financial measurements mean little for the first three or so years of a fund, after that the fund wants to communicate progress to the investors. This is where specific valuation rules and processes become important. The agreed valuation procedures for individual portfolio companies become the basis for progress assessment as the fund matures and ultimately distributes cash to the investors.

So while portfolio company valuations are more of an art than a science, especially for pre-revenue or even pre-EBITDA companies, most limited partner agreements (LPAs) establishing a venture capital fund require the venture firm to provide quarterly and annual financial statements using Generally Accepted Accounting Principles (GAAP). GAAP requires fair value measurement for portfolio positions. Therefore, most GPs must issue financial statements using fair value.

The Evolution of Valuation Guidelines: 1989 to 2007

This section reviews the various efforts to create comprehensive portfolio company valuation guidelines for US private equity.

  • 1989-1990 – A group of investors, private equity fund managers, and fund-of-fund managers formed a group to develop a set of portfolio company valuation guidelines. Contrary to a very persistent rumor, the NVCA did not endorse, adopt, bless, publish, or otherwise opine on the guidelines.
  • Decade of the 1990s – Two noteworthy developments occurred in the 1990s. Despite no endorsement by the NVCA these guidelines became accepted practice by much of the US industry, especially in the venture capital side of private equity. These guidelines were referred to by many as being issued by the NVCA but in fact they were not. The second development is national venture associations creating localized guidelines based heavily on these guidelines. These were created in Europe and other international regions. In fact, by 2005, there had been multiple iterations of the European and British guidelines.
  • 2003 – A self-appointed group of private equity practitioners, fund managers, fund-of-fund managers and others formed the Private Equity Industry Guidelines Groups (PEIGG). The overall constitution of this group is not hugely different from the 1989-1990 group. The PEIGG group announced that it was contemplating taking on four initiatives, of which portfolio company valuation guidelines was the first one.
  • December 2003 – After an extensive input phase and review by various industry groups and service providers, the first version of the PEIGG guidelines were issued. Throughout the process PEIGG had been actively soliciting feedback and input from a number of industry groups including the NVCA.
  • March 2004 – NVCA board issued statement of support, but not endorsement as some pundits had hoped. NVCA position was widely consistent with input provided by members of the NVCA CFO Task Force, members at large, and the NVCA Board of Directors. The text of NVCA’s statement is printed below.
  • March/April 2004 – The Institutional Limited Partners Association (ILPA) hails NVCA support as welcome support – especially as it relates to the GP and LPs mutually agreeing to the valuation process. PEIGG also hails NVCA support
  • July 2004 – After consulting quietly with various industry groups, PEIGG issues guidance on controversial paragraph 30, which allows for and requires non-round write-ups under certain circumstances. This is the most discussed and debated provision in the guidelines.
  • September 2004 – Based on input from ILPA and others, PEIGG agrees to minor wording changes in two paragraphs. This becomes PEIGG guidelines version 2. These two wording changes were consistent with, and in part inspired by, language the NVCA board used in its March 2004 statement of support.
  • October 2004 – ILPA endorses the PEIGG guidelines.
  • December 2004 – As most fund accounting year’s end, GPs prepare for their first audits since the effective date of AICPA’s SAS 101 rule. Essentially that rule says that if a reporting entity claims to be reporting “fair value” – which is required by GAAP – then the auditors must document and test that this is, in fact, true. It was not clear to what extent this increased scrutiny would affect valuation expectation and practices.
  • March 2005 – NVCA board issues an updated statement, which now refers to the September 2004 version of the PEIGG guidelines. The NVCA also decided to make the PEIGG document widely available to its members. The text of that statement is below.
  • April 2006 – Guidelines issued by a consortium of three Europe-based venture capital associations (AFIC, BVCA, EVCA) are released. The authors cite compliance with IASB rules. Informal feedback from US venture capital professionals reviewing this document was that the document was more formulaic than PEIGG counterpart and partially compliant with US GAAP as defined at that time. Subsequently 30 non-US private equity and venture capital associations endorsed this document. Go to http://www.privateequityvaluation.com. The most recent edition is October 2006. These guidelines have gotten little traction in the US.
  • September 2006 – Financial Accounting Standards Board (FASB) issues its long-awaited and long-anticipated fair value measurement standard as FAS 157. Only a few of its 145 pages relate directly to typical venture capital and private equity funds. Because FASB maintains that this is a clarification and further definition of fair value which was already required for portfolio accounting, some auditors began requiring selective compliance in advance of the 2008 effective date.
  • March 2007 – PEIGG issues a revised portfolio company valuation guidelines document to reflect the Fair Value Measurement standard (FAS 157). As of this writing, neither the NVCA board nor its Research Committee has reviewed this new document. In the coming months we expect the NVCA Research Committee to consider re-supporting the new version of the guidelines.

NVCA Position on Portfolio Company Valuation Guidelines
(widely published statement included in 2007 NVCA Yearbook in Appendix I)

The Board of Directors of the NVCA reaffirmed its March 2004 position on the PEIGG guidelines on September 18, 2007 and revised the statement below to refer to the updated version of PEIGG’s document released in March 2007. While the NVCA has not specifically endorsed the PEIGG or other valuation guidelines, the NVCA board statement is below:

The NVCA recommends that its members create, follow and communicate clearly the specific procedures and methodologies used for valuing their portfolios. These methodologies should be agreed to by the firm’s investors (LPs), and conform, when required, to Generally Accepted Accounting Principles and fair value measurement standards, recognizing that the ultimate responsibility for valuations remains with the general partner. When evaluating current valuation procedures or developing new approaches, the NVCA suggests its members include a review of the Private Equity Industry Guidelines Group (PEIGG) December 2003 “Private Equity Valuations Guidelines” document, as reissued in March 2007 (found at www.peigg.org). We commend the fine efforts of PEIGG, an independent group which sought and reflected input from the NVCA and other industry stakeholders. The NVCA encourages diligence, prudence, and caution when implementing the specific elements of any guideline, such as valuation changes to early-stage companies in the absence of market-based financing events.