1.1 Equity Accounting Standards
Private Market valuation, although required to adhere to Fair Value standards laid out in all accounting standards and signed onto by key GPs and LPs, still continues to ignore Fair Value, as is evident by the smoothed appraisal-based returns or other market phenomena.
A naive justification for not considering fair value (or FV), or in other words delaying/ignoring marking to market the valuation of private companies, is that these assets are held for a longer term or until maturity. Hence, the argument is that there is no need to adjust valuation according to variations in factor prices.
However, this approach of ignoring FV is not compatible with the application of accounting standards such as IFRS (International Financial Reporting Standards) or US GAAP (Generally Accepted Accounting Principles), both of which support the accounting of financial investments at their FV. Moreover, the publication of IFRS 9 in 2014 has decreased the potential to use historical cost accounting for financial assets, making marking to market essential.
FV is the exit value at the time of consideration and, by definition, does not permit any consideration of the holding period to be incorporated. Thus the principle of FV is that, in the absence of a market, it is possible to estimate a value as if the market exists. Any estimation should therefore constitute a proxy for this market value and, as such, the modelling should always try to favour observable market values. Also, irrespective of the methodology used to arrive at FV, there can only be one FV per asset at a time, and this unique FV cannot depend on the investor’s holding intentions or business model. The International Private Equity and Venture Capital Valuation (or IPEV) provides guidelines for private market participants, and its board’s view of FV is in alignment with US GAAP and IFRS. For example, IPEV (2022) guidelines state:
“The Valuation Guidelines have been prepared with the goal that Fair Value measurements derived when using these guidelines are compliant with both International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US GAAP). This has been done in order to provide a framework, which is consistent with accounting principles, that Private Capital Funds should utilise to determine a Fair Value for Investments.”
IPEV reiterates that FV can only be a value that corresponds to the market parameters at each measurement date; this definition leaves no room for the idea of a conservative principle such as claiming that the valuation is done below the FV at exit value or that exit usually happens at a higher price. Such claims are often promoted by GPs as providing a smoothing effect and protective effect on PE investments; they are in violation of FV principles and do not give investors better information about their investment performance or future potential. Even in the US, regulations such as Accounting Standards Codification 820 (ASC 820) (SEC, 2016), enacted in 2018, require PE funds to report the FV of the assets to their investors. ASC 820 defines how FV should be calculated for financial reporting purposes. It establishes an FV framework applicable to all measurements under the US GAAP. Before ASC820, US GAAP allowed PE funds to report valuations based on historical costs or simply the valuation in the latest financing round (Easton et al., 2020).
ASC 820 lays out a three-level hierarchy of FV measurements, with level one for liquid assets, level two for assets that can be priced with market inputs such as derivatives, and level three for highly illiquid assets, such as investments in private companies. IFRS 13 applicable in Europe also provides similar recommendations for computing FV of illiquid assets (Grant Thornton, 2021).
Thus, using the proposed factor model is in line with IPEV guidelines, ASC 820 framework, and IFRS 13 for unlisted assets. Specifically, calibrating a model with observed transactions that are orderly transactions happening at arm’s length automatically adheres to the recommendations on calibration and backtesting, respectively, in IPEV guidelines.
IPEV (2022). International Private Equity and Venture Capital Valuation Guidelines. International Private Equity and Venture Capital. Accessed July 17, 2024. https://www.privateequityvaluation.com/Portals/0/Documents/Guidelines/IPEV%20Valuation%20Guidelines%20-%20December%202022.pdf
SEC (2016). Form 10-K: Richardson Electronics, Ltd. U.S. Securities and Exchange Commission. Accessed July 17, 2024. https://www.sec.gov/Archives/edgar/data/96885/000118518516005266/R15.htm.
Easton, P. D., Larocque, S., & Stevens, J. S. (2020). Private Equity Valuation Before and After ASC 820. SSRN. Accessed July 17, 2024. https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=3314992.
Grant Thornton (2021). IFRS 13 – Fair Value Measurement. Grant Thornton International Ltd. Accessed July 17, 2024. https://www.grantthornton.global/en/insights/articles/ifrs-13/.