Private equity’s mantra (under-promise and over-deliver) is falling out of favor

Since its inception almost 25 years ago, the mantra of private equity fund managers has been under-promise and over-deliver. In practice, this meant carrying a fund’s assets at cost rather than consistently updating their value on a periodic basis. Each asset – companies that the fund bought outright, invested in, or provided start up capital to – presumably used the investment funds to increase revenue, earnings and free cash flow. Fund managers, however, traditionally did not account for these incremental changes in value, giving their financial statements a conservative bias – essentially, they were under-promising, or tempering the expectations of their own investors, with the intent of depicting a surge in value when they exit from an investment either through M&A transactions or an initial public offering of common stock.

The large increase in value, fund managers hoped, would entice more investors – wealthy individuals and institutions – to ante up money for new funds that they wanted to launch.

And that’s exactly what happened. As IPOs throughout the 1990s generated tons of cash for young companies, especially those in the tech sector, no one questioned the status quo. Private equity funds and their investors saw their investments yield double and in some cases triple returns, so why rock the boat. But as the bubble began to deflate, the status quo prevented investors from realizing that private equity portfolios were losing value; assets were carried along at cost, as was the tradition, in spite of the changing market conditions. Not until after the bubble burst did investors realize that the fund managers failed to provide information that might have led them to cash out sooner and stem losses.

"The industry is anti-transparency by definition," said Fred Wainwright, Executive Director Tuck’s Center for Private Equity and Entrepreneurship. "The move worldwide is toward fair value accounting, and that’s a new ballgame for private equity funds." Fair value is a murky concept, and auditors want to establish a standard definition that will enable them to sign off on the books of private equity funds, reassuring investors that assets have been properly valued, without risking the consequences that befell Arthur Anderson.

In light of these concerns, everyone is wondering if the industry will govern itself, or allow an outside entity, such as the Financial Accounting Standards Board or the NASD, to step in as a regulator.

To head off the intrusion of a regulatory body, members of the private equity industry have formed a committee to standardize the process for updating the value of the assets in their portfolios. The committee, called the Private Equity Industry Guidelines Group, recently tabled the most widely recognized set of valuation guidelines.

In parallel, British Venture Capital Association, European Venture Capital Association, and France’s AFIC have jointly established an alternative, though similar set of guidelines for estimating fair value. On both continents, auditors are forcing the process along, joining institutional investors like insurance companies.

"Still, there’s a lot of work to do, a lot of figuring out how important it is to use these guidelines," said Colin Blaydon, Director of the Center for Private Equity and Entrepreneurship.

Some private equity funds have asserted that if they start using a standard set of valuation guidelines, too much of their financials will be exposed, revealing their investment strategies and eroding their competitive edge. "There’s a strong body of opinion that say that it will undermine the ability of funds to differentiate themselves from each other and build value," noted Blaydon.

Even some state governments are opposed to these measures. Colorado, Massachusetts, Florida and Illinois have passed laws barring their state pension funds from disclosing details of their forays in private equity investing.

What’s more, fund managers fear that this type of accounting will foster a ‘mark to market volatility’ in their funds, similar to the wild ups and downs of the futures market, because asset valuations will rise and fall with market conditions. This volatility, they worry, will scare off prospective investors.

"There’s one overriding issue in the mind of general partners – we do not want to give our investors any bad surprises," said Wainwright, paraphrasing concerns of fund managers he’s spoken to. "They’re not going to write something up based on their judgment of market value when the market value may go up or down dramatically a year from now."

Professors Blaydon and Wainwright are convening a group of industry professionals to determine how the industry, and its valuation guidelines, can mature without imposing a too onerous a level of transparency. Representatives from the Financial Accounting Standards Board, the National Association of Venture Capitalists, international accounting authorities, and general partners and limited partners from leading private equity funds will attend. Bladyon and Wainwright expect to publish the results of their work in June.