Since 2007, the "fair value" rule has applied to the valuation of assets held by institutional investors, with the definition of fair value as the price that would be received by a seller for an asset in an orderly transaction between willing market participants at the measurement date. These accounting rules explicitly require institutional investors to take market prices and conditions into account when valuing all their assets. Private equity fund managers themselves, therefore, had to implement these rules.
However, the application of the rules created certain difficulties. Establishing the valuation of a private company as if an orderly transaction were executable can be problematic; the price of private companies can be elusive until there is an actual transaction between willing market participants. The International Private Equity and Venture Capital Valuation Guidelines, first written in 2012, provided some guidance, by offering a pecking order of valuation techniques. The top two methods — the price of the most recent investment and multiples of listed comparable companies — use a market approach, which led fund managers to mark portfolio companies to market.
The multiples method is the most frequently used to value private companies. In stable market conditions, this method can provide an acceptable estimation of the value of a private company. Nevertheless, one of the drawbacks of the system is to transfer some of the volatility of listed companies to private portfolios. As many institutional investors associate volatility with risk, this potentially means that private portfolios could be perceived as riskier than they actually are. In reality, private companies are not traded at the measurement date and are usually sold only when the price is attractive enough, therefore fair value reporting could artificially magnify the risk associated with private assets.
Ten years after the generalization of the fair value rule, it is possible to assess whether the value of private equity portfolios has recorded a higher volatility. To explore this we have analyzed the impact of two major crises on private equity portfolios: 2001-2003, prior to the implementation of the rule, and 2007-2009, which happened simultaneously to the introduction of the fair value method.
Figure 1 shows the multiple of invested capital, or MOIC, of U.S. levearged buyout funds of vintage years up to 1996 progresses rather smoothly, with a marked acceleration around the 16th quarter. Assuming an average holding period of 3.5 years, this would match with the first sale or refinancing of portfolio companies. Despite recessions and geopolitical events, the funds captured in the sample did not register any correction of their valuation.
The picture changes with vintage years 1997 to 2001 (Figure 2), theoretically affected by the crisis of 2000-2003, and for younger funds the crisis of 2007-2009 as well. While the fair value rule was not yet mandatory during these periods, the price of portfolio companies reflected the evolution of stock prices.
The maximum drop of the MOIC is registered in 1999 with a 25.1% decrease between the peak of Q3 2000 at 1.10x and the trough of Q4 2002 at 0.82x. As a matter of comparison, the S&P 500 lost 47.4% from Aug. 28, 2000, to Sept. 30, 2002. The MOIC of vintage years 2000, 1998 and 1997 dropped respectively by 19.7%, 17.2% and 16.5%.
How were vintage years affected prior to the 2007-2009 crisis? The difference in the profile is visible in the vintage years 2000, 2001 and 2002, which record strong performance, while 2007 and 2008 record good performance and 2009 an exceptional one.
Strikingly, despite the introduction of the fair value rule in 2007 and its implementation during the following years, the sensitivity of the vintage years to recessions does not seem to have changed significantly. The magnitude of the drop of the S&P 500 is similar (56.2%) between Oct. 8, 2007, and March 2, 2009, and from 2000-2002. The maximum drop of MOIC is registered for the vintage year 2006 at 32.4%, while the MOIC of vintage years 2004, 2005, 2007 and 2008 dropped respectively by 16.5%, 18.9%, 20.3% and 31.1%.
What could explain the fact that the two crises were recorded similarly in the MOIC of LBO funds? The fact that the crisis happened just after the implementation of the new rule began could be one reason: LBO funds were still in the process of implementing it. A second explanation is that as this was a V-shaped stock market crash: the drop in the value of listed companies was as sharp as the recovery. Some of this volatility was therefore eliminated as fund managers consider average valuations over a significant period of time.
From our analysis, two conclusions stand out. First, fund managers already started to take into account the evolution of listed assets in the valuation of their portfolio before the generalization of the fair value rule. Second, the introduction of the rule in 2007 did not translate immediately in significant visible change in the evolution of MOIC of LBO funds during the subsequent crisis. Among the possible explanations are the unprecedented nature of stock market crash experienced in 2007-2009 as well as the time required to implement the rule changes. The next significant market correction will therefore be a truer test of the application of the fair value rule.
However, if one thing remains sure, it is that each crisis is unique in its trigger, strength, length and recovery. Marking private companies to market will therefore likely remain an art as much as a science for the foreseeable future.
Thibaut de Laval is chief strategy officer of eFront in Paris. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.