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.