Iâ€™d like to thank everyone at Truth on the Market for allowing me the opportunity to guest-blog over the past two weeks. Iâ€™ve really enjoyed the chance to share some of my thoughts and contribute in some way to this wonderful forum.
Before departing, I wanted to tie-up a loose end that I left dangling in my earlier post on private equity regulation (Iâ€™m sure folks have been up nights awaiting resolution of this issue). As my prior post discussed, I generally find little merit in the recent calls for subjecting the private equity industry to greater regulatory oversight. (You can read my prior post here). I suggested, however, that there are some market imperfections in the private equity industry that may merit some reform. What are these market imperfections? In general, they are the information asymmetries that result from the challenge of valuing privately-held corporations.
The problem is fairly straight-forward. Private equity firms are in the business of investing in private companies whose securities lack an established trading market. Consequently, itâ€™s not possible to obtain a current value of these securities as you would for, say, shares of IBM. Moreover, many of these companiesâ€”particularly start-up companiesâ€”lack reliable financial metrics that can be used to value the firms using other valuation techniques (e.g, discounted cash flow analysis, etc.). Where a company raises additional financing, the latest round of financing might provide a valuation of the company, but future financing rounds may be infrequent, if they occur at all.
Traditionally, the response of the private equity industry to this challenge has been to carry investments at cost (less impairments) until a value increase can be confirmed by a subsequent round of financing led by a third party or a liquidity event such as an IPO. In fact, this was the valuation method recommended in the informal valuation guidelines produced by the National Venture Capital Association in 1990. Interestingly, the concern was that VC firms would make unjustified interim write-ups in the value of companies; writing-down the value of a security because of adverse changes in the company was considered perfectly fine (the theory being that investors in VC funds would much prefer a surprise jump in valuation at an IPO or acquisition, rather than hearing that a prior write-up turned out to be overly optimistic.) As a result, a weird reality often exists on the books of many private equity firms in which the â€œfair valueâ€? of a company is significantly under-stated. An example commonly cited is Google, whose VC investors allegedly carried their investment at the valuation used in Googleâ€™s latest round of VC financing until the day of its IPO. (A more detailed discussion of the industryâ€™s valuation practices can be found here and here).
This â€œconservativeâ€? valuation practice naturally creates a number of challenges for investors in private equity funds who want to monitor the performance of fund managers. Until a portfolio company is sold, goes public or is liquidated, investors will have to rely on inaccurate data regarding the value of the fundâ€™s investment in the company. Of course, these are generally pretty sophisticated investors, and agency cost theory suggests things should work themselves out in the end. For instance, investors might discount the value of their investment to account for this problem or demand greater monitoring rights such as a right to participate in a fundâ€™s valuation decisions (indeed, major investors will generally demand a seat on a fundâ€™s valuation committee).
Yet there remains a broader problem that is created by the traditional valuation techniques. Using the conservative valuation method produces industry-wide performance results that may skew asset allocation decisions made by investors in private equity funds. David Swensen (chief investment office of Yaleâ€™s endowment) notes as much in his marvelous Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (2000):
By masking the relationship between fundamental drivers of company value and changes in market price, illiquidity causes private equityâ€™s diversifying power to appear artificially high. If two otherwise identical companies differ only in the form of organizationâ€”one private, the other publicâ€”the infrequently valued private company appears much more stable than the frequently valued publicly traded company. Although both companies react in identical fashion to fundamental drivers of corporate value, the less volatile private entity boasts superior risk characteristics, based solely on mismeasurement of the companyâ€™s true underlying volatility. Not only does lack of valuation information reduce reported risk levels, the private company gains spurious diversifying characteristics based solely on lack of co-movement with the more frequently valued public company.
Thus, Swensen emphasizes the need to engage in both a quantitative and qualitative analysis of private equity returns before making asset allocation decisions, lest an investor be mislead by the apparent diversifying power of private equity. One would hope all institutional investors engage in a similarly thoughtful analysis; yet so long as the â€œconservativeâ€? valuation methodology is used, investors may be misled by the apparent low volatility of private equity results (especially venture capital results). That very smart economists have occasionally advocated such a straight-forward quantitative analysis to make asset allocation decisions is further reason to be concerned.
All of this brings me back to the original issue of private equity regulation. Does the valuation problem suggest a need for government intervention? At present, it appears the industry is taking steps to solve the problem on its own. Over the last three years, both U.S. and European private equity investors have devised new valuation guidelines that require private equity firms to value portfolio securities at fair market value using one of several recommended valuation techniques. (For a summary of these initiatives, see here). Initial survey evidence suggests that these new guidelines are being implemented voluntarily by many private equity firms, especially buy-out firms. Venture capital firms are more reluctant to adopt them, owing to the difficulty of applying standard valuation techniques to start-up companies. Recent changes to the tax code (in particular, adoption of Section 409A), however, will now force start-up companies to make â€œreasonableâ€? valuations of stock grants, which should make venture capital firms more comfortableâ€”or at least, more experiencedâ€”with the notion of valuing their portfolio companies. FASB, too, may help spur movement towards fair value accounting for private equity portfolios in light of its initiative to require reliable fair-value measurements of all financial assets and liabilities.
To be sure, moving to a mark-to-market system is hardly a cure-all. Private companies will remain difficult to value, and even the new valuation guidelines will allow funds to use a variety of different measurement techniques. Inconsistent valuations will therefore result, and the potential for abuse by fund managers will remain (letâ€™s not forget that part of Enronâ€™s fraud relied on its use of fair-value accounting to value its special-purpose entities). My tentative conclusion at this point, however, is that the transition will at least diminish the potential over-allocation risk that the traditional valuation system created. While a mark-to-market system may create additional challenges for investors, my suspicion is that they can be managed through innovations in financial contracting. So in the short term, Iâ€™m inclined to take a wait-and-see approach on the feasibility of moving to a fair-value regime, but I could certainly be swayed otherwiseâ€¦