What's It Worth?

I am out here in San Francisco at a Private Equity Conference. Yesterday we heard all about these new valuation guidelines that are being promoted throughout the private equity business. In case you are interested, the Wall Street Journal ran a story about them yesterday that is a pretty good summary of the issue.

If you don’t want to pay to read that story, but are still interested, you can go to the website of the group that is promoting these new guidlines, called the Private Equity Industry Guidlines Group.

To sum this all up, this industry group is saying that our investments which are illiquid, can’t be easily sold, often have to be held for 5-7 years before we can exit them, must be valued on our books at “Fair Value”. Hey, that makes a ton of sense. If you are valuing your investments, they should be valued at what they are really worth. I can’t argue with the logic of that.

But I take objection to it anyway. Why? Because the way we’ve been doing it in the venture business for as long as I’ve been around is better. We’ve avoided writing up our investments until they’ve been valued higher than our cost by some real event – either a financing or a sale. But we have total freedom to write them down for any reason we think results in their impairment. This results in an inherently conservative assessment of the value of the investments. But even so, when one of our partnership interests trades in a “secondary sale”, it always goes for less than our current carrying value. So the reality is that our conservative bias in valuing our investments isn’t conservative enough to reflect market realities.

And yet the industry is now saying we need to be less conservative. We need to write up our investments in the same way we write them down. If something happens in our companies other than a third party financing or sale that makes them more valuable, we should reflect that in a higher valuation. I don’t think that’s a good idea. Who is to say that the increase in value is permanent? Why are the General Partners a good aribiter of that value? Doesn’t this offer an incredibly tempting opportunity to “play with the numbers” when it comes time to raise another fund.

I can see why this is a good idea for the buyout business. Those investments are often held at cost for many years without an external valuation event because there aren’t subsequent financings in that business the way there are in the VC business. And value in that business is much more a function of cash flow and so as cash flow increases, the value clearly goes up. And the valuation multiples in the buyout business aren’t nearly as volatile as they are in the tech driven world of venture capital.

So if the industry wants to change the way the buyout funds value their investments, that sounds like a good idea to me. But I don’t think the industry should change the venture capitalist’s current methodology.

There were two other substantitive recommendations which I enthusiastically endorse. The Private Equity Industry Guidelines Group proposes that all funds be valued every quarter and that it be done in consultation with a valuation committee comprised of a select group of the fund’s investors. Both of these recommendations are consistent with the way most venture capital firms operate today, but making this the rule instead of the norm sounds like a good idea to me.