LPs Need To Trust General Partners in Setting Valuations –

The call for public scrutiny of the highly private world of venture capital peaked recently with the disclosure of some funds’ interim internal rates of return. There is much that is worth debating about the wisdom of public disclosure of interim fund IRRs, but the debate ignores the important point that these IRRs are only as good as the data that goes into calculating them, namely the underlying portfolio company valuations.

Interim IRRs do not report a “true” return on a fund’s investments. They are an interim report on the performance of the fund and rely on a general partnership’s assessments of unrealized portfolio company values. Any discussion over IRR disclosure must strive for a better understanding of what constitutes best practices in assessing interim company valuations. Central to the debate is the need for limited partners to have confidence in GP valuation practices and to recognize the importance of GP judgment in applying them.

(For more on valuations, see the Blaydon & Horvath column in the October 2002 issue of VCJ).

IRRs are a touchy subject with investors, who have always been concerned about the understandable incentive of a GP-particularly when fund-raising-to put its investment performance in a favorable light. This concern led to much discussion and guidelines aimed at standardizing the information and calculations to be used in computing IRRs. But until the recent market downturn, there was little demand for public disclosure of fund IRRs and little discussion or debate about underlying portfolio company valuations. This was understandable in an era when IRRs were high and most valuations rose over time.

The UTIMCO Factor

The market downturn prompted the highly publicized demands by newspapers for disclosure of private equity returns by the University of Texas Investment Management Co. (UTIMCO), the California Public Employees’ Retirement System (CalPERS), and the California State Teachers’ Retirement System (CalSTRS). Demands for disclosure at other public pension funds will certainly follow. But these demands lack sufficient discussion of how the underlying assessments of company value are arrived at, other than to note that some funds may have widely differing assessments of the value of the same company, much to the frustration of LPs to whom these assessments are reported.

As commonly referred to in the venture capital industry, IRRs include a current assessment of the value of unrealized investments held in a fund portfolio. Another IRR could be calculated that takes into account only actual cash flows in and distributions out (so-called cash in/cash out). This is the IRR that would be calculated for a fund after it is finally wound up and no unrealized investments remain. If this IRR were calculated over the life of the fund, it would not be subject to any debate about interim unrealized values for the portfolio company. But any such calculation implicitly assumes that unrealized investments are being carried at zero value, which would mean that the usual J Curve that shows negative fund returns in early years of a fund would be much more negative.

There are other downsides to this type of IRR calculation. One, it does not reflect any of the very real, if hard to assess, value of the unrealized investments. Two, it would not give LPs a sense of the current value of their investment and would also portray the performance of the fund very unfavorably, especially in cases where a GP cuts losses early in an effort to focus money and time on potential winners. For this reason, most LPs and GPs want to see interim valuation assessments as part of the financial reports to investors. But in current market conditions, it is these interim valuations that cause the problem.

The Valuation Challenge

There has been a widely used valuation approach in the industry for more than a decade but it has always been the subject of some criticism and, in some respects, may offer insufficient guidance for how to assess valuations under current market conditions. Most firms have used some form of the guidelines that were proposed to (but never adopted by) the National Venture Capital Association in 1989. In general, these guidelines specified that an investment in a portfolio company should be carried at cost, or at the value set by the last round of financing (if the financing included a new outside investor), or at some other appropriate value if the company had experienced a material change.

These guidelines were seen as comfortably conservative when most company outlooks were improving, but it was always recognized that these valuations could become “stale” if no financing event resulted in a change for any length of time. In a market where “material adverse changes” are dismayingly frequent, this conventional approach does not give much guidance. Even when there are financing events, the aggressive non-price terms often seen in follow-on deals today will mean that a valuation based on the price per share of the financing may not reflect a reasonable assessment of company value.

The attraction of the conventional approach was that it was a simple prescription that required little effort or judgment to assess (apart from the nettlesome “adverse change”). But while easy, these guidelines are increasingly seen as inadequate under today’s circumstances. “Staleness” does not look conservative if value is declining, and the admonition to do something appropriate under those circumstances is not much guidance. This dilemma is widely recognized and there are a number of efforts underway by both established bodies of LPs and GPs as well as ad hoc industry groups.

Most industry participants would still like to see a prescription that could be easily followed. GPs see their jobs as making good investments and working to make their investments succeed. Spending a lot of time and effort to better assess interim valuations is seen as a potentially large demand on their time and attention that will not improve the final outcome of the fund. While understandable, the search for simple prescriptions is counterproductive if a standard and agreed-upon measure of accuracy is the goal. There are many valuation methodologies that can be applied but no one methodology will fit every set of circumstances. Any disclosure of IRRs, regardless of how accurately calculated, would be misleading or misunderstood without recognition of this fact.

Potential Prescription

If simple prescriptive rules are not adequate under today’s circumstances, what is needed? What is required is agreement on the goal of what a valuation is supposed to represent, in principle, and reliance on the professional judgment of the GPs as the ones with the best information to make the valuation assessment.

As one prominent GP told us, “Our LPs give us a lot of freedom and expect and trust us to use our best judgment in making investments. They should also expect us to also use our best judgment in making valuation assessments and trust us to do the right thing.” What is needed is agreement on “the right thing” accompanied by helpful guidance on best practices.

Given that the desired result is an assessment of a company’s value at a point in time, the goal is to assess the market value of that entity at that time. Such a “mark to market,” or fair market value standard, has broad acceptance in principle, but it has often been seen as difficult to achieve or subject to abuse for investments without a readily available market and a long time horizon. The abuse of such an approach gained attention in the scandals over “marking to market” long-term energy contracts.

The venture capital industry has a built-in advantage that can help with this problem. Generally more than one GP invests in a portfolio company. In the past, different VCs may have had different valuation policies and it was difficult to know if differing valuation assessments of a portfolio company were due to different assessments of the company or simply reflected a different policy. If there is agreement on the principle that the valuation should be an assessment of market value, then differing valuations by VCs should reflect their different assessments of the company, not a mechanistic reliance on a particular “approved” valuation calculation. LPs could then look at differing valuations as differing judgments about a company’s health and prospects and not as confusing contradictions that are hard to understand.

Still, the assessment of value for a privately held investment is not simple and requires thoughtful judgment. There are many methodologies that can be applied, ranging from use of comparable transactions to public market comparables to variations of discounted cash flow analysis to the company’s own financing experience. These various approaches can lead to widely different valuation assessments and one might be tempted to dismiss the whole idea as hopelessly speculative. But if the underlying principle of market value is agreed upon, sorting through which approaches are most appropriate in a given situation becomes an exercise in judgment by those in the best position to judge, namely the GPs who are the investors in the portfolio companies. On the other hand, any set of guidelines that could be seen as primarily a list of acceptable prescriptions that could be applied mechanistically would not meet the challenge of today’s market environment.

In the end, investors will be best served by an approach to performance reporting that defines a clear standard and places the responsibility for portfolio company valuation judgments on GPs. That makes more sense than relying on simple prescriptive rules that may be easy to apply but will not capture the best available assessment of the value of a company.

Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth. They are also directors of the university’s Foster Center for Private Equity. They can be reached at pecenter@darmouth.edu.