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Valuation Guidelines for Private Equity and Venture Capital

Valuation Guidelines for Private Equity and Venture Capital

Kenneth Ma

In response to the increasing demands for building consensus within the valuation industry, various valuation guidelines have been developed to suit different purposes, and to cater different needs. Among them the International Private Equity and Venture Capital Valuation (IPEV) Guidelines and International Valuation Standards (IVS) are two of the most widely adopted standards in the private equity investments and accounting practices respectively.

First launched in March 2005, the IPEV Guidelines set out recommendations on the valuation of private equity investments. The objective of the guidelines is to provide uniform and principle-based valuation guidelines for private equity and venture capital practitioners, especially during and after the M&A transaction processes.

According to IPEV, the term “private capital” is used in a broad sense to include privately held (i.e. unlisted) investments in early stage ventures, management buyins/buyouts, infrastructure, credit and similar assets, as well as funds investing in such assets. Therefore, IPEV was set in a form that is simple for all practitioners, including private equity managers, institutional investors and investment professionals, regardless of the size of their investments, to implement. Nowadays, many limited partnership agreements and venture capital agreements are required to comply with the IPEV Guidelines when it comes to entering into positions in portfolio companies. Demonstrating compliance with IPEV can ensure all fund interests are measured in the same basis and hence provides additional comparability between the funds and minimizes the asymmetric information issue.

IPEV Guidelines are updated every 3 years. The latest edition issued in December 2018  enhanced the previous 2015 guidance and eliminated confusion with respect to valuing early stage and debt investments. It provides further guidance on areas such as the use of the price of a recent investment as a valuation technique to enhance the premise that the fair value must be estimated at each individual measurement date and on the investment date.

On the other hand, the IVS, which was first published in the 1980s by the International Valuations Standards Council (IVSC), is a universally accepted valuation standard for a wide range of assets, including equity interest, financial instruments, real property, intangible assets, and commercial interests, with an aim of building confidence and consensus within the valuation industry by creating a framework for the delivery of credible valuation opinions by professional valuers. IVS provides explanations of common valuation methods and principles, as well as guidelines that the valuers should follow during the bearing of an assignment. Hence, the diversity of the valuation standards applied across different countries and markets is greatly restricted.
Fair value is a widely adopted set of basis across valuations as IPEV Guidelines, the IVS, and even worldwide accounting standards such as IFRS 13 all share the same consistent definition - “Fair Value is the price that would be received to sell an asset in an Orderly Transaction between Market Participants at the Measurement Date”.

Despite the similarities above-mentioned, there are some key differences between the IPEV Guidelines and IVS. For instance, the IPEV Guidelines considers that fair value is the preeminent form of valuing private equity investments. Fair value valuation requires the application of professional judgments to ensure that the reported values are robustly determined. Such judgements needed to be consistent between valuations in order to enhance the relevance, reliability and comparability of fair value estimates. The IPEV Guidelines further elaborates that when the price of the initial private equity investment is deemed as fair value, the valuation techniques that are expected to be applied in the future should be calibrated using market inputs as of the date the investment was made.

Also, the IPEV Guidelines addressed when cost can be used in establishing a value for private equity investments. The guidelines state that although the recent investment price is prohibited to be adopted as the valuation basis, cost may still be used in representing fair value if such applicability can be proved by the valuer.
Moreover, the guidelines point out the necessity of incorporating backtesting as a component of the valuation process, in which the valuer should seek to understand the substantive differences that legitimately occur between the exit price and the previous fair value assessment, by comparing an actual liquidity event (for instance, sale and IPO) to the most recently determined fair value estimate. At such, the valuer can continuously improve the rigor of the fair value estimates.

Recently, the IVSC signed a memorandum of understanding with the board of the IPEV. The two organisations have agreed to work together with a view to ensure both valuation guidelines are consistent with each other. At such, the IVS will consider the increasing demands of the private equity and venture capital investors in its future revision.

That being said, as the investment flow is becoming more globalised and connected, all practitioners and participants in the valuation industry, including fund managers and other investors, should expect various principle-setting agencies to work hand-in-hand to achieve more consistent standards, which will deliver them the required level of transparency regarding the value of their private equity investments.

The table below summarises the similarities and differences between IPEV and IVS:
Feature IPEV IVS
First published date 2000s 1980s
Purpose Building consensus within the valuation industry
Latest version Dec 2018 (updated very 3 years) Jan 2020 (updated from time-to-time when necessary)
Valuation subject Primarily private equity investments A wide range of assets, including equity interest, financial instruments, real property, intangible assets, and commercial interests
Usage Mainly for M&A purposes For a variety of purposes, including tax, financial reporting and litigation purposes
Definition of Fair Value The price that would be received to sell an asset in an Orderly Transaction between Market Participants at the Measurement Date
Basis of valuation Considers that Fair Value is the preeminent form in valuations of private equity investments Basis of value is selected on a case-by-case basis. Besides Fair Value, other basis such as investment value, liquidation value also exist.
Backtesting and calibration The requirements of incorporating backtesting and calibration during the valuation process No such requirements

This article was written by Kenneth Ma, a director of Corporate Finance at Moore Hong Kong. 

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