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Private equity valuation guidelines explained

Harpreet Kaur Harpreet Kaur

An updated version of the International Private Equity and Venture Capital Valuation (IPEV) Guidelines was issued in December 2018, superseding the previous 2015 version.

The amendments aim to eliminate misinterpretation and ensure compliance with both International Financial Reporting Standards (IFRS) and United States Generally Accepted Accounting Principles (US GAAP). The guidelines represent best practice for the valuation of private capital investments and are effective for reporting periods beginning on or after 1 January 2019.

The guidelines are applicable across the entire range of alternative funds – seed and start-up venture capital, buy-outs, growth/development capital, infrastructure and credit – as well as financial instruments commonly held by these funds.

The amendments made to the guidelines lay emphasis on ‘private capital’ investments to be reported at ‘fair value’ to standardise the valuation approach worldwide and help investors make better economic decisions. Further, the guidelines emphasise the need for calibration and back-testing, a written valuation policy, proper documentation of the valuation process and the use of independent persons to be involved with the valuations process.

Notable is the removal of Price of Recent Investment (PRI) as a standalone valuation technique. This change is to reinforce the premise that the fair value must be estimated at each measurement date and PRI must not be applied blindly without additional analysis for an extended period.

Further, the guidelines provide additional guidance about the valuation of debt investments, and early stage investments.

Key highlights from the guidelines

Removal of PRI as a valuation technique: PRI should not be considered as a standalone valuation technique to reinforce the premise that fair value of investments must be estimated at each measurement date. Earlier versions of the guidelines allowed PRI as a standalone technique, but it was used sometimes blindly without an additional analysis for an extended period. PRI may be considered as a starting point to estimate fair value for measurement dates subsequent date of investment.

New guidance for valuing debt as an investment: The guidelines have extended valuing debt investments, which typically includes senior debt, mezzanine loans, shareholder loans, cash pay coupons and/or equity enhancements (such as warrants). The debt investments are required to be fair valued as at the measurement date using a market or income approach considering risk, coupon, time to expected repayment and other market conditions. The fair value of debt is deducted from the enterprise value to estimate fair value on a market participant basis at each measurement date. The guidelines recommend using a discounted cash flow method as the cash flows and terminal values of debt investments can be predicted with certainty. Further, for valuation purposes, any warrants attached to the mezzanine loans may be considered separately.

Additional guidance for valuation of early-stage investments: The guidelines provide a description regarding the valuation considerations for early-stage investments. Typically, a milestone analysis or a scenario analysis is considered in determining fair value. However, it is difficult to assess the probabilities and the financial impact of any research and development activities for these types of investments. It is therefore recommended that the fair value of these investments should be estimated using a valuation technique based on market data. Furthermore, the industry-specific benchmarks/milestones should be considered to calibrate the values derived from the milestone analysis or scenario analysis, where appropriate.

Clarification regarding treatment of transaction costs: The transaction costs are, sometimes, capitalised as part of investments costs in accordance with the applicable accounting standards. The guidelines recommend that these transactions costs should be excluded from the valuation analysis, as they are not considered a characteristic of an asset.

Valuation of infrastructure investments: It is recommended that an income approach should be considered for the valuation of real estate infrastructure investments as enough market transaction data is not generally available. The guidelines clarify that the inputs considered for a discounted cash flow technique should be based on a market participant basis.

‘Private equity’ to be replaced with ‘private capital’: To prevent misunderstanding and highlight the applicability of the guidelines to various types of private investments in debt and equity, the term ‘private equity’ was replaced with the term ‘private capital’.

If you would like to discuss any of the updates to the guidelines or have a more detailed conversation about our portfolio valuation capabilities, please contact Harpreet Kaur.

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