Fair Value: Challenges to the Private Equity Industry

BY DAVID L. LARSEN

The private equity (PE) market (including venture capital, buy-out, mezzanine and similar longer-term, illiquid investments) has expanded exponentially over the past 10 years.

U.S. GAAP requires private equity (PE) investments be stated at fair value. Given the nuances inherent in PE, there can be significant challenges in determining the fair value of underlying portfolio company investments. GAAP defines fair value as the “amount at which the investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.” The FASB’s proposed standard says fair value “is the price that would be received for an asset or paid for a liability in a transaction between market participants at the reporting date.”

PE managers always have had difficulty estimating the fair value of investments. For private equity funds that prepare financial statements in accordance with GAAP, the AICPA Audit and Accounting Guide, Investment Companies, provides the primary guidance on valuing investments. Many private equity funds, particularly venture capital funds, have used cost or the value of the latest round of financing as an approximation of fair value. Over time, managers have realized that more robust estimating techniques are needed to determine fair value. Industry groups, including the Private Equity Industry Guidelines Group (PEIGG) in the United States and the venture capital associations in Europe, have developed PE valuation guidelines that help managers estimate fair value in accordance with relevant GAAP rules in a consistent manner.

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