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(May-2004) New PE guidelines:be on the lookout
The Australian Venture Capital Association (AVCAL) recently released a new set of guidelines for the valuation and disclosure of private equity investments.
Such investments typically cover venture capital, management buyouts, and growth or development capital, and represent a growing percentage of a superannuation funds’ asset allocation.
The new guidelines must be used by AVCAL members (generally most of the leading private equity managers) from January 1, 2004 when reporting to investors in private equity funds. Accordingly, the guidelines will impact the value of private equity investments that are held by superannuation funds either directly or indirectly through a private equity fund.
The new guidelines place greater emphasis on market value based measures compared to the previous guidelines, which principally relied on cost-based valuation measures. They recommend different valuation methods depending on the stage of development of the underlying business. Further, the guidelines stipulate a primary method of valuation to select and a recommended secondary method as a crosscheck for the values obtained from using the primary method.
The following is a brief summary of the new guidelines compared to the old guidelines.
n The shift from a cost-based approach to a market based approach is likely to provide superannuation funds with a more up-to-date view of their investment. For example, where a business has performed better than expected in the current year, this should lead to an increase in its value. At the same time, the new guidelines may lead to more fluctuations in the value of the investment as it depends on the performance of the business. This has ramifications for a superannuation fund in terms of its annual investment returns. Further, the treatment of movements in the value of the investment from an accounting and tax perspective will need to be considered.
n The use of revenue multiples has been recommended as a primary method for early stage and mid- or expansion- stage companies. This method values a business as a multiple of its sales. The approach was typically used to value start-up businesses with losses during the internet/technology boom a few years ago. This approach can be particularly subjective and lead to wide fluctuations in value.
n The discounted cash flow (DCF) approach, which is suggested as a secondary methodology in the new guidelines, may be more appropriate for businesses during the development phase. These businesses typically exhibit high annual growth rates in sales and profitability and its annual cash flow may fluctuate significantly from year to year. This is best captured under the DCF method which values a business based on its future cashflow forecast.
The reliability of the DCF method is, however, significantly dependant on the integrity of the forecast information. In new start-up situations, where the businesses are still exploring markets and products, there can often be a relatively high degree of uncertainty around the forecasts. In such cases, we believe that using the DCF methodology in conjunction with other techniques such as probability-weighted scenario analysis, options pricing and decision tree analysis may represent the best valuation approach.
n Industry valuation benchmarks have been recommended as a secondary method. The use of industry valuation benchmarks is common in a number of industries eg. “price per subscriber” for cable television companies and “price per bed” for nursing homes. These industry benchmarks provide a useful cross check and allow comparisons to be made with other competitors in the same industry.
Overall, AVCAL’s new guidelines represent a positive step for the valuation of private equity investment in Australia.
It is hoped the guidelines will improve the consistency and transparency of valuations of private equity investments. The new guidelines are consistent with a general shift in financial accounting and reporting standards towards fair-value based measures over cost-based measures.
Managers and trustees of superannuation funds which have private equity investments will need to be familiar with the various valuation methodologies set out in the new guidelines and ensure that it is appropriately applied to a particular investment.
This requires a blend of technical knowledge, industry expertise, and above all, judgement and experience. An expert valuer can assist in this regard.
AUTHOR
Mike Taylor
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