GMT’s Long agrees. “Speaking with some of my peers, it’s clear they’re now saying whatever’s in the accounts doesn’t really bear a strong relationship to what they think the underlying value of the company is,” he says. Other private equity players describe mark-to-market as “trying to make an art a science.” For Tim Green, Long’s colleague and a managing partner at GMT, it’s an exasperating situation. “What you [have to] put down is the value at which an unrealistic view of a seller would be prepared to sell to a potentially willing buyer,” he says. “What the hell does that mean? It’s a bit of a joke.”
Fair-value accounting has led to some notable write-downs. London-based Terra Firma, for example, wrote down its portfolio from €7.8 billion in 2007 to €4.5 billion last year, leading it to give back to investors performance-related payments the management team would have accrued since 2004.
Yet the International Private Equity and Venture Capital Valuation Board (IPEV)—set up by pan-European private equity bodies—insists that fair value is the best measure of a portfolio company’s worth. The board argues that institutional investors should be able to monitor the interim performance of a private equity asset. According to David Larsen, a managing director at adviser Duff & Phelps and an IPEV board member, “There is volatility with investments. To mask that volatility by not reporting it does not cause it to go away.” Most private equity firms have subsequently agreed to use fair value under the IPEV guidelines.
Rowland says Alchemy Partners is happy to follow the IPEV guidelines, if only because it gives the firm a reason to keep in constant contact with its investors to explain why a write-down under mark-to-market doesn’t mean a portfolio company’s worth is crashing.
Indeed, the lesson from all this is that close communication with investors is crucial for private equity firms. At AXA Private Equity, Florin says he is “on the frontline with investors” today. “As the CFO, the main objective is to get the best quality of information to your [investors],” he adds. Fortunately for Florin, he knows just what they want. He joined the firm in 1998 to help set up its fund of funds division—that is, an investment fund which invests in a range of other private equity portfolios—and so understands from such experience what investors want to know. “Now that I’ve moved to the other side, I have in mind the quality [of information] that the investors are looking for,” he says. “The more detailed the information, the better it is.”
The private equity landscape is still shifting. Following debates about its business model which have raged in recent years—particularly in the UK, where big buyout firms have been demonised as asset-strippers, and Germany, where they are still frequently referred to as “locusts”—the expectation is that the industry will create a pan-regional code of conduct, covering reporting and transparency, among others. The European Venture Capital Association, an industry body, sent a 300-page letter to the European Commission, which promised to work with it to develop a new regulatory framework.
CFOs, though, are wary of any new regulation. “The kind of risk we’re all concerned about is systemic risk and a blow-up,” Long says. “And guess what? What we’ve had [during the crisis] is systemic risk and a blow-up, which wouldn’t have been stopped by over-legislating against private equity firms…If you want to control leverage, pricing and over-valued assets, you can do it by sheer quantitative controls.”
While firms wait to see how any regulatory changes will affect private equity, AXA’s Florin doesn’t expect a return to the highly leveraged buyouts of recent years. Rather, he predicts, private equity will focus once again on growth capital. Back in the 1990s, he says, “private equity was almost only expansion capital or development capital. I think with the current crisis, our industry—or some players in our industry—will move back to [that] original business model.”
And some believe that new opportunities will arise from the downturn. Alchemy Partners’ Rowland says private equity is facing “one of the best periods for investing, probably since the last recession in the early 1990s.” He claims that historic returns for private equity are strongest coming out of a recession, when valuations are low and executive teams have the benefit of having managed through a downturn. Alchemy has a £300m special-opportunities fund, predominantly focused on distressed debt investments. Today it has yet to invest 40% of its available capital, so the firm has plenty of purchasing power for when the team decides the market has bottomed out. For Rowland, it’s a matter of keeping their options open. After all, as he says, “one of the challenges of the private equity business is that you should be able to invest through good times and bad.”
Tim Burke is a senior editor at CFO Europe.