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Measuring the performance of private equity investments is a tricky subject. Because the companies in question are unquoted there is no published share value as such. So various techniques can be employed to value them and the funds which invest in them.
In addition, performance data is provided by the private equity firms managing these investments. And with different valuation methods available, the comparability of return figures for individual funds can be in doubt.
“As the industry develops, this is increasingly becoming an issue,” says Steen Villemoes, Nordic representative of Altius Associates, a gatekeeper and private equity adviser to institutions. “If you have audited figures – usually for the larger funds – then there is more reliability, but certainly for the smaller funds, calculated figures are an issue. It is only when you have access to the individual cash flows of investments that the performance figures can be checked.”
“There is a problem, in that we sometimes see figures that are not right,” says Jan Bernhard Waage, managing director, Wassum Investment Consulting in Sweden. “We work out the figures ourselves and can get a different result from those published – sometimes by a wide margin.”
“The fundamental problem with private equity is that you have at any point in time a portfolio with participation in privately-held companies with no market value,” says Stefan Hepp, chief executive officer and founder of Strategic Capital Management, a private equity adviser to pension funds and insurance companies. “So how are these companies to be valued? Each method requires judgment. For instance, if you use multiples of earnings, the question is what sort of multiples are appropriate for a specific company.”
There is then the issue and importance of defining the parameters used. Earnings, for example, could be earnings before interest and tax (EBIT), earnings before interest,
tax and amortisation (EBITA) or earnings before interest, tax,
depreciation and amortisation (EBITDA). And returns could be gross or net of management fees.
“Furthermore, private equity companies can be conservative or aggressive in the way they react to value changes,” says Hepp. “For instance, if a company loses its biggest customer, you could write down the investment. Or you could leave it unchanged because you know the situation is temporary since the company is due to start another contract later in the year. The point is that investors need to understand how these people arrive at their valuations. They need to have an idea of how aggressive the general partner is. Once they know that, they can adjust the figures to make them comparable.”
Without this information, the danger is that many pension funds that do not have the resources to compute figures on a like-by-like basis run the risk of taking them at face value, he says. This means they could end up making the wrong investment decisions, because comparisons with peer groups or other benchmarks are not totally accurate.

Scrutinising the performance figures of their clients’ investments is, of course, part of the remit of pension fund consultants.
“We get the fund of funds data from fund of funds managers, but we don’t just take what they give us,” says Phil Chesters, European partner, Mercer Investment Consulting. “We ask for more information which we can use to compare more directly with other funds.”
One way to measure performance is to compare the investment with publicly quoted funds. Chesters says that the only proper way to do this is to look at the cash flows – the call for money into the fund, then the return from the fund.
“You could then calculate the return from the same amounts of money paid into publicly-quoted equities, using market indices,” he says. “That way you can see whether the private equity manager is beating the public market. But for that you need the cash flow information.”
Both the UK and European Venture Capital Associations have previously published separate sets of guidelines on fair valuation, the first British proposals being released in 1987. However, last year the two organisations plus the French Private Equity Association issued a new set of guidelines to embrace the European private equity industry as a whole.
The consultation period ended on 28 February, although the guidelines are already in force.
“The original EVCA guidelines were very different to those in the UK,” says Anthony Cecil, head of assurance, KPMG private equity group, who drafted the guidelines on behalf of the working group. “The fundamental difference is that in the UK valuation is an art, not a science, whereas the EVCA guidelines were more rigid. The new guidelines give people a framework within which they can work, exercising their professional judgement.”
The guidelines, which comply with IAS39, set out best practice where private equity investments are reported at fair value, which is defined as the price paid by a willing buyer to a willing seller.
They give details on the principles of fair value and a list of valuing methodologies, such as price of recent investment, earnings multiples and discounted cash flows. Guidance is given on how to select the appropriate methodology. For example, the cost of the investment is likely to be an appropriate method for up to a year after the investment in a company is made, while an earnings-based methodology is likely to be more appropriate where the business is well established and has consistent income streams.
Valuations should also be adjusted to events that have an impact on value. “This process is very similar to previous BVCA guidelines, in making people disclose what they are doing,” says Cecil. “We’re not trying to stop prudence, we’re trying to stop outrageous prudence.”
“I wouldn’t say there is outrageous prudence at the moment,” says Hepp. “The policy should be to keep things at cost, as long as there is no substantial change in circumstances. They should be cautious on the upside, and conservative on the downside, so there are no bad surprises. So fair value may be an underestimate of true value, but is probably more desirable than risking an overestimate of true value.”
And he says that the comparability issue is not confined to the pension fund’s own investments. “Even if your own figures are accurate, you don’t know how accurate the external benchmark is,” he says. “The guidelines are very useful and they do rule out some practices, but they still leave some room for manoeuvre. So they will not guarantee cross-comparability between funds.”
“You are always going to have problems with comparability between funds,” says Cecil. “The only way to make them comparable is to follow the same mathematical process for valuation. I don’t think the new guidelines will necessarily give a boost to the private equity industry, but they will make reporting more consistent.”
One new ingredient in the mix, at least as far as the UK is concerned, is its Freedom of Information Act, which came into force on 1 January. Under the Act, thousands of public authorities have to make certain information available to the public.
In the US similar laws have enabled entrepreneurs to write to local authorities demanding information on their pension fund performance with the intention of publishing the returns on private equity investments. It remains to be seen whether a similar situation develops in the UK.
“The problem is that under the act, new performance data could be published without any caveats on how it was calculated,” says Chesters.
Nevertheless, in spite of his qualms, Hepp does see a slow but sure move in the right direction. “There is now a trend among pension fund trustees to be more focused on what the numbers mean, driven by auditors who demand a fair value approach,” he says.

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