Since the emergence of the private equity and venture capital sector in Europe in the mid-1980s, this fast-growing sector has been steadily establishing itself as an asset class for institutional investors.
In addition to being able to demonstrate long-term returns which are at a significant premium over the listed equity markets, the industry has set out to ‘professionalise’ its activities through industry-wide adoption of valuation and reporting guidelines that will bring greater harmonisation, transparency and ultimately benchmarkability to the private equity sector.
At the centre of this has been the European Private Equity and Venture Capital Association (EVCA), which has endeavoured to establish coherent and harmonised performance measurement criteria for private equity and venture capital funds across Europe. A key to this is consistent and transparent valuation of the unquoted investee companies.
In 1993, EVCA made a great step forward in the professionalisation of the venture capital and private equity business by drawing up agreed principles for the performance measurement of funds. These principles, which have been widely adopted across the industry both in Europe and the US, have gone a long way to establish venture capital/private equity as a recognised and valued asset class and establish greater fund comparability, transparency and consequently increased confidence for funders.
In the light of rapid growth of the venture capital and private equity sector over the past few years and with a particular eye on the ‘new economy’ directions of some of the portfolios, the association has undertaken a thorough review of their valuation guidelines. This further refinement of the valuation guidelines, which complement the reporting guidelines launched last year, was felt shall help bring greater accuracy and transparency in the information provided to investors.

Survey of practitioners
In February 2000, EVCA brought together practitioners, investors and intermediaries under a ‘Valuation Guidelines Taskforce’ to review the existing guidelines and revise them where necessary.
An informal survey undertaken of the market practitioners and institutional investors showed that there was a widespread perception of the need for greater consistency of valuation standards by both managers of, and investors in, venture capital and private equity funds.
Greater transparency of fund valuation and reporting, it was felt, would help to assess performance more accurately. This in turn would help promote the asset class to new and existing investors.
Also, the increasing number and diversity of venture capital and private equity funds in existence have generated a desire among fund managers themselves to have access to comparisons with their industry counterparts.

The guidelines
A significant change from the 1993 valuation guidelines has been to eliminate distinctions between the ‘stage’ of the unquoted investment. A six-month-old start-up is now assessed on the same basis as a mature company.
The overriding principle is that valuations must be carried out in a consistent and professional manner, objectively and with integrity, and either by, or under the review of, senior management with the appropriate level of skill and experience.
Above all, two overriding principles should be employed when valuing investments:
q that the valuation should be prudent and applied consistently and professionally; and
q that the method, data and process used in coming to the valuation should be clearly disclosed.
The basis of valuation should be consistent from year to year and the effect of any changes in the method used should be clearly stated.
Valuations should be reviewed by a party independent of the fund managers. It is recommended that the appropriate body to review the valuations is the fund’s advisory committee, possibly to include the fund’s auditor and/or recognised representatives of business having no direct relationship with the fund’s managers, investors or investments.

Twice-yearly valuation
All valuations should be calculated to account for the dilution resulting from the exercise of ratchets, options or other incentive schemes. All quasi-equity investments should be valued as equity unless their realisable value can be demonstrated to be other than the equity value.
Valuations should be produced at least twice a year, and audited once. Valuations should take account of the effect of the difference between the currency of the investment and the currency of the fund, using the exchange rate applicable on the last day of trading of the relevant period.

Transparency and disclosure are critical to the valuation exercise. The EVCA Guidelines recommend that two levels of disclosure are applied – a basic level to be included in the reporting to all investors, and an advanced level, to the advisory committee or other body whose role it is to review the valuations.
The basic level for all investors should include a statement as to whether the EVCA Valuation Guidelines are being applied; a statement as to whether the investment is quoted or unquoted; a statement of which valuation methodology is being applied and reasons for such choice.
Two valuation methodologies are recommended for unquoted investments: the conservative (at cost) value and the ‘fair market’ value.
The fair market value is the one that gives investors an interim assessment of how a fund’s investments are performing. The fair market value is defined as: “The estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion.”
The most appropriate indication of fair market value is likely to be an independent third-party transaction within the valuation period. In the absence of any such third- party transaction, methods are defined for investments with profits or positive cashflow and those without profits or revenues.
For quoted investments, valuation should be based on their quoted mid-market price on the last day of trading in the valuation period, to which a discount should be applied.
“It should be emphasised that the guidelines do not impose an obligation on managers of funds, but seek to set a benchmark against which members may wish to relate their reporting,” explains Edouardo Bugnone of Argos Soditic, the chairman of EVCA’s Valuation Guidelines Taskforce. “Fund managers also need to be judged by ongoing ‘performance’ and investors also want to know the fair market value to see how their investment is progressing. Also we felt it important to develop guidelines for how to handle new situations such as, for example, the dot-coms.
“One of the goals of the private equity sector is to provide greater transparency to its investors and harmonised valuation and reporting will help promote private equity and venture capital as an asset class.”
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