Decisions decisions

by David Carey, Vipal Monga and Vyvyan Tenorio

The Deal.com

Private equity used to be a simpler business. Once predicated on the concept that management was better able outside the glare of the public markets and quarterly earnings pressures to take struggling companies, remedy their problems and turn them out again, the business of leveraged buyouts has recently been turned on its ear. The culprit: mark-to-market accounting, which is now forcing private equity firms to struggle with many of the same pressures that beset public companies.

Take the recent markdown four private equity firms took on their combined $7.1 billion equity investment in Freescale Semiconductor Inc., which they acquired in December 2006 for $17.6 billion.

In 2007, Freescale's sales fell by 10%, to $5.7 billion, and its adjusted Ebitda dropped 18%, from $1.86 billion to $1.53 billion. Despite the bad results, Freescale wound up generating $440 million in free cash flow last year, and it easily paid the $760 million of cash interest on its massive debt.

In the past, the LBO sponsors — Blackstone Group LP, Carlyle Group, Permira Advisers LLP and TPG Capital — would have booked their stakes at cost simply because the company wasn't close to default. Not so in 2007. According to a source, Blackstone, Carlyle and TPG all took 15% write-downs, roughly in line with Freescale's decline in Ebitda. Permira, a London-based firm whose investments are denominated in euros, which fell marginally against the dollar last year, took a 16.6% markdown.

"It threatens what I consider the model of private equity," says Paul Levy, the head of New York middle-market firm JLL Partners Inc. Still, he says, "we're following the rule."

Just now, the mark-to-market regimen is being imposed on the private equity industry, owing to a U.S. accounting rule known as FAS 157, promulgated in 2006 by the Financial Accounting Standards Board.

Although the new standard is not to every leveraged buyout specialist's taste, some express qualified support. "It's a pain," says one supporter, Diamond Castle Holdings LLC's CEO Lawrence Schloss, alluding to the "hours and hours" his aides recently spent with accountants trying to set credible market values for the eight companies in Diamond Castle's portfolio, none of which trade publicly. "But the rule makes sense."

Whatever one's opinion, there's no debating the view of valuation specialist Lawrence Levine of the Chicago accounting firm RSM McGladrey Inc., who says: "It's a sea change for private equity" that's having "a big impact" on how private equity firms vet their results and report their returns. It also stands to amplify firms' unrealized losses in 2008 if the market remains turbulent, even though buyout executives say it had relatively little impact on their results in 2007.

The rule, which took effect Nov. 1, 2007 — just as the credit crunch was really settling in — swept aside buyout firms' long-standing practice of carrying assets at original cost up until they sold them. The only exceptions traditionally were stakes in publicly traded companies, which usually were marked just below market value, and stakes in companies that were in default or had gone bankrupt, which were written down or off. Because the better-performing LBO houses kept the bulk of their holdings at cost, many of which plainly had jumped in value, they habitually would undervalue their portfolios, often by a wide margin.

But now, owing to FAS 157, every private equity firm — along with hedge funds, banks, pension funds and every entity with an investment portfolio — must "fairly value" every single one of its investments, the criterion being a holding's likely current sale value. For those that don't trade publicly, buyout houses and their auditors must approximate the value as rigorously as they can, guided by the pricing of recent LBOs and valuations of "comps," or comparable public companies. While buyout firms do enjoy a certain degree of flexibility, most auditors say they now require a robust and well-documented determination of fair value by their clients.

"There's reduced wiggle room," says one accounting officer at a private equity firm, noting that, in the past, his firm could — lacking an exit or bankruptcy — decide when and how it wanted to write something up or down. Now the market must decide. "This has taken a lot of judgment away from accounting firms," the accounting officer says.

Some of these calls are tough. As the banks have discovered recently, finding comparable benchmarks in sometimes illiquid and turbulent markets can produce valuations that may be well below or above what makes sense. In transactions like that of Spanish-language television broadcaster Univision Communications Inc., the private equity owners had to decide to mark the asset down based on the price of the debt, which had been beaten down in a depressed market. In the past, debt selling that low suggested that the company was sliding toward default, even if that was not an accurate snapshot of the situation today. See related story: Valuing Univision in abnormal times

In recent weeks, private equity firms have spent many hours in the company of auditors, vetting investment values for their 2007 statements. The ensuing reports, many of which LBO firms' limited partners received in March, have afforded the firms' LPs a glimpse of a radical, unprecedented volatility in quarterly and annual investment results they can expect going forward.

To be sure, even huge losses aren't likely to lead to the sort of bloodletting and bailouts commercial and investment banks have recently suffered, simply because the vast majority of LBO firms and the investment funds they manage have debt-free balance sheets. Still, the new mark-to-market accounting regime is certain to discombobulate some LPs who had come to think of private equity as a bastion of steadiness. Under the old accounting convention, most of private equity's surprises were windfall gains, not unexpected write-downs.

"Now, with the new formula," says one large LP in private equity, "even between quarters, and especially when you've got sectors under attack and public comparables come down, you could end up throwing a lot of volatility in numbers."

And volatility, for a business considered relatively stable (at least until the exit), complicates the general partners' relationship with the limited partner investors in their funds.

As one partner at a prominent buyout shop puts it, "It's always easier when you can tell a simple story about your fund: When you write something up, things are good, and when you write it down, things are bad. But volatility is not good for an investor from a story point of view. "

For the first time, LBO firms have started to write down assets they clearly would once have marked at cost, as with Free–scale. Thus far, the write-downs have been modest.

New York private equity giant Kohlberg Kravis Roberts & Co., for instance, wrote down a handful of holdings in KKR Private Equity Investors LP, a portfolio of buyout investments that trades publicly on Amsterdam's Euronext exchange. The markdowns, taken in last year's fourth quarter, resulted in $259.4 million of net unrealized losses that dropped the fund's net asset value by 5.5%.

Whereas several of the knocked-down valuations involved public companies whose share prices have tumbled, such as France's PagesJaunes Groupe SA, Germany's ProSiebenSat.1 Media AG and Sun Microsystems Inc., some others did not. Among these were KKR PEI's write-downs for NXP BV, a Dutch semiconductor company similar to Freescale; Capmark Financial Group Inc., a U.S. commercial real estate lender, and Auto-Teile-Unger Holding GmbH, a German car parts and service-station chain.

Of the three nonpublic companies, only ATU, on which the fund recorded an 83% write-down, is in severe financial trouble. And in the same way that Freescale's backers undoubtedly would not have taken a write-down under the old accounting scheme, KKR also, presumably, would have left untouched its investments in NXP and Capmark, neither of which is close to default.

Such departures from past practice point to the wider variability in reported performance that FAS 157 henceforth will bring about. When the economy is strong and markets are on the rise — as has been the case during most of the buyout industry's nearly 40-year history — the resulting boost to individual holdings and overall portfolio values will be reflected in the numbers much more quickly.

On the other hand, when the economy ails and equities are in the dumps, as they are today, the downside impact on private equity results will also become evident sooner in reported results.

Whether these developments are good is hotly debated by private equity players. JLL's Levy, for one, believes that assigning hypothetical interim "market" values to nonpublic investments makes no sense for private equity, given its focus on cash returns that can take years to cultivate and reap. For hedge funds, by contrast, Levy argues that FAS 157 makes perfect sense, considering that most hedge fund managers are paid performance fees based in part on unrealized profits or losses. But private equity fund managers are paid incentives only on realized gains.

What's more, Levy views FAS 157's implicit short-term focus as a potentially dangerous distraction from private equity firms' time-tested strategy of improving the companies they own in an atmosphere purged of short-term earnings pressures. Private equity's usual modus operandi, explains Levy, is to "go behind the curtain and do what you have to do to invest in the long term. You might be happy to have a bad quarter because you're taking a step backward so you can lunge forward. All of that is thrown into question" by FAS 157, he says.

Moreover, Howard Marks, chairman of Oaktree Capital Management LP, recently assailed FAS 157 for more than simply destabilizing the credit markets and abetting illiquidity. He also attacked it for endorsing an imperfect standard above alternative valuation methods that are equally flawed. " 'Cost' is objective but often out of date and far from accurate," Marks said in a memo to Oaktree clients. " 'Lower-of-cost-or-market' is conservative but asymmetrical in its error. 'Market value' is contemporary but not always reliable," since it "requires subjective judgments and bakes in price fluctuations that may prove transitory."

LPs are also of two minds about the rule. Increased volatility certainly negates one of the attractions of private equity as an asset class that's historically been less volatile than the public market components of their fund portfolios. Many investors tend to rely on information provided by their general partners to report the net asset value of a fund portfolio. How they will react to the heightened volatility remains to be seen, but investors are braced for the ripple effects in both directions.

Particularly galling in their view is that LPs have to value private equity assets as though they were selling them today, which suggests a much bigger haircut than what an LP might otherwise realize those assets for. Accounting firms also struggle with audits of discounted values that may not necessarily be easily justified. "It's never pleasant from an LP's standpoint that we're having to reflect those write-downs in assets that we have no intention of selling at the moment," one disgruntled investor says.

On the other hand, mark-to-market accounting could help avoid the sharp disconnect between public and private equities in a down cycle, as happened in 2001. As public market valuations fell and investors' overall portfolios shrank in size, LPs found themselves overallocated to private equity, since corresponding valuations hadn't come down. Many had to divest holdings at a considerable loss in the secondary market or stopped investing in PE altogether.

Many pension funds and endowments in fact now buy and sell limited partnership stakes in the secondary market and need a reasonably precise idea of what those stakes are worth. Scott Sperling, co-president of Thomas H. Lee Partners LP in Boston, one of the country's largest buyout firms, says TH Lee Partners began conducting annual mark-to-market audits several years ago at the request of LPs who are active in the secondary market.

For 2007, despite some high-profile write-downs on deals like Freescale, NXP and ATU, nearly all the private equity firms interviewed for this story said their audited results tended to preserve or even upgrade the carrying value of their portfolios. That, they said, was because they'd habitually booked so many holdings at below market that their write-ups outnumbered their write-downs for last year.

In 2008, however, the new accounting regime may trigger a wave of markdowns, judging solely by the public market's recent performance: From Jan. 1 through April 11 this year, the Standard & Poor's 500 index was down 9.2%. In 2007, by contrast, notwithstanding considerable market turbulence, the S&P 500 rose nearly 4%.

One old habit FAS 157 doesn't seem to have entirely quashed is that of valuing holdings conservatively. Even though buyout firms now must mark to market, valuations of public comparables can vary widely.

And if, for instance, public stock multiples for plastics producers range between 9 and 15 times Ebitda, some buyout firms say they'll choose a multiple at the low end of that range when valuing their own plastics companies.

The reason for this, they explain, is that they'd prefer to avoid springing unpleasant surprises on their LPs. Says one buyout player: "If you bought something for 2 times and have it marked at 5 times, then sell it for 4, it comes across as a defeat when it should be a big victory. That's why we mark on the conservative side of fair market value."

That tendency, says one valuation expert, underscores the truth of the adage that old habits die hard. "We've had to [encourage] our clients to change their expectations and their behavior, to get them to realize that the lower number isn't always the better number," says RSM McGladrey's Levine.

"The better number is the fair value. That can take some education for clients to learn."

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