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Reliability and relevance of fair values: private equity investments and investee fundamentals

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Abstract

We directly test the reliability and relevance of investee fair values reported by listed private equity funds (LPEs). In our setting, disaggregated fair value measurements are observable for funds’ investees; and investee accounting fundamentals are also publicly disclosed. We find that LPE fair value measurements reflect equity book value and net income in a manner consistent with stock market pricing of listed companies. However, LPE fair value measurements appear to distinguish between Level 1 and Level 3 inputs – they reflect investee net income to a lesser extent for Level 3 inputs. Further evidence based on the stock market pricing of LPE funds indicates that the discretion exercised by LPE fund managers when determining investee valuations is perceived as reliable.

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Notes

  1. See Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FASB 2006), and IFRS 7, Financial Instruments: Disclosures (IASB 2005).

  2. See, for example, Barth (2004), Penman (2007), Landsman (2007), Benston (2008), and Ryan (2008) for discussions of costs and benefits of FVM.

  3. The literature is extensive and is not covered comprehensively here. Several review papers and critiques are available. See, for example, Landsman (2007).

  4. Lawrence et al. (2016) further replicates and extends the Song et al. (2010) study for a set of banks and find evidence that the differences between value relevance of Level 3 fair values and those of Levels 1 and 2 are insignificant after controlling for an omitted variable.

  5. We note that the unit of account concept is potentially important in all FVM. For example, is a fair value estimate of an investment holding based on the value of a single share in a company, or is it a proportion of the estimated value for which a company could be sold? The resulting FVMs can differ. Clear guidance on this issue as it applies to private equity firms is not available from existing accounting standards. However, because representational faithfulness is a primary qualitative characteristic aimed at representing economic substance, valuation guidelines in the private equity sector usually focus on the investee company as the appropriate unit of account (see, for example, International Private Equity and Venture Capital Valuation Guidelines, International Private Equity and Venture Capital Valuation Board 2012).

  6. Even if fair value estimates exploit private information held by corporate management, there is still uncertainty in fair value estimates because of latent business uncertainty.

  7. Since 2005, firms listed in the European Union are required to report under IFRS if they report consolidated financial statements. However, listed firms that do not produce consolidated financial statements are permitted to report under domestic accounting standards.

  8. Since 2012, the authoritative body issuing U.K. GAAP standards is the Financial Reporting Council, and U.K. GAAP have been consolidated under Financial Reporting Standard 102 (FRC 2013).

  9. See, for example, Hayn (1995) and Barth et al. (1998).

  10. A common indication that a Level 1 input has been applied is when the investee is traded on the Alternative Investment Market (AIM). AIM is a trading platform set up in 1995 by the London Stock Exchange that is designed to permit a wide range of businesses including early stage, venture capital-backed, and more established companies to seek access to capital. Currently, over 3,600 firms have their shares traded on AIM.

  11. Following Petersen (2009), when estimating Equations (1) and (2), we include year fixed effects but do not cluster by year, because the number of clusters (years) is only 10. However, we also estimated versions of the equations clustering by year; untabulated findings result in the same inferences as those based on tabulated findings.

  12. When constructing Res_ratio1 and Res_ratio3, we use the version of Equation (2) that includes only year fixed effects. Including fund fixed effects would remove the average discretion applied by each fund manager over the sample period. For our analysis, it is important to assess each fund’s discretion applied relative to that applied by the others, not the fund’s annual discretion relative to its average.

  13. Means are based Res_ratio1 and Res_ratio3 after winsorizing at the 5th and 95th percentiles; by construction, winsorization does not affect median values that are used when estimating Equations (4) and (5).

  14. We set Res_ratio1it and Res_sign1it (Res_ratio3it and Res_sign3it) to zero if fund i in year t does not have any Level 1 (Level 3) investments.

  15. IFRS 7, Financial Instruments: Disclosures (IASB 2005) explicitly identifies Levels 1, 2, and 3 fair value inputs and is effective for annual accounting periods starting after Jan. 1, 2009. Although LPE funds did not disclose explicitly the level of their fair value estimates, they did disclose information that enables us to infer the levels for sample years before 2010.

  16. Throughout we use a 5% significance level under a one-sided alternative when we have a signed prediction, and under a two-sided alternative otherwise.

  17. For example, Table 5, Panel D of Barth et al. (1998) reports average equity book value and net income coefficients of 0.89 and 6.57 for a sample of financially healthy publicly listed firms.

  18. We also estimated versions of Equation (1) for a subsample of observations of Level 1 investments, using both estimated investee fair value, FV, and investee equity market value, MVE, as the dependent variable. Untabulated findings reveal that equity book value and net income coefficients are 0.86 and 8.63 (0.88 and 9.01) in the FV (MVE) estimation. Although the coefficients are essentially the same in both estimations, the primary reason they differ is that we calculate FV based on the percentage of investee’s equity held by the fund. Hence, it appears that LPE fund managers appropriately use Level 1 inputs when estimating fair values for listed investees.

  19. Although Equation (2) includes BVE, which can be viewed as a size proxy, it is possible that difference between Level 1 and Level 3 investee net income coefficients reflects size differences between publicly traded and non-public investees. As an additional means to address this possibility, we estimate Equation (2) separately for subsamples above and below the median BVE. Untabulated regression summary statistics reveal that inferences relating to the difference between the Level 1 and 3 investee net income coefficients are the same as those based on tabulated findings, i.e., the Level 1 NI coefficient is significantly larger than the Level 3 net income coefficient in both estimations.

  20. We also cluster standard errors by investee when estimating Equation (8).

  21. Although winsorizing continuous variables should mitigate the effects of outliers, we also checked for influential observations using the Cook’s distance measure, eliminating the most influential observations. Untabulated findings reveal the same inferences as those based on tabulated findings.

  22. More generally, young funds also appear to be valued differently by their investors. In particular, both of the BVE_FV3 coefficients are smaller than for older funds, as is one of the BVE_FV1 coefficients, and both of the NI coefficients are significantly negative.

  23. We calculate earnings persistence using a version of Equation (8) that excludes the Level 3 interaction terms.

  24. In particular, we replace \( \frac{\mid Res{1}_j\mid }{\mid FV\_{fit}_j\mid } \) and \( \frac{\mid Res{3}_j\mid }{\mid FV\_{fit}_j\mid } \) with the absolute value of percentage change in investee j fair value.

  25. In particular, we replace Res1j and Res3j with percentage change in investee j fair value.

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Acknowledgements

We thank participants from the European Accounting Association Annual Congress, the Annual Washington Area Research Symposium, and the Private Equity Research Consortium Symposium and an anonymous reviewer for helpful comments. We acknowledge the Institute of Chartered Accountants in England and Wales charitable trusts for generously funding our research.

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Authors and Affiliations

  1. Kenan-Flagler Business School, University of North Carolina at Chapel Hill, Chapel Hill, NC, USA

    Petrus H. Ferreira & Wayne R. Landsman

  2. Luxembourg School of Finance and Hoover Institution, Stanford University, Stanford, CA, USA

    Roman Kräussl

  3. School of Business, George Mason University, Fairfax, VA, USA

    Maria Nykyforovych Borysoff

  4. Bocconi University, Milan, Italy

    Peter F. Pope

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  1. Petrus H. Ferreira
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  2. Roman Kräussl
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  3. Wayne R. Landsman
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Correspondence to Wayne R. Landsman.

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Ferreira, P.H., Kräussl, R., Landsman, W.R. et al. Reliability and relevance of fair values: private equity investments and investee fundamentals. Rev Account Stud 24, 1427–1449 (2019). https://doi.org/10.1007/s11142-019-09509-9

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