These guidelines are recommended globally by most of the major private equity and venture capital associations, including the Southern African Venture Capital and Private Equity Association (SAVCA).
The intention is to promote best practice where private equity investments are reported at fair value as well as compliance with International Financial Reporting Standards (IFRS). Two changes which directly impact on the valuation of investments are:
- Removal of the reference to a benchmark of one year for valuing an investment at the price of a recent investment (often its original price)
- Removal of the deduction of a marketability discount as the second last step in arriving at the equity value.
The guidelines allow for the price of a recent investment to be used as an indicator of fair value where the price of the recent investment was representative of the fair value at the time and the conditions at the reporting date are materially the same as those at the transaction date. The length of the period for which this methodology remains appropriate depends on the specific circumstances of the investment.
However, the guidelines previously noted that a period of one year is often applied in practice. This resulted in many practitioners and funds using this methodology for the first year of ownership of an investment with limited consideration of the other factors required to ensure that it remained an appropriate indicator of fair value. By removing the reference to the period of one year and giving greater emphasis to the stability of market conditions in determining how long this methodology can continue to be applied, more onus is placed on the valuer to justify the use of this methodology.
Previously, a marketability discount was deducted as the second last step in arriving at the equity value and illustrative examples with benchmarks of the discount were provided. These examples have been removed in the updated guidelines and the reference to a discount for lack of marketability of an instrument (also referred to as a lack of liquidity) is limited to the discussion on adjustments to market multiples. This implies that the discount is now effectively applied to the enterprise value instead of equity value but remains open to interpretation.
Other changes include:
- An update to the definition of fair value
- The inclusion of two new potential valuation methodologies (enterprise value/revenue market multiples and adjusted price of recent investment)
- New guidance on valuing an interest in a fund
- A greater emphasis on current values, current multiples and current market conditions.
The guidelines continue to prioritise valuation methodologies based on market multiples over the discounted cash flow methodology. Due to the limited number of truly comparable listed South African companies from which to derive market multiples for valuation purposes, the discounted cash flow is generally the primary valuation methodology for valuation practitioners and certain private equity funds.
Ultimately, more than one valuation methodology should be applied to check the resulting values for reasonableness, regardless of which is the primary methodology.