Challenges to the private equity industry.

The private equity (PE) market (including venture capital, buy-out, mezzanine and similar longer-term, illiquid investments) has expanded exponentially over the past 10 years.

U.S. GAAP requires private equity (PE) investments be stated at fair value. Given the nuances inherent in PE, there can be significant challenges in determining the fair value of underlying portfolio company investments. GAAP defines fair value as the "amount at which the investment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale." The FASB's proposed standard says fair value "is the price that would be received for an asset or paid for a liability in a transaction between market participants at the reporting date."

PE managers always have had difficulty estimating the fair value of investments. For private equity funds that prepare financial statements in accordance with GAAP, the AICPA Audit and Accounting Guide, Investment Companies, provides the primary guidance on valuing investments. Many private equity funds, particularly venture capital funds, have used cost or the value of the latest round of financing as an approximation of fair value. Over time, managers have realized that more robust estimating techniques are needed to determine fair value. Industry groups, including the Private Equity Industry Guidelines Group (PEIGG) in the United States and the venture capital associations in Europe, have developed PE valuation guidelines that help managers estimate fair value in accordance with relevant GAAP rules in a consistent manner.

Determining fair value requires managers to exercise judgment. While each manager's judgment may result in different but supportable views on valuation, using common guidelines consistent with GAAP should narrow the range of these numbers. The PEIGG PE Valuation Guidelines and the International Private Equity and Venture Capital Valuation Guidelines (currently undergoing harmonization) provide the PE industry with best practices in determining fair value in accordance with GAAP. The historic bias that used cost as the best estimate of fair value is giving way to the practice of applying a valuation methodology appropriate for the facts and circumstances of an investment. In general, fair value would be determined using the following hierarchy:

* Cost or the latest round of financing for a period of time.

* Quoted prices in active markets if they are available.

* Comparable company transactions.

* Performance multiples.

* Other valuation methodologies such as discounted cash flow (this should be used rarely, and with caution, for PE investments).

As the private equity industry matures, it needs greater consistency in the reported results and valuation approaches used by managers of, and investors in, private equity funds. The PEIGG and European PE Valuation Guidelines were designed to provide a framework for valuing private equity investments using transparent methodologies intended to be consistent with relevant GAAP.

[GRAPHIC OMITTED]

--David L. Larsen, partner, KPMG LLP's transaction services practice, and leader, the institutional investor segment, private equity practice, San Francisco