Fair value nightmare - FAS 157 could cause huge write-offs !!

It’s haunting the private equity industry: the value of an otherwise healthy PE/LBO deal may be written down to zero now!!!

Its bacause of "FAS 157 - fair value" and it has come at the worst-possible time. Investment firms might have to declare that they invested into worthless equity during the LBO boom. Effective November 15, 2007, the Financial Standards Accounting Board mandates that assets be measured at "fair value", described as "the price that would be received to sell an asset now". Most PE's wouldn’t dream of selling an asset until they felt both the asset and the exit path were as strong as possible. But FAS 157’s fair value approach requires them to imagine selling their portfolio items each quarter, and to identify the factors that would play into the value. Generally PE's/LBO's are generally conservative when it comes to valuations & they prefer to keep the investment at cost (anyhow auditors need a real good reason to okay a write-up).

The trouble is, these buyout deals took place at huge premiums just over a year ago, and now the markets have fallen dramatically. If you value these companies based on public comparible companies - the fair value of your investment is probably zero!! Lets take an exapmle: in the roaring first half of 2007, a buyout firm buys XXX for $1 billion. The company has EBITDA of $100 million, they agrees to pay a 10x multiple – at the high end of a range of multiples in the sector. The deal involves say $300 million equity and $700 million debt, in line with the average 7 times EBITDA debt multiple banks generally offer.

Then things change. Assuming no debt is yet paid down, the public market for XXX, and now the median multiple is now around 8 times EBITDA (using bloomberg/ Capital IQ etc). This means XXX is valued at $800 million (even still XXX earnings are steady at $100 million) - which values the equity in the deal at $100 million – a 66% decline from cost.

Things worsen - still assuming no debt has been paid down, the economy forsees recession, XXX sees a slight decline in earnings and EBITDA is now $85 million. Still trading in the lowered range of 8 times EBITDA, the fair value of XXX is $680 million now. In other words, "Dear investor - Greetings: the portfolio company is worth less than its debt and your equity is (for now) worthless" !!!

Perhaps with certain auditors refusing to sign off on numbers that they feel are unrealistically high, we may see a tussle between the Investment Banks/PE's and auditors (widely hated objects :)) … FAS 157 is here to stay!!