Fair-value changes loom for alternative funds

Managers of private equity, venture capital and other alternative private investment funds have not completely dodged the fair-value bullet.

Under new U.S. and international accounting proposals now being circulated, managers would face much tougher rules on explaining how they arrived at an asset's value and the methods used to value assets. They'd also be subjected to more involved reporting requirements.

Fair-value accounting — which took effect in 2007 in the form of Financial Accounting Statement 157 — made the private equity and real estate investment worlds apoplectic. Unable to keep portfolio companies and other assets at book value, the managers feared adopting the standards would cause massive write-downs. Indeed, many investment managers did end up reporting at fair value, which brought down valuations in some cases.

However, how fair value should be applied — especially in a distressed environment — has become a hot topic in the industry, and the new proposals fan the flame.

While not all aspects of the newest fair-value proposals apply to alternative investment funds, those funds are not exempt, said Christine Klimek, communications manager, Financial Accounting Foundation, Norwalk, Conn., which oversees the U.S. Financial Accounting Standards Board.

The financial crisis of the past few years has put the matter of unified international accounting standards on a fast track. Executives of both the FASB and the International Accounting Standards Board were called to account for their progress on convergence at last month's G-20 meeting in Toronto, said Greg Forsythe, Pittsburgh-based director and business valuation technical specialist with Deloitte Financial Advisory Services LLP.

The exposure drafts of each board's fair-value standard were released June 29, with comments due by Sept. 7. Many of the changes proposed by the FASB are meant to bring U.S. standards in line with international standards. Neither the FASB nor the IASB has stated when final standards would be issued, but insiders say they could be made public by the first quarter of 2011.

“Part of this (FASB) standard is a converged standard. When it is finalized, it should apply no matter where a manager is reporting,” said Mr. Forsythe, who is a member of the advisory committee on the global accounting standards.

But the drafts are far from identical. For example, different assets, liabilities and equity instruments are measured at fair value in the U.S. and under international accounting standards. The boards are still “in discussions” and those discussions will continue after the comment periods, according to information on FASB's website.

Robert Stewart, spokesman for the Private Equity Council, a Washington-based industry lobbying and trade association representing some of the largest private equity firms, said his group is “monitoring the situation.”

The international proposal beefs up the IASB's definition of “fair value” to require increased transparency about fair-value measurements, including valuation techniques and assumptions made to measure fair value, according to a July project summary published by the IFRS Foundation, London. The proposal would define fair value as an exit price, rather than the price a firm paid for the asset, as is common among private equity firms.

And in the U.S. proposals, there are three main areas that are likely to be hot topics among alternative investment managers, explained John Hildebrand, a partner in the national professional services group of PricewaterhouseCoopers.

In what might be the most controversial proposal by both boards, alternative investment managers would be required to disclose the effect on the reported value of certain assumptions they made to value an asset.

Fair-value accounting standards places assets into three levels ranging from those that are clearly valued based on quoted prices, like a stock trading on the NYSE, to ones for which managers are making their best estimates on internally developed information or so-called unobservable inputs, Mr. Hildebrand explained. Private equity portfolio companies generally fit into the latter category, or “level three.” Under the proposed rules, managers would have to disclose the effect on level three fair-value measurement of changes in any of the significant inputs that went into that best guess.

Basically, under the new FASB proposal, managers would have to peel back the curtain and explain how they arrived at “fair value.”

Some think this could expose managers to legal issues, Mr. Hildebrand said, because someone could always claim the manager based valuations on the wrong assumptions. What's more, there is concern that complying with the rules would require a lot of work. It is also unclear how managers should apply the standard or make the calculation, Mr. Hildebrand said, although methods did develop for such disclosures under the international standard, which is comparable.

A similar U.S. standard had been proposed in the past but was not adopted, he said.

Another change eliminates one of the ways firms can value assets. Currently, a private equity investment firm could either combine assets and value them as a group, or value each individually. The new proposal would require individual valuation of assets, which could negatively affect holdings that would be worth more if they were grouped together.

The third key issue for private equity managers is the proposed elimination by both boards of the so-called blockage factor, which allows managers that hold a block of securities to account for a discount they would have to take if they sold all the holdings at the same time. Managers now apply a blockage factor to adjust the fair value of a position in financial instruments due to the quantity held relative to the trading volume or market for level two and level three holdings.

“One interpretation could be that a large holding of any security, regardless of level, would have to be analyzed as the price of a single share sold times the quantity held, which would not take into account that a holder might have to take a significant discount to sell the block,” Mr. Hildebrand said.

Some private equity firm executives, who declined to be identified, said there is another issue that they would like to see resolved. That is whether they will be required to submit a consolidated statement for the value of the entire portfolio or if they can submit separate statements for each portfolio company. The consolidated statement would be a problem because of the cost and complexity, industry executives said.

But managers still might have an out.

“There is a deferral for investment managers,” the FAF's Ms. Klimek wrote in an e-mail response to questions. “The private investment firms need to meet certain criteria to qualify for the deferral.

“Under the FASB's proposal, private equity firms that meet the criteria for investment companies ... would have their financial assets and financial liabilities measured at fair value through net assets,” she stated in the e-mail. “Companies owned by private equity funds would apply the proposal to their own financial statements. Under the proposal, the financial instruments held by those companies would generally be measured at fair value (including loans). However, the proposal does offer an amortized cost option for certain financial liabilities.”

The entire fair-value discussion is re-emerging at a time when the world has undergone a major economic crisis. With or without new accounting standards, institutional investors are seeking greater transparency from their alternatives investment managers.

The distress in the real estate marketplace — commercial real estate prices fell 25% in the year ended March 31 and 42% from their October 2007 peak — is bringing discussions about fair value and how the standards are being applied into even sharper focus, said Scott Farb, managing principal in the Los Angeles office of accounting and consulting firm Reznick Group.

Revealing how valuations are calculated could be a positive development — and offer a level of protection — for real estate investment firms.

“Especially in a distressed market, it is difficult for managers to value the funds' real estate holdings because of the lack of observable inputs and comparable sale transactions,” Mr. Farb said. “The required disclosures of the valuation methodologies and assumptions used in the valuations hopefully provide transparency for the readers of the financial statements.”