Investors forced to take bigger role in valuations

The time when institutional investors could rely on their private equity managers' say-so on the valuation of their investments is just about over.

Proposals both by the Financial Accounting Standards Board and Department of Labor are making investors more responsible for ensuring that the values they get from their general partners are truly fair value. This is an issue for investors because consultants and accountants say that on average only about a third of private equity managers are reporting to investors at fair value.

On Nov. 1, FASB and the International Valuation Standards Council, which is charged with establishing international valuation standards, are scheduled to address potential changes to fair value.

Even managers that do value their portfolios at fair value use differing methods, which vary from discounting cash flows to finding comparable public companies. Club deals, transactions in which two or more private equity firms team up, raise issues especially when the firms use different methodologies.

FASB and DOL officials have reiterated informally that limited partners are responsible for the valuation estimates in their own financial statements, industry insiders say. FASB has continued to release proposals and advisories, while DOL officials are deciding whether additional regulations are necessary.

This means investors can't always use the numbers their general partners give them. “Limited partners cannot blindly use NAV (net asset value) as many did in the past,” said David Larsen, managing director and a leader of the corporate finance consulting practice for the San Francisco office of Duff & Phelps, a financial advisory and investment banking firm.

Proposed changes to FASB rules including rules affecting fair value estimates and disclosures of fair value are expected to be finalized in early 2011, said Mr. Larsen, who is a member of FASB's valuation resource group.

“They can use NAV to estimate fair value if the limited partner has concluded that the general partner has done a good job of estimating underlying fair values,” such as when the general partner uses a third-party valuation expert, he said. There also cannot be a time lag, which is a problem because most private equity contracts give general partners 90 to 120 days to provide quarterly reports.

Time lags or poor estimates of fair value force investors to modify reported net asset values or use different, more difficult methods to estimate fair value, Mr. Larsen said.

More than 70% of the private equity managers used by the West Sacramento-based California State Teachers' Retirement System report at fair value, including all buyout managers, stated Ricardo Duran, spokesman for the $138.6 billion system, in an e-mail.

The private equity staff scrutinizes the methodology its general partners use to ensure that the fair value figures are accurate, he explained. “It's that examination process that helps us ensure fair value,” he stated.

But the shift to fair value has had at least one unintended consequence — volatility. “The move to fair value has increased the volatility of the valuation of these partnerships,” Mr. Duran stated.

As for club deals, in which more than one manager is an investor, CalSTRS generally accepts “a range within fair value, with the knowledge that different firms take different approaches to valuation — some are more aggressive than others,” Mr. Duran stated. “It's kind of like having different appraisers value a home. ... You'll get three different amounts — some higher than others, but usually not that far apart. “

The importance of reliable valuations was highlighted during the financial crisis. Investors found that while the stock market was plummeting and companies were struggling, their private equity portfolios were still showing sunny days. Some investors demanded more information.

Executives of the Washington State Investment Council, for instance, asked private equity managers in its the Total Allocation Portfolio, a hybrid defined benefit/ defined contribution plan, to give them the bad news sooner, said Liz Mendizabal, spokeswoman for the $74.4 billion board. Typically, returns lag by three months.

Washington officials now are confident that they are getting accurate information from their private equity managers “due to our close and longtime relationships with our partners,” she said.

Washington officials get additional insight into their private equity funds by sitting on advisory boards, where they receive regular updates about values of the private equity fund's holdings. “We are confident they are giving us accurate information,” Ms. Mendizabal said.

Officials at the Santa Fe-based New Mexico Educational Retirement Board ensure they are getting fair value by auditing all private equity managers annually, said Bob Jacksha, chief investment officer of the $8.2 billion system. Board officials also sit on advisory boards.

Executives are satisfied with managers' valuations as long as they come from audited statements by an outside auditor, Mr. Jacksha said. Most of the system's private equity managers hire outside, third-party auditors, he added.

It is too early to say whether fair value has increased the volatility of the board's $302 million private equity portfolio because it began in 2007 and therefore is still young, Mr. Jacksha said in an e-mail. Also making it difficult is that the private equity program is heavily invested in debt-based funds, Mr. Jacksha added.

Under both FASB and Labor Department proposed rules, investors need to be able to show that their managers are reporting at fair value, said Mr. Larsen, who was principal drafter of the U.S. Private Equity Valuation Guidelines and is a technical adviser to the Private Equity Industry Guidelines Group and PEIGG's valuation subcommittee. (In 2003, the industry group recommended that private equity managers switch to fair value instead of carrying a portfolio company at cost, but allowed managers to stick to the cost method for an unspecified period.)

Under the most recent guidance issued by FASB, limited partners that use net asset value for estimates must “satisfy themselves that the underlying investments are reported at fair value,” Mr. Larsen said.

Investors have to ensure that portfolio companies are reported at fair value without time lags, Mr. Larsen said. Under new guidance, the net asset value has to be reported as of the same date as the limited partners' financial statement, he said.

At minimum, investors are starting to ask a lot more questions. Some institutional investors are hiring outside help. Los Angeles Fire & Police Pension System, for example, hired an outside auditor, stated Michael Perez, general manager of the $13.2 billion system in an e-mail. As a result, all of the system's private equity managers report at fair value, he said.

Guidance offered by the American Institute of Certified Public Accountants suggests that investors should ask for such things as the general partners' valuation policy and whether or not the general partner uses an independent third party to validate fair value, Mr. Larsen said.