Valuing fund interests of increasing concern?

Asset valuation processes for funds continue to be a prominent topic of discussion despite no major revisions in the past five years to FASB ASC 820 or IFRS 13, the two accounting rules defining fair value for fund financial reporting purposes. GASB Statement 72, issued in early 2015, mirrors the definition of fair value used by the Financial Accounting Standards Board and the International Accounting Standards Board and highlighted that investors in funds cannot blindly accept net asset value as the fair value estimate. In addition, investors' focus on fair value includes obtaining transparency, evolving industry best practices and the evolving regulatory landscape.

Fair value measurements are no longer considered by investors as a compliance box to tick on a monthly or quarterly basis. Investors continue to become increasingly sophisticated and the NAV received has evolved into an input into multiple processes: the investor's own financial reporting; asset allocation calculations; and risk considerations, incentive compensation, etc.

While not news, investors that report under GASB have to report their assets on the same fair value basis as other funds that report under U.S. generally accepted accounting principles or International Financial Reporting Standards. From experience, it is clear that many general partners are aware of this fact and that a weak valuation process on the GP end has operational impacts at the limited partner level. 

LPs often lack the resources (human or funding) to have a robust valuation process. As such, these investors increasingly look to GPs or lead investors to leverage the GPs' valuation work for their own reporting purposes. To be able to leverage valuation work done at the GP/lead investor level, limited partners must be able to show the GP/lead investor has a robust and well-documented valuation process — starting with an up-to-date valuation policy and ending with robust documentation for the fair value determination of each asset, increasingly using the best practice of validating underlying investment valuations through the use of a qualified experienced third-party valuation expert. Absent the ability to show that, limited partners must have their own robust process at the asset level.

Related to fair values for financial reporting is the fact that LPs are becoming more sophisticated in the criteria used to manage their investment portfolios — both existing and new investments. Fair value is the only objective measure to compare dissimilar investments on each measurement date. Robust fair values enable LPs to make well-informed decisions around performance and asset allocation. Advancements in technology are making it increasingly easy for even smaller, resource constrained LPs to look at their portfolio's makeup and performance in ways they couldn't even a few years ago. When an LP sees a fund's NAV or the fair value of an underlying investment remain constant for a number of periods, it is increasingly being seen as a reason to reach out to the GP for a greater understanding of the valuations in question. 

LPs are now looking past the fund level performance and have a greater understanding of the performance of the underlying investment performance. Be it allocations to industries or asset classes, robust fair values give LPs the information they need to make informed allocation decisions. GPs that do not have robust valuation processes might find interests in their funds being sold in the secondary market and/or not receiving future allocations. Looking forward, LPs are examining how GPs create value (alpha) in their investments and fair value is an important piece of the analysis that is an input to the capital allocation decision. Gone are the days when a GP got meaningful credit for increases in value because the market went up. 

Harvard University recently announced significant changes to how it manages its endowment. These changes include a move away from asset-class-based investing to allocating resources based on risk. For all assets, movements in fair values are an important input into the true assessment of risk. For illiquid assets, market prices are not observable, therefore, robustly determined fair values are the basis for investors' assessments of risk for an individual investment or illiquid asset class. If fair values are not robustly determined, one's risk assessments will be misinformed, potentially having significant impacts on investment decisions.

The regulatory world continues to affect the world of fair value determination as well. From the European Union's Alternative Investment Fund Managers Directive making a clear push for independence in the valuation process to Brazil's enacting fair value rules for the first time (and requiring public disclosure of fair values by investment), regulators have taken notice of the importance of fair value to all constituents. 2016 saw the Securities and Exchange Commission and European regulators fine several funds for poor valuation practices despite valuation not being at the top of the published list of examination priorities. 

The American Institute of CPAs is working on a new guide for the valuation of private equity investments that is due out in draft form in early 2018. The AICPA guide is expected to be rich in examples that demonstrate proper valuation methodologies as well as the need for judgment in the valuation process. Weighing in at an expected 700-plus pages, the AICPA guide hopefully will provide more consistent guidance across the industry and, as it will be considered by auditors, it is likely to be pushed globally across the audit firms, enhancing global consistency.

There is also a push in the U.S. to add consistency to the valuation profession through regulation and requirement of a professional certification or designation. The requirements for the Certified in Entity and Intangibles Valuations designation are now being developed, as is the certification process. Auditors will be the “regulator” and will have the ability to accept/place more emphasis on valuations performed by a professional holding the CEIV designation and less emphasis on valuations not performed by a CEIV holder. This is developing in real time and is expected to be rolled out later this year.

In conclusion, while the definition of fair value remains unchanged, robust fair value measurement remains an evolving global topic and the trend continues to move toward higher quality, greater consistency and better transparency.

Chris Franzek is a managing director at Duff & Phelps LLC based in New York and David Larsen is a managing director based in San Francisco.

This content represents the views of the authors. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.