The US’ Financial Standards Accounting Board has released draft guidance on fair value accounting that if enacted would require even more documentation work be done in valuing private fund portfolio investments.
The draft guidance is part of a larger codification of existing FASB standards.
The story was first reported on sister news service PrivateEquityManager.com.
The proposals would require GPs to group assets and liabilities into classes and value each class, and more detail would be required in the “roll-forward table” of Level III assets, defined as assets for which “observable inputs” are not available in the valuation process.
But the biggest headache for private equity managers will result from a requirement that they disclose any “reasonably possible alternative Level 3 inputs” and the alternative valuations that would result.
A well known challenge in the private equity fund management business is that private company investments can at any given moment have a range of valuations assigned to them, arrived at using differing assumptions and inputs. GPs who have co-invested in the same deal often value these investments differently.
Many in private equity have argued that the fair value mandate is inappropriate for the asset class, given the long-term, illiquid nature of the investment strategy.
Private equity funds already use multiple inputs and analyses in determining a range of possible values, after which they come to a single point estimate of fair value, David Larsen, a managing director at valuation specialist Duff & Phelps, told sister news site PrivateEquityManager.com. Now, GPs will have to disclose that range of possible values to their investors and to third-party auditors.
It could create a non-productive discussion, given that in private equity these are illiquid investments and management has done its best job to come up with them.
Already the proposal is eliciting howls of protest from the private equity CFO community.
Larsen said that the disclosure requirement could cause auditors and limited partners alike to question the GP’s assumptions, perhaps unnecessarily.
“If the private equity fund determines that the range is 50-100, and their best estimate is 80, do they have to disclose the 50-100?” said Larsen. “And if they do, does the LP ask, ‘Why didn’t they use 70 or 90?’ And does the auditor start second-guessing? It could create a non-productive discussion, given that in private equity these are illiquid investments and management has done its best job to come up with them.”
The chief financial officer of a US venture capital firm said the additional language is unlikely to help any readers of his firm’s financial statements, and will increase the amount of documentation necessary to support the firm's Level 3 assets.
The accountant’s staff and the (more expensive) technical review partner will need to spend more time in his or her review of those disclosures, which invariably spawn a new laundry list of questions, many of which lack substantive relevance.
Venture capital CFO
“It’s another accountant full-employment effort, in that the accountant’s staff and the more-expensive technical review partner will need to spend more time in his or her review of those disclosures, which invariably spawn a new laundry list of questions, many of which lack substantive relevance,” he said.
The requirements were most likely written for mortgage-backed securities or asset-backed securities that used to be actively traded but now must be measured with Level 3 inputs for the first time, the CFO noted.
“The feeling is that investors [in formerly liquid assets] want more information about how those assets are valued using Level 3 inputs,” Larsen said. “Private equity is sort of caught in the wider net.”
FASB has spent the third quarter of 2009 working on an organisational overhaul of US Generally Accepted Accounting Principles, harmonising the entire body of generally accepted accounting principles by topic. All accounting principles relating to fair value now fall under Topic 820. Going forward, instead of issuing staff positions, FASB will issue Accounting Standards Updates.
The proposal will now go through a comment period that ends 12 October, after which the final version of the Accounting Standards Update will be released.