Beginning last year, for the first time, private funds were faced with implementing a methodology to comply with the requirement to “fair value” their investments pursuant to Financial Accounting Standards Board Statement 157 (“FAS 157”), which became effective for fiscal years beginning after November 15, 2007. The difficulty in assigning fair values to hard-to-value assets, which historically have been valued at cost, is further exacerbated by the current credit crisis and resulting global market disruptions. This mark-tomarket requirement raises various concerns for both private equity funds and hedge funds.
Overview of FAS 157
In general, FAS 157 provides guidelines that prioritize the type of data required to be used to mark-to-market investments under U.S. Generally Accepted Accounting Principles (“GAAP”) and requires detailed financial statement disclosure concerning such valuation. Under the guidelines, investments must be valued using the price that would be received in the market to sell the investment based on market data (observable inputs). Only if there is little, or no, market activity, or when relevant market data is unavailable, is management allowed to rely on its own assumptions (unobservable inputs). FAS 157 introduces a hierarchy of three levels of inputs, with observable inputs or quoted prices for identical assets being the preferred source of valuation. Because this approach to fair value measurement assumes orderly transactions between market participants, it will be difficult to apply in times of market disruption where transactions are often distressed or forced. The SEC and the FASB have acknowledged that the determination of fair value will require challenging judgment calls during this period of market uncertainty; however, requests to postpone its application were rejected.
What Does This Mean for Private Funds?
The requirement to mark-to-market illiquid investments raises various issues, particularly in the midst of the current credit crisis when comparable investments and observable inputs are likely unavailable. The following are some issues private funds may be grappling with:
Market Comparables vs Discounted Cash Flow ("DCF")
Private equity funds and hedge funds that hold non-public investments, which has become increasingly common in recent years, will undoubtedly have difficulty identifying comparable investments in the current market. Securities of a public company that operates in the same market sector as a privately-held portfolio company may have suffered a significant decline in value in the current turbulent stock market, which may not be indicative of the value that should be attributable to the private investment. Thus, a private fund sponsor must first decide whether it should consider the value of public companies in valuing its own private investments. Other observable inputs may not be available to begin with due to the lack of comparable private transactions in the current stagnant marketplace. As a result, fund sponsors may use less favored valuation approaches, such as a DCF approach. Reliance on DCF, which emphasizes a company's potential for longterm cash flow when analyzing its value, could enable a fund sponsor to avoid reflecting large losses associated with the sudden decrease in asset values since September 2008. DCF can also help avoid the “choppy” results that many have feared a mark-to-market approach would introduce to otherwise smooth private equity returns. Nonetheless, whether a comparables or DCF approach is used, a fund sponsor must take care to include appropriate disclosure regarding the particular approach it implements to fair value the fund's assets.
One Investment, Multiple Valuations
Investments may be valued very differently by different fund sponsors as one fund sponsor may consider a public comparable in valuing while another fund sponsor determines no comparable exists. For an institutional investor holding the same investment through different fund sponsors, this means it could have multiple valuations for the same investment in its portfolio. The existence of multiple valuations can undermine investor confidence, which is already in short supply.
Many private equity funds take unrealized losses into account when distributing proceeds of an investment to investors only if the unrealized losses represent a significant and permanent decline in value. Some private equity funds, however, define the concept of unrealized loss based on GAAP. Depending on the relevant definitions used in the partnership agreement's distribution provisions, fair value accounting may require those funds to take into account unrealized losses that previously would not have affected distributions of investment proceeds. This in turn can affect the fund’s “IRR” calculation and delay the receipt of carried interest distributions by the fund sponsor.
Similarly, hedge funds with “side pocketed” illiquid investments typically take only realized losses into account when striking a fund-wide net asset value for purposes of calculating the management fee and annual incentive allocations. Taking unrealized losses into consideration could decrease fee and incentive income unless the fund sponsor is comfortable with “NAV Divergence.” See “NAV Divergence” below.
Private equity fund investors with limited capital resources available given current market conditions may make calculated decisions as to which of their investments to default on based on valuations reported. Prior to the implementation of FAS 157, this information would not have been available to these investors. Default considerations may place an additional strain on a firm's valuation methodology.
The decision to buy or to sell a fund interest in the secondary market will also be made based on investment value information. Therefore, the approach taken to value investments and the values assigned to those investments will affect not only decisions made by a fund’s current investors - whether to redeem or sell in the secondary market - but will also affect the decisions of potential secondary market purchasers. This valuation issue could add additional complexity to the secondary market which is growing rapidly to address existing investors' needs for immediate liquidity.
Institutional investors, such as pension funds and funds of funds, will now base their own investment allocations (for current and future years) in part on valuations received from their fund investments. Therefore, mark-to-market valuations will likely affect certain investors' own investment allocations, as well as what they report on their financial statements to their investors.
A fund sponsor raising a new fund must decide whether to report its performance based on its GAAP-based financial statements or based on an alternative set of financial statements that do not contain mark-to-market valuations, but that disclose such value differences. During stable markets, GAAP-based financial statements could have the effect of arguably overstating the value of investments that have not been sold, while in the current market they will potentially understate such values, resulting in additional “paper losses” which could unsettle an already anxious investor base. It may be difficult to determine which approach provides the most appropriate picture of the performance of a fund's investments.
Disclosure; Operative Documents
Fund sponsors must disclose in their financials which category of “input” they relied upon to value their assets. They may also consider including disclosure in their offering documents regarding their implementation of FAS 157. In addition, fund sponsors may consider including provisions in their operative fund documents that set forth the framework they intend to use for their valuation methodology and include an investor acknowledgement as to such procedures.
Some funds, hedge funds in particular, have already implemented what accountants refer to as “NAV divergence” - the use of one value for purposes of subscriptions, redemptions and management fee and incentive allocation calculations and the use of another value, an FAS-compliant value, for purposes of financial statements and creation of reserves. Although this practice pre-dates the arrival of FAS 157, it may come under stricter scrutiny as fund sponsors and investors struggle to grasp the full effects of FAS 157.
Investment Advisers Act
Rule 206(4)-(8) of the Investment Advisers Act of 1940 prohibits investment advisers from making false or misleading statements to investors and prospective investors in private funds. Distributing misleading financial statements could fall within this rule. Because the rule also applies to misleading “conduct”, a fee calculation - without any corresponding statement - based on an improper valuation could also be caught by the rule. Importantly, the rule does not require any specific intent or knowledge of the improper valuation. As a result, a fund sponsor relying on valuations provided in the financials of its portfolio companies could run afoul of the rule if those valuations are incorrect. Fund sponsors should be mindful of this risk when working with portfolio companies, auditors and valuation experts to establish their valuation techniques, methodologies and policies.
As FAS 157 begins to be implemented by private funds this year, we expect that additional issues and concerns will arise, which will be fueled by the difficulties in applying the guidelines in practice as well as ever-changing market conditions.
FASB Proposes Additional Guidance
FASB recently announced two proposals relating to FAS 157 intended to address issues associated with (i) measuring the fair value of securities in markets that have become inactive and may reflect distressed transactions and (ii) reflecting impairment of value in the current economic crisis. The comment period for these proposals ends on April 1, 2009.