No free pass

Though the private equity community may have been under the impression that a FASB accounting standard update issued in September 2009 would mean less valuation work, Duff & Phelps managing director David Larsen warned this week that those who believe that could be in for a rude awakening.

Larsen discussed technical practice aids released in December by the American Institute of Certified Public Accountants (AICPA) relating to the Financial Accounting Standards Board’s Accounting Standards Update 2009-12, which allows an investor to use net asset value reported by the general partner to estimate the fair value of an alternative investment. But in order for LPs to take advantage of the shortcut, general partners must actually produce net asset value based on the fair value of their underlying investments, and net asset value must be as of the same measurement date as the LP’s own financial statements (known as “in phase” reporting).

During a webcast on Wednesday, Larsen explained how the AICPA practice aids (which can be found here) help to clarify what LPs and, indirectly, GPs must do to generate reliable fair value estimates. One point that he stressed is that LPs still have to take responsibility for their valuation assessment.

“One of the key takeaways here is that after ASU 2009-12 came out, some press reports said now LP’s have a free pass , they don’t have to do anything, they can take NAV, life is good,” he said. “Really what it said is you can’t blindly take NAV, and the technical practice aids highlight that.”

Instead, LPs need to look at additional factors on top of their normal due diligence to determine that the GP has used appropriate rigor in coming up with their fair value of underlying assets. Some examples the AICPA has provided for LPs includes: 

• -The use of independent third-party valuation experts to augment and validate the investee fund’s procedures for estimating fair value
• -The portion of the underlying securities held by the investee fund that are traded on active markets
• -The professional reputation and standing of the investee fund’s auditor
• -Whether there is a history of significant adjustments to the NAV reported by the investee fund manager as a result of the annual financial statement audit or otherwise
• -Findings in the investee fund’s advisor or administrator’s SAS 70 report, if any
• -The investee fund’s fair-value estimation process and control environment, and any changes to those processes or the control environment

“This is not exactly a checklist, but the more items on this list that exist the less work the LPs themselves usually need to do,” Larsen said. “The fact that all of these things are in place tells me [as an LP] that I have a general partner that is giving me rigorous and robust fair value, and I need to do less work on this general partner than I do on the other general partner that is not using a third party [auditor], for example.”

Larsen also reiterated that NAV has to be in phase, which could pose problems in the private equity space as most firms commonly report 90 to120 days after year end. 

“If you are an LP who has a financial statement of 31 August, very few general partners report as of 31 August, so you will almost always have to make an adjustment to NAV to bring it in phase,” he said. “That means the LP has to do additional work. LPs will look at [their GPs] and say ‘if I have a choice between two funds, everything else being equal, I’m going to pick the one whose reporting is more timely and gives fair value more rigorously’.”