The new regime

The Financial Standards Accounting Board’s Statement 157 on fair value measurement goes into effect for the December 31, 2008 reporting cycle, and private equity firms of all sizes and strategies will have to change their reporting methodologies to comply. For some this is a wholly new regime, and not necessarily reflective of what they feel is the true value of their investments. Others have been marking to market for years, based on guidelines put forth by groups like the Private Equity Industry Guidelines Group, but will still have to tweak their strategies to be in line with FAS 157.
The planning and coordination necessary to implement FAS 157 were among the issues discussed at a recent roundtable organized by PEI Manager. Held at CCMP Capital’s offices in midtown Manhattan, the conversation included finance officers from publicly traded multi-strategy firm American Capital Securities, and middle market firms CCMP Capital and Lincolnshire Management, as well as a valuation expert from accounting firm PricewaterhouseCoopers.
The needs of each firm differ by their sizes and their portfolios, but everyone agreed that living with FAS 157 is going to require forethought and planning, as well as cooperation and communication with external auditors, accountants, and investors.

Change in the air
“I think our firm has always taken the view that you need to look at valuation at fair value, this has just formalized it,” said Marc Unger, chief financial officer and chief operations officer of CCMP Capital, which spun out from JP Morgan in 2006. His firm manages a portfolio of assets on behalf of JP Morgan, as well as a $3.4 billion fund the firm closed last year.
The first close of that fund was in the first half of 2006, and the firm used FAS 157 for its very first set of financial statements issued at the end of that year. “So it’s no issue for us,” Unger said. “We’ve been doing it for a year already.”
Vineet Pruthi, the senior managing director in charge of finance at lower middle market firm Lincolnshire Management, said his firm has also been using FAS 157 for some time.
“We’ve been using fair value accounting for the past several years, so we don’t need to change much,” he said.
As a public firm, American Capital has long faced more stringent reporting requirements than its peers, said Jay Beam, who heads the finance team at the Bethesda-based firm. “We’ve really faced fair value for ten years now,” he said. While many private firms, like CCMP, have a policy of holding the value of their investments at cost for a year to 18 months, American Capital calculates the fair value of its holdings from day one, he said. The firm also faces the requirement to issue comprehensive financial statements on a quarterly basis, rather than an annual or semi-annual basis.
Nonetheless, there are some technicalities that will require the firms to change their procedures. Beam and Pruthi both mentioned excluding transaction costs from the value of the investment, for instance.
All three men mentioned that footnotes are getting longer due to added disclosure requirements, particularly the requirement that a GP define whether the asset in question falls under Level 1, Level 2 or Level 3.
“Over the course of the last two to four years, our footnote disclosures continue to get longer and longer,” Beam said. “And we’re trying to explain more and more. It’s not necessarily that the regulations are getting more complicated, but there is more defined and as that comes to fruition a lot of people want more information from the technical side.”
Club deals are also a source of concern under FAS 157, the valuations of the co-investors might not be in harmony, Pruthi mentioned.
Dimitri Drone, a valuation specialist at PricewaterhouseCoopers, said most auditors would like to know what the other investors in the deal are doing.
“I think auditors will look for corroborating data points,” he said. “Let me see what this co-investor is doing, and see how that lines up with what I’m doing. And you know that most of the time the values will differ. So what do you do? Is one answer wrong and one right? Do you split the difference between the two? Of course the answer is none of the above. You have no idea what is more reasonable or more on point until you have an event that gives rise to a realization of the investment.”
Unger replied that he isn’t overly concerned with the valuations of co-investors, because he is comfortable with the robustness of CCMP’s methods and procedures. “That doesn’t mean if it’s another public company in the deal, that we don’t reference to see how their numbers move, but by and large we’re comfortable with what we do… What someone else does is their business.”
Drone noted that in a situation where one co-investor is a minority owner and one co-investor is a majority owner, the minority owner might discount its holdings while the controlling owner might take apply a premium. “Creating an apples to apples comparison is going to be difficult…it won’t be easy to navigate with so many differences between them.”

Leaving room for judgment
One of the more challenging aspects of FAS 157, said Beam, is that it’s a principle-based set of guidelines rather than rule-based. “It’s one of the first times FASB has issued principle-based guidelines,” he said. “I think a lot of firms out there, be it auditors, valuation firms or even accounting groups, are struggling a bit about how you implement principle-based guidelines. For the past 12 months, the interpretation has evolved, and you can see even today that there is going be some diversity in the practice of it.”
Unger agreed: “You can’t apply it as an absolute rule. You have to use judgment, the auditors need to use judgment, and it’s not going to be perfect. There’s nothing perfect unless it’s a freely tradable public security.”
Beam, Pruthi and Unger all said that preparing valuations is a firm-wide effort. But the extra manpower and resources needed to steer a firm toward compliance with FAS 157 increases with the size of its portfolio.
Beam has a staff of 70 that performs around 300 valuations on a quarterly basis.
While his staff doesn’t solely do valuations, they spend a good eight weeks per quarter on them. The firm implemented FAS 157 in the first quarter of this year, and since then has been working closely with its auditors, as well as some members of the Valuation Resource Group and even the Securities and Exchange Commission. Beam estimates that in the last nine months the firm has spent more than 2,000 hour on implementation.
“When you look at the number of individuals that we needed to touch, in order to be sure we understood what 157 meant, maybe we went overboard,” he said. “But being a public company, I don’t think you can ever go overboard.”
American Capital uses a significant amount of automation to handle the huge amount of data it must process to do these valuations.
“We built a system 18 months ago that automatically pulls in all our portfolio company data and all the third-party data provider information, allowing us to eliminate the manual data-crunch- ing piece of the valuation process,” he said. “That has created efficiencies, although you can never completely replace the human resource element.”
CCMP has been compliant with FAS 157 since its 2006 spinout, but the time required to set forth its policies initially was still significant time sink, Unger said. “It really took some time and effort to implement it, when we were first coming up with the policies and vetting it all out. The time and effort to get there was pretty incredible.
Now that we’ve gotten used to the model, we’re back to steady state at this point.”
The top levels of the firm were involved in formulating CCMP’s policies: the chairman, the CEO, Unger as the CFO, and the head of portfolio management. “This was not something that we took lightly,” Unger says. And many different parties are still involved in the implementation of those policies: the associate on the deal monitors the investment and prepares the valuation. Then the finance staff will review it, and eventually the investment committee as a whole will review it.
Lincolnshire’s portfolio holds between seven and 20 companies at any point in time, so the valuation process is not nearly so difficult to manage, Pruthi says. “We’re the small guys in this room,” he noted. The burden is also lightened because the firm only needs to produce annual, rather than quarterly or semi-annual valuations.
Thus the firm doesn’t need a large internal finance team or a complex data management system. The individual deal teams, the whole investment committee, and Pruthi suffice to handle the process.
“The firm’s been around since 1986, and we’ve been doing valuations as we always did,” he said. “We don’t have a formal written policy, but there is a practice that is consistent from year to year.”

Healthy debates
Drone noted that the audit teams have ramped up their resources as well. In order to handle the additional work they are faced with, the audit teams that work with the funds are reaching out to internal valuation specialists like him.
“The audit teams are very close to the funds themselves, but the individuals on those teams may not be as familiar with valuation techniques as someone like the individuals in my group,” he said.
“So I’ll say that the auditors at least within my firm, and within all the other Big Four firms, they’ve reached out to their own internal specialists and included them in the team in the process of getting to an audited set of financial statements. So the audit teams are effectively doubling the number of people who would be helping out.”
The inclusion of these internal valuation specialists can add a layer of complexity to the relationship between the auditors and the private equity clients, as the internal specialists are often less familiar with the client and its investments. All of the roundtable participants agreed that an auditor and a private equity firm need to understand and be comfortable with each other, a relationship which is built over time.
Unger recalled his experience working with auditors last year: “One thing that I found in this round of valuation was that the auditor gave [the valuation] to an in-house valuation group that didn’t know us from Adam,” he said. “They just see the investment on a piece of paper. So I felt it was very important – I insisted – that our audit partner was on the phone as we were going through this, so he could interpret the numbers for the in-house team. They need to understand who we are and what we do.”
Drone agreed that more communication is always better. If a fund gives him a single sheet of paper that shows their investment still held at cost two years after the initial transaction, “there you’ll have some healthy debates.” What’s needed is a process whereby a firm can demonstrate that they’ve thought about the performance of the company and the general market, and that they’ve searched for comparable companies, he says.
“Show me what you did to get to the end result,” he said. “If you’ve got a process in place, and I can understand how you got from point A to point B, and it’s not so out of line with what the market has been doing and whatever comparables exist, I’m probably going to buy into your assessment of fair value at the end of the day.”
Sometimes debates between auditors and their clients aren’t always over write-downs. Both Unger and Beam mentioned instances where they initially hesitated to write up the value of their investments.
Unger recalled a company that was performing slightly above budget, and doing very well. After about 13 months, a valuation from an independent valuation firm showed a “healthy increase in value.”
“We sat down with the valuation team, and the auditor on our other engagement as well, and we said, look, we’ve only owned this thing for a little over a year, it’s going along it’s plan, but right now it’s too early to say the price we paid for it isn’t the true value of the company.”
Several years ago American Capital was investing in the construction of ethanol plants. In the six month gap between signing the deal and closing the deal, President Bush gave a speech on ethanol that cause ethanol stocks to “shoot through the roof.”
“We had a very healthy debate regarding the value, the first quarter we bought the asset, because there was a significant amount of time between when we priced the deal and when we invested,” Beam recalled. “In that instance, we took a write-up in the first quarter. Clearly significant events had occurred, and third party market data supported that. We went to the point of engaging a third party valuation firm to provide an independent valuation. We spent a significant amount of time with industry experts and investment bankers regarding valuations of a number of companies in the field that were planning to go public. I can’t tell you how many hours we spent on that one valuation.”

Talk to your investors
All three private equity firms represented are confident that their investors are sophisticated enough not to be alarmed by FAS 157, or the resulting fluctuations in the value of their holdings. But the GPs are still doing what they can to make the transition as smooth as possible.
“We meet with the advisory board on a quarterly basis, and communicate with them throughout the quarter,” Beam said. “They’re fairly well versed on the changes that are going on out there. They’re very inquisitive as to the impact of FAS 157 on the investments, but they’re comfortable with our approach. I think that most of the conversations we have with them, they are more concerned about how the overall economy effects our portfolio companies and valuations and what that does to our multiples.”
CCMP too is in the habit of having a lengthy discussion with its investors on a quarterly basis. “They understand that there are more valuation issues now,” Unger said. “Some investors request more information for their own disclosure requirements, so we’ll walk them through our methodology and explain what we do and how we do it. Others will simply sit back and wait.
Pruthi added that in one sense, if an LP has committed to 50 or 60 different funds, they can’t be expected to know what goes on at 2,000 or more portfolio companies. “I don’t think they’re interested,” he said.
When asked if they believed that FAS 157 would make their firms less appealing or competitive over the long run, all three said they were unconcerned.
“It does create more adjustments on a quarterly basis,” Beam said, “but I think comparability and consistency in the industry are welcome out there.”
“Ultimately, the performance of your portfolio is what makes you competitive or uncompetitive,” Unger said. “Valuation is just a point in time.”

Jennifer Harris also contributed to this article