Judgment day

A recent change to the controversial fair value accounting rules will give GPs more room to maneuver in pricing investments but could mean more work for LPs in assessing the worth of their portfolios.

The move has come in response to an outcry by many in the industry, including Blackstone chairman Stephen Schwarzman, who blamed the previous mark-to-market rules – which require assets to be valued at prices reflecting current market conditions – for helping prolong the current financial crisis. Private equity GPs have lately struggled with assigning “fair value” to portfolio investments, with 3i one of the latest private equity firms announcing further expected write-downs as it moves from holding portfolio companies at cost to valuing them on a mark-to-market basis.

The issue came to a head during a 12 March US House Financial Services Committee hearing in which FASB chairman Robert Herz came under fire from lawmakers who urged a revision to the fair value rules. “I heard you – I heard you – very clear,” Herz said during the hearing, which came five days before FASB issued a proposed amendment – FASB 157-e – and heard from over 350 groups and individuals during a two-week comment period before voting in favor on 2 April.

Under the new guidelines, which will apply to the second quarter that began in April, assets can be valued at what they would sell for in an “orderly” sale, as opposed to a forced or distressed sale.

Specifically it establishes a two-step process to determine whether a market is not active and a transaction is not distressed, and lets firms to use their own valuation techniques to value assets in distressed markets.

As such it provides a list of eight factors that indicate that a market is not active, including if the markets have few recent transactions, price quotations are based on old information or vary substantially over time or among market makers, and if indexes that previously were highly correlated with the fair values of the asset are now uncorrelated with recent fair values. By evaluating such factors and considering the significance and relevance of each, but not having to meet all eight, firms will be allowed to use “significant” judgment when determining the price of their investment.

However, Warren Hirschhorn, managing director for valuation firm Duff & Phelps, believes the new rule doesn't significantly change the meaning of 157, which he says always allowed for financial statement preparers to use judgment in valuing assets, even though many auditors mistakenly came under the impression it required virtual fire sale pricing. “In an illiquid, non-orderly market, you have the situation where the audit firms would go to an observable price, which would be the last price,” he said. “People would just defer to the last price and not look at these other factors.”

The accelerated period between 157-e's proposal and its conformation, as opposed to the lengthy comment period held before the original 157 rule was implemented, indicates that FASB is looking to stay ahead of the issue and keep Congress from implementing its own accounting rules and regulations. It also reflects the new economic environment since the rule was originally formed.

“I think the problem comes in that when 157 was written, it was in a period of an up market, and of course when it went into effect in 2007 and 2008 we were in a down market,” Hirschhorn. “No one could have anticipated at the time that the market would be as far down as it has come.”

While a relief for GPs, the new rule will also require LPs to do more work in conducting their own valuations of their private equity investments. “You can't separate what the LPs are going to have to do under 157-e from what the GPs have to do; clearly the LPs will have to do more verification now than they've done in the past,” Hirschhorn said. “You can't just take that net asset value supplied by the GP anymore. And if the LP is an endowment or an insurance company, they could be invested in hundreds of funds, and they are going to have to do this review for all of them. That is a lot of work.”