Private equity investors, just like fund managers themselves, are becoming increasingly frustrated with the amount of modeling and calculations required of GPs during the valuation process.
“All this excessive work GPs are doing on valuation, it’s causing a delay in when they send us their financial reports,” says one prominent limited partner from a US-based university endowment.
The ‘excessive work’ has to do with appeasing US auditors, who are asking GPs for more – and more detailed – information on valuations, which must be ‘marked to market’. More data and calculations, the thinking goes, allows auditors to show their overseers that GPs’ valuations were adequately stress-tested. Fund managers are expected to generate complex option pricing models and include complicated graphs in their financial statement footnotes detailing when an asset becomes harder to price due to illiquidity. Or, as one private equity chief financial officer puts it, auditors expect GPs to create “a bunch of variables to plug into a bunch of formulas that nobody uses for transacting business.”
…the dirty little secret is that valuations aren’t changing much from what they were
The irritation is shared by a growing number of LPs. “Fund managers are spending all this time justifying their valuations to auditors. And the dirty little secret is that valuations aren’t changing much from what they were,” says one US-based fund of funds investor. “The worst part is it pulls them away from their investing and monitoring duties.”
To be fair, most LPs stress that the transition to fair value reporting was a necessary and positive shift for the industry. In the past, most GPs would report static portfolio valuation figures that only showed movement when a portfolio company had a milestone event. The introduction of US accounting standard FAS 157 (now Topic 820) in 2007-2008, pushed more private fund managers to mark their assets to market every quarter, rather than allowing them to be held at cost, as used to be the case. The shift to more accurate performance reporting was inarguably a good thing for LPs who rely on up to date portfolio information to monitor their investments in 10 year closed-ended funds. The problem comes in with the amount of work GPs must complete to produce this level of transparency.
Frustration around fair value is, of course, nothing new. CFOs and others have long complained about the amount of work it takes to mark to market each quarter and often argued it is unnecessary to come up with such valuations given private equity firms aren’t constrained by short-term needs to exit their holdings.
Those protests have died down somewhat as the industry got used to the fact fair value requirements were here to stay. But auditors’ interpretation of Topic 820, argue GPs, unnecessarily increases their workload, which in turn has LPs worried about returns.
“In the past, our managers didn’t spend much time or resources on valuation. Now I’m hearing from some GPs that they’ve spent seven figures on valuation work. Well, those costs are passed down. That hurts our return,” says the LP from a university endowment.
“I pay these fund managers to exercise judgment. I’m not saying throw out the methods used to find fair value, but don’t raise them up to a level of sanctity that is unwarranted,” adds a second US fund of funds LP . “Let’s give more room to the GP, acting in concert with its LP advisory board, to find fair value.”
When auditing fair value estimates, the LP says a more principles-based approach, as opposed to the more prescriptive rules-based accounting standards in the US, would save everyone time and expense. He notes most institutional investors have an obligation to report portfolio performance numbers to their own fiduciaries, so when a GP is late delivering their numbers, LPs are at risk of missing their own reporting deadlines.
“And even blaming auditors is tough to do because they’re really working off limited guidance,” adds one CFO of a US-based mid-market firm. “They want to conduct a ‘by the book’ feel without any real standard to work off of – and so now auditors are applying a public company standard to everything they do.”
[Auditors] want to conduct a ‘by the book’ feel without any real standard to work off of
One LP from a large US bank echoes the sentiment: “Auditors are acting out of fear . They’re afraid to get comments from the [Public Company Accounting Oversight Board] that could hurt their reputation.”
Perhaps surprisingly, auditors agree with the complaints lobbed their way, but feel that their hands are tied without more instruction from the PCAOB and oversight bodies. “I believe that the PCAOB could provide more guidance especially around the allocation of the enterprise value over the company’s capital structure,” says one US-based private equity auditor. A separate said that “it is human nature for auditors to have ratcheted up their scrutiny of private equity funds now that we know the SEC is looking over our shoulder.”
Some industry sources are looking to the Financial Accounting Standards Board (FASB), the body responsible for setting US accounting standards, to help alleviate the frustration around fair value audits.
Stephen Holmes, chief operating officer of venture capital firm InterWest Partners and winner of the 2013 PE Manager Leadership Award, recently warned FASB members that the board faced reputational risk because of how Topic 820 was being implemented.
…it is human nature for auditors to have ratcheted up their scrutiny of private equity funds now that we know the SEC is looking over our shoulder
“I don’t think it’s FASB’s fault, but it’s FASB’s responsibility to try and fix things,” he said during a board meeting made public via video. One fix would be for FASB to provide more clear guidance around Topic 820– perhaps taking a step towards more European-style principles-based standards – that can make it easier for auditors to fact-check illiquid, difficult to value, portfolio company investments.
The good news is that FASB is alive to the issue. A spokesperson for the group said US accounting standard setters are in the process of a “post-implementation review” of Topic 820 which began recently. A team assembled by the Financial Accounting Foundation (FAF), the body that oversees FASB, recently completed its “initial research” into possibly reforming fair value accounting guidelines, according to the spokesperson. FAF plans to open a public consultation survey in September, and then later share its findings with FASB and others in late 2013 or early 2014.
It’s fair to assume that standard setters are already anticipating letters from GPs that bemoan auditors’ approach to Topic 820. What they might find surprising is how many LPs – the stakeholders fair value guidance is designed to benefit – agree with them.