Minding your Ps and Qs

It’s no secret that the Chinese public markets have been unpredictable of late. Since July, the government has been intervening on multiple rescue missions – suspending trading for 1,400-plus companies, preventing shareholders from offloading stakes, delaying IPOs and, most recently, devaluing the yuan.

But less visible has been the effect on managers of private funds. Managers with publicly-traded Chinese investments are witnessing their portfolios experience wild swings in price, despite believing the true fair market value of these assets to be following a more consistent trajectory.

The problem stems from accounting rules. The Federal Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) require that actively-traded securities be valued at P (public share price) times Q (quantity owned), which is a suitable metric for liquid investments.

But for private equity, where investments are held long-term and exits are timed to coincide with benign market conditions, this approach results in some misleading financial reporting. Earlier this year for instance, during a massive market rally, the PxQ rate artificially ballooned GPs’ valuations – as high as 100x price/earnings ratios for some portfolio companies – causing GPs to report sky-high valuation estimates that no reasonable buyer would accept.

Another complication are the trading suspensions imposed by the Chinese government, most recently in mid-July. During a suspension, GPs are given the latitude to value the company based on unobservable inputs, leading to a more accurate reflection of what they feel the company is worth at the time of measurement. But the subtlety here is that the measurement may move substantially from the previous quarter’s estimate that was artificially inflated (or deflated) by the PxQ rule.

To those who don’t work in the firm’s finance and accounting team, this might seem a technical and minor point. But GPs are entrusted to provide investors with a genuine estimate of the portfolio’s fair value on a quarterly or annual basis. This is because LPs most often use the GP’s reported NAV as their own fair value estimate. The concern is that GPs will end up presenting valuations that they don’t really stand behind, leading to a potential credibility gap that neither investors nor inspectors can accept.

One solution may be for GPs to present a second fair value estimate – one better reflecting their market senses – in an investment letter, but it may not be wise for GPs to appear to be challenging internationally accepted accounting standards, especially with regulators eyeing valuations ever more closely.

The solution then has to come from the standard setters themselves. Unfortunately, we have no reason to believe FASB will provide much attention to what is the small corner of the market owned by private equity, but the current situation in China does raise the question of whether or not they should reconsider the PxQ rule.

Granted, a new rule would probably take years to introduce (likely long enough for China’s markets to balance out again). But if the result would be a more credible, predictable and meaningful valuation process for all, then it is worth waiting for.