Reporting transparency: A property downturn imperative

Over the past decade, real estate fund investors and advisors have clamoured for greater real estate fund transparency and comparability. In the midst of a severe market downturn with fierce competition for scarce capital, anything less than full, timely and consistent disclosure may be considered suboptimal and result in competitive disadvantage for fund managers.

Simply stated, transparent reporting is the communication of financial information with enough clarity and detail that an investor or advisor would be able to fully understand the fund manager’s investment strategy, execution status, leverage utilisation, fund financial position and performance to date on both a realised and unrealised basis. Financial data and performance metrics should be reported in a form and level of detail that will allow for comparison with similar information provided by other fund managers. Unfortunately, standardised reporting in the industry is still a long way off, resulting in inefficiencies for both the fund managers and the investment community.

In the fall of 2005, a survey conducted by Ernst & Young on the reporting practices of real estate fund managers indicated that the real estate fund community was utilising six different methods to report primary financial data to investors.
 
As this information is used as the basis of analysis, comparison and evaluation of performance, it’s not hard to see how massively inefficient the lack of standardisation really is. If investors find it exceedingly difficult to analyse performance or benchmark a prospective fund against others in its portfolio, they may just take their scarce capital elsewhere. Although some progress toward standardisation has been made in the last three years in anticipation of the proposed (but never issued) Statement of Position 07-1 on investment company reporting, significant diversity of practice still remains. Nowhere is this reporting diversity greater than in the valuation of investments.

As noted in the chart above, two of the primary methods of accounting utilised by fund managers do not provide for investments to be reflected at their fair value in the fund financial statements. Among the other methods of accounting that do provide for investments to be reported at fair value, the judgmental nature of such determination often leaves investors wanting more data and making requests supplementally. Common inquiries include:

• • What does fair value represent in this context? Is it truly a market clearing value as of the balance sheet date given a proper exposure to the market?
• • What were the primary methodologies employed in deriving the fair value estimate?
• • What were the critical assumptions employed?
• • How sensitive is the valuation to the variation of the assumptions?
• • How does the valuation analysis compare to the latest trades that have been made for similar assets?
• • How were the assumptions derived if no recent comparable trades have been made to support a valuation thesis?

Valuation has always been a highly judgmental area. In today’s dislocated markets, with bid/ask spreads for assets as wide as they have ever been, the exercise has become exceedingly more difficult.

The issuance of FASB Statement No. 157 (Fair Value Measurements), as amended, has gone a long way to create some level of standardisation to help facilitate comparability and transparency.

Among other things, this accounting guidance has:

• • Clarified the definition of fair value to be used industry wide.
• • Clarified the distinction between distressed pricing and fair value, and
• • Attempted to standardise the level of disclosure around critical valuation methodologies and assumptions.

However, as with any accounting standard, there are various degrees of compliance and fund managers exercise individual discretion in interpreting what constitutes good disclosure.

At a recent industry meeting on investment valuation, fund of funds managers were bewildered by the variation in both fund managers reporting of investment values and the level of analysis provided to support valuation conclusions. To be sure, these investors acknowledged that there are a great deal of fund managers doing an outstanding job reporting their portfolio valuations providing both market analysis and accumulated data to support their valuation conclusions. Although they observed little standardisation, these best-of-class managers had enough transparency that the investors could easily work through the critical valuation elements and gain comfort with the conclusions. Other managers, however, were not as forthcoming.

One fund of funds investor actually revalues all portfolio investments for its internal reporting and graphs the disparity between its valuation conclusions and those of the fund managers each quarter. A not-so-subtle intimation was made that this type of disparity in the transparency of reporting would factor in to the decision making process for future fund manager selection.

Institutional investors are still nursing wounds inflicted by the financial crisis. As they attempt to gain a handle on deteriorating fund performance, the frustration associated with a lack of standardisation and, absent that, a lack of transparency continues to mount. Fund managers have observed a threefold increase in the number of special requests for portfolio data from investors. 

Some institutional investors are now requiring fund managers to report financial data pursuant to a prescribed methodology and format as a precondition to any new investment. As an example, as reported in PERE on 12 August 2009, the California Public Employees’ Retirement System has developed a customised set of valuation reporting guidelines that it is mandating from all the fund managers in its portfolio. In the absence of industry standardisation, this mandate is understandable. Consider however, the notion of a dozen large institutional investors all developing their own “standards”. At a time when pressure is building for fund managers to lower fees, these varying standards, however well individually conceived, create additional reporting inefficiency that drives up the cost of doing business for all market participants.

Standardisation of reporting is a concept that investors and fund managers alike embrace, as long as the change is to the reporting method that they currently employ. (Everybody likes progress, but nobody likes change). Reporting standardisation is still beyond the immediate horizon for the real estate fund industry. Until standardisation becomes a reality, transparency is the key objective and perhaps, for fund managers to stay competitive, a reporting imperative.

Gary Koster is a partner with Ernst & Young LLP and the Americas Leader of Ernst & Young’s Real Estate Fund Services practice.  You may contact him at +1-212-773-0525 or gary.koster@ey.com.

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.