Under pressure

With FAS 157's adoption date of November 15, 2007 fast approaching, the private equity community can no longer wiggle its way out of confronting the fair value issue. Fair value is not new ? it is a core concept in GAAP, and private equity limited partnerships have for years required GAAP-compliant reporting.

The adoption of a robust approach to fair value accounting has not been widespread ? many general partners have preferred to hold investments at cost, and to declare cost to be fair value. Limited partners have traditionally looked toward realizations, and shrugged at interim valuations.

But pressure to adopt fair value accounting in the aftermath of Enron, et al, is growing. Auditors are coming down hard not only on GPs, but also LPs, to come up with a burden of proof for how a valuation came to be. Their view is that no one is exempt from adopting fair value. LPs in turn are looking to GPs for documentation of a fair value approach.

The pressure on LPs comes from the rules of the American Institute of Certified Public Accountants (AICPA), which last year released the Alternative Investments ? Audit Considerations practice aid on AU 332 for auditors.

An additional source of pressure comes from a FAS push to encourage the early adoption of footnotes to explain valuation markets.

The LPs' burden
Valuing a portfolio of privately held companies is no easy task, not for an LP especially, and auditing them can be trickier. To this end, the AICPA issued a practice aid meant to help auditors who audit alternative investments, including hedge funds, private equity funds, real estate funds, venture capital funds, commodity funds, offshore fund vehicles, and funds of funds, as well as bank common/collective trust funds. These can be structured as limited partnerships, limited liability corporations, trusts or corporations.

?The new audit guidance is putting pressure on overall valuations from the point of view that an LP that reports financial information in accordance with GAAP has to record its investments at fair value,? explains David Larsen, managing director at Duff & Phelps. ?The LP has to take responsibility for its fair value assessment.?

The life of an LP is already not an easy one. GP reports come to them in all shapes, forms, sizes and times. LPs say they don't get the level of information on a fund's underlying portfolio companies that they want to make their own valuations. There are no valuation standards either, with some GPs holding things at cost, and others using the guidelines outlined in the limited partnership agreements.

Similar to GPs, LPs must now have a policy and process in place to arrive at fair value. The documentation, says Larsen, will vary based on the individual LP or GP, and in part will be influenced by the requirements of the auditor.

The greater pressure on LPs to justify the valuations they produce is playing out in a few ways. ?The AICPA guidance essentially said that LPs need to do their own independent assessment of the fair value of the assets,? says Thomas Keck, chief investment officer at private equity advisor StepStone Group. ?It's not a very practical recommendation. There's still a fair bit of work to determine how much work is reasonable for LPs to determine what is the underlying fair value of an investment in a fund.?

Stiff demands, slim resources
Not all LPs have sufficient manpower to do the assessments necessary to justify the numbers required by auditors, particularly if it means combing through the financial information for each and every investment they own in a fund and doing the follow-up calls and emails to arrive at a number they are comfortable with. And this is all within the reporting time frame.

A large LP may hold thousands of underlying investments. And while investments in the first year can be held at cost according to guidelines by two industry groups (the Private Equity Industry Guidelines Group ? PEIGG in the US and the International Private Equity and Venture Capital Valuation Board ? IPEV in Europe), and another portion may be publicly traded, an LP could still be left with several hundreds, if not thousands, of companies that need evaluation.

Staffing can be particularly problematic for public LPs. ?Pension funds can use third-party providers to assist in the audit process,? says Keck. ?This is still a pretty new issue ? there are a lot of pension funds that have not gone through an audit cycle under the new guidelines.?

Larsen, however, believes that the assessments must be done in-house. ?While managers [LPs or GPs] can't outsource their determination of fair value, some funds are using a third party to assist in the valuation process,? he says.

Another problem for LPs is that there are no guidelines for valuing partnership interests. LPs hold not securities in the underlying portfolio companies, but membership interests in the fund. When it comes to valuation, LPs have to contend with additional interpretation and information issues.

The clubbing question
Keck says that one approach in valuing a partnership interest is to use standard fair value guidelines and go through each of the underlying portfolio companies to come to a value. But what if an investment is part of a club deal or consortium of buyers? ?The [various] GPs may be holding that company at different valuations. The valuations may be valid according to GAAP, but what does an LP do? Do we use the midpoint, or come up with our own valuation?? he asks.

Owning a partnership interest in a publicly traded fund does not necessarily make things easier, says Keck. Public securities can trade at a discount or a premium, and rarely at the fair value. ?FAS 157 says I'm supposed to use any market information I can get as input in a valuation process. As more and more private equity managers get involved in the public markets, that could complicate the process as you try to figure out what information you may or may not be getting from those publicly traded securities,? he notes.

What, then, to make of valuing partnership interests in funds that are private and illiquid? In the months leading up to the FAS 157 adoption deadline, Keck believes that auditors have been reasonable, and that the community is trying to figure out how to interpret new regulations and guidelines. ?There's a sense of trying to work with LPs to come up with solutions that aren't too traumatic,? he says.

Randy Stilman, chief financial officer at private equity advisor Hamilton Lane says, ?I don't think that [the new guidelines have] affected how we're being audited, other than there's been an emphasis in making sure that we have procedures in place regarding fair value.? But there is more work involved ? the firm has set up a valuation committee to ensure that the valuations reported by the GPs or produced by the firm are reasonable. ?We spend a lot more time in-house revaluing and reviewing information,? says Stilman.

Devil in the footnotes
One of the ways LPs will be reviewing that information with greater rigor is by examining how various valuations were reached. An element of FAS 157 calls for investment managers to use footnotes to provide the rationale for a given valuation. The footnote requirements of the standard must be included in the financial statements beginning in the first period the company adopts FAS 157 and the standard itself must be adopted for December 31 fiscal year end companies on January 1, 2007. This will naturally send LPs running back to their GPs for greater detail on how a given number was reached. In response, GPs will have to provide an X-ray for their numbers tracing their own steps toward the final valuation.

These expanded footnotes will disclose the ?hierarchy? of valuation inputs is required by FAS 157. ?It basically requires that the hierarchy level be used and disclosed. If Level 1 is not available, you move to Level 2, and if Level 2 not available you move to Level 3. Level 3 is going to apply to many private companies, which don't have public-market comparables to help arrive at valuations,? says Larsen.

Without those easy markers to generate valuations, the footnotes will articulate what uncommon or less concrete metrics were used to arrive at the numbers. ?One of the objectives of FAS 157 is to better characterize the reliability of a given fair value measurement valuation,? says Amie Thuener at PricewaterhouseCoopers. ?How they gauge that will be from how observable the inputs were for a given valuation. For example, with a stock price for a public company you'd have the stock price which is observable. However, when projected cash flows figure into the valuation, that's relatively unobservable, and therefore require greater explanation in the footnotes. For assets and liabilities measured at fair value on a nonrecurring basis, these footnotes will now include a discussion of the information used to develop the inputs to address what factored into that projection,? explains Thuener.

The footnotes will mean more than frequent phone calls between GPs and LPs, and thicker reports on the portfolio. The shadows where GPs can apply art over science in their calculations will recede. The skeleton of a given valuation will be in view, where the LP can contest any assumptions being made for either a higher or lower valuation. The partner at one middle market firm admitted the firm expected more disputes with investors, as LPs will now have greater specifics of a valuation in hand. Much as GPs may defend their valuation to auditors, they should now be prepared to substantiate the numbers to LPs as well, in far greater detail than ever before.

While FAS 157 may be intended to provide greater clarity to ?fair value,? there continues to be room for interpretation, even with the substantial time and cost involved for GPs and LPs to defend every number. Providing interim value for a private equity portfolio involves more than a few assumptions, and that even while posted in the most lengthy of footnotes, remain that ? assumptions and not facts. Valuation may yet remain in the eye of the beholder, though the beholders better be ready to explain themselves.