For a private equity fund, the portfolio company investments can represent nearly the entire balance sheet. With fair value accounting, this means that the entire financial statement is inherently based on a great deal of judgment and subjectivity. Not only does investment performance, but the amount at which investors carry the holding on their financial statements hinges upon the fair value determined for portfolio investments. In a volatile market, valuations can fluctuate widely from quarter to quarter. Fund managers have a fiduciary responsibility to their investors, who rely on and make investment and allocation decisions based on these valuations. Given that many fund investors are institutions, pension funds or other entities that have their own fiduciary responsibilities to their various stakeholders, the valuations that fund managers provide will flow into other entities’ financial statements, creating additional layers of investors and constituents who require reliable valuations. Even prior to the discussions of registration, limited partners and institutional investors have enquired about how their investment managers performed valuations, and begun to challenge those valuations. With the rash of scandals that surfaced in the recent credit crisis, investors have turned up the heat on their investment managers, not only in terms of fraud risk assessments, but also in terms of digging into the fair values that are reported.
Although some might think that fair valuation of assets and liabilities began with the adoption of SFAS (Statement of Financial Accounting Standards) 157 in 2006, regulatory guidance, as well as various professional associations such as the Private Equity Industry Guidelines Group (PEIGG) and others, promulgated the use of ‘fair value’ in reporting investment values before the Financial Accounting Standards Board’s pronouncement of SFAS No. 157. Investment companies registered with the Securities and Exchange Commission (SEC) have long been required to use fair value for their securities under the Investment Company Act of 1940. Section 2(a)(41)(B) of the Act states that, ‘[w]hen market quotations are not readily available, a fund must use fair values, as determined in good faith by the fund’s boards of directors, to value its portfolio securities and other assets.’ Registered investment advisers were also required to consider fair value in reporting to their investors.
However, prior to SFAS 157, most private equity funds had a valuation policy defining fair value as requiring that investments be reported on a ‘lower of cost or market basis’ until a liquidity event or funding round. Thus, portfolio company investments were held at original cost on the balance sheet and might be written down if there was a significant impairment or other event which would indicate a reduction in value. However, investments were only written up if the gain was ‘locked-in.’ These valuation criteria provided a relatively objective and standardized method for reflecting investments in portfolio companies on financial statements. By only reporting gains that were realized, but writing down investments that were not performing, advisers believed they were being conservative in how they provided information to their investors. It was objective, but perhaps bore little relation to the actual fair value of the investments at any point in time.
With the promulgation of SFAS 157 (now known as ASC 820) and International Financial Reporting Standards (IFRS),1 fair valuation began to become more standardized across entities’ financial statements. IFRS and generally accepted accounting principles (GAAP) currently require investments to be classified as either a Level 1, 2 or 3 asset with Level 3 investments’ fair value being derived, at least in part, through non-market observable inputs. Both IFRS and US GAAP define ‘fair value’ under an exit price notion, that is, what a market participant would be willing to pay to acquire or require as compensation to assume an asset or liability.
The three different levels for determining the fair value of assets and liabilities established by SFAS 157 are based on the transparencies of the inputs to valuing the assets or liabilities.
• Level 1, the highest on the hierarchy, indicates assets or liabilities with the most transparent valuations, most typically with quoted prices on active markets, for example, a publicly traded equity share. This type of instrument has the most verifiable and, ostensibly, reliable fair value measurement.
• Level 2 instruments require more valuation analysis than Level 1 instruments. Level 2 ‘inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.’ For example, an interest rate swap uses known public data, such as interest rates and the contract terms, to calculate its value. The instrument can be valued indirectly using observable data. Another example would be using quoted prices for similar assets or liabilities in active markets.
• Level 3 entails the use of valuation techniques and data that may not be observable or verifiable. Valuing these types of instruments involves a great deal of subjectivity and numerous assumptions and estimates. Examples of Level 3 instruments include infrequently traded asset backed securities or investments in privately owned companies.
On June 29, 2010, FASB and IASB jointly issued a proposed accounting standard update (ASU), Fair Value Measurements and Disclosures, Amendments for Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRSs. This exposure draft is intended to align fair value treatment and further improve consistency under the two accounting regimes. Under the proposed ASU, the highest-and-best-use concept, in which an asset should be valued based on its highest and best use, has been clarified and would now apply only to non-financial interests with the boards (FASB and IASB) agreeing that financial assets and liabilities do not have an alternative higher and better use. In addition, the boards also agreed that information on sensitivity analyses would be required in disclosures if changing one or more of the unobservable inputs used in the fair value measure to a different amount that could have reasonably been used in the circumstances would have resulted in a significantly higher or lower fair value measurement. This means that a range of potential valuation outcomes based upon varying assumptions and sensitivities would need to be disclosed in the financial statements. This would provide additional information to investors by showing the potential impact of various assumptions on the value conclusions, but may also create more uncertainty around valuations if the range of potential valuations is relatively wide.
This partial chapter is one of 24 in The US Private Equity Fund Compliance Guide: How to register and maintain an active and effective compliance program under the Investment Advisers Act of 1940, a new book from PEI Media.