Why GASB may keep CFOs up late at night

Now that certain LPs will soon have their own fair value accounting rules to follow, they may require more rigorous, timely reporting by GPs.   

If any GPs out there are trying to get a better sense of how far LPs’ expectations around valuation have risen these days, their finance and accounting team will no doubt be delighted to set them straight.

These days during due diligence, LPs can often be found poring over the firm’s valuation policies. And they’ll want to know exactly who sits on the valuation committee, and sometimes they’ll even want to be walked through a hypothetical portfolio company valuation to examine the types of inputs and assumptions being used. A few LPs even require any quarterly estimates to be pre-approved by an investor advisory committee. It’s a changed world since late 2008, when most GPs started to increase the rigor with which they marked their assets to market in response to FAS 157 (now topic 820).

But after that initial trust is built, and a commitment is made, LPs for the most part have been able to rely on the fund’s reported net asset value – on the assumption that it was diligently arrived at by the GP through a fair value estimate of the fund’s underlying assets – to complete their own financial reporting. In accounting lingo, it’s known as a ‘practical expedient’: rather than doing a bunch of possibly redundant valuation work, LPs have been able to piggyback off the fund NAV, as long as their own measurement date was close enough to the last quarterly or annual fund financial statement sent by the GP. And if the two measurement dates were too far apart, some adjustments to NAV could be made based on new information like market swings, fund investments and realizations since the last fund financial statement. For a long time now, this practical expedience concept – mixed with a dose of trust – has been all LPs have really needed for internal reporting purposes. 

Things may be about to change, however. Earlier this year, the Governmental Accounting Standards Board (GASB) released an exposure draft that better codifies how state and local governments should define and measure fair value. And of course, state pension plans – which make up a large chunk of the industry’s capital commitments and often set best practices in the LP-GP relationship – are subject to these GASB standards. So while the exposure draft may not have made much of a blip on the industry’s radar (since GASB is the standard-setter for public sector bodies), it’s set to create a ripple effect headed straight for GPs’ valuation and accounting teams. 

Hard and fast rules

What makes the exposure draft so significant is that it ends GASB’s silence on how exactly LPs should go about reporting the value of their private fund holdings.

The exposure draft acknowledges that the practical expedient concept is useful, saying the fund’s NAV per share can be reported instead of having LPs run their own valuation models on LP interests (they would need to estimate fair value for direct and co-investments), of which GPs presumably have a better understanding. But GASB also states that as a safeguard, LPs should make additional disclosures when relying on the practical expedient – and it’s this second part that may force LPs to require more rigorous and timely reporting from managers.

Some of the disclosures are fairly basic: the fund’s reporting date, a description of its primary strategies and the amount of any uncalled commitments. Other disclosures may prove more difficult though, including a time estimate of when the LP expects the fund to be liquidated and whether the investments are likely to be sold for amounts different from the NAV per share on the secondaries market.

As mentioned, many LPs have already moved in the direction of more valuation due diligence. But “to have GASB carve the practice in stone could push many investors to formalize and enhance the process,” says David Larsen, managing director at financial advisory and investment banking firm Duff & Phelps. “And LPs subject to GAAP who never really gave much thought to how much trust they put in GPs’ fair value estimates will need to begin thinking about this more.”

There could also be a significant impact on LPs’ expectations around timeliness. LPs’ own reporting dates typically fall at different points in the year; sometimes a pension plan’s financial statement can be completed months after the actual reporting period. Nonetheless, LPs will want their reporting date to be “in-phase” with the latest financial statement from the fund, mostly as a way of reducing the amount of headache that goes with adjusting its NAV. Most GPs provide quarterly performance statements and a more thorough annual statement given a sign-off by auditors, but “the demands to be in-phase may force some GPs to begin providing more timely reports each quarter or possibly monthly,” cautions Larsen.

To further complicate matters, auditors will need to give their own interpretation of GASB’s new fair value rules – which means more scrutiny of LP’s fair value disclosures is likely in the months ahead. Naturally, LPs will want to feel prepared to answer auditors’ questions about fair value disclosures, armed with strong documentation and an understanding of their GP’s fair value customs and practices.

“I can even imagine this resulting in a knock-on effect where one LP with exceptional best practices forces everyone else to raise their bar,” said one private fund CFO (speaking on the condition of anonymity). “If auditors see one public pension plan perform this incredible level of review on GPs’ valuation policies and procedures, they may wonder why other pension plans aren’t doing the same.”

Competing standards

A less noticeable risk to emerge from the exposure draft is that GASB’s interpretation of fair value accounting may not ultimately match what the Financial Accounting Standard Board (FASB) says in topic 820. For the most part, GASB and FASB say the same thing on fair value accounting – though GASB’s language is written in a more plain English style – but a few areas of differences could conceivably result in GPs, LPs and auditors interpreting the same asset’s fair value in different ways.

“Something that stuck out to me was the inclusion of ‘option pricing model’ in the exposure draft’s glossary, which may give the implication to some that this model should be applied in estimating fair value,” says John Taylor, head of research at the National Venture Capital Association. As reported in pfm in the past, private fund managers have questioned auditor’s insistence on including the option pricing model valuation methodology in certain instances where it doesn’t sync with industry practice.

The International Private Equity and Venture Capital Valuation board (IPEV) flagged this concern, too, during a consultation period on the draft that ended last month. On option pricing models, IPEV said that “it should be made clear that such models would only be appropriate if they reflect market participant assumptions”.

Another difference between GASB and FASB on fair value relates to control premiums or discounts. While GASB seems to assume in the absolute that a control premium exists when holding a controlling interest, IPEV wrote in its letter that “market participants in the private equity and venture capital industry do not typically think of value in the context of control premiums or minority discounts.”

A GASB spokesperson said the board was in the process of reviewing comment letters and expects to issue a final statement on fair value in the first quarter of 2015. If they haven’t already, the private funds community should be keeping close track of what these proposals say. It’s likely to be big news for the firm’s valuation and accounting team.