Editor: David, you have been involved extensively with the fair value accounting issue. Can you tell us in which groups you participate?
Larsen: Yes, I serve on the Financial Accounting Standards Board's (FASB's) Valuation Resource Group. FASB is the private sector organization in the United States that establishes financial accounting and reporting standards governing the preparation of financial statements. I also sit on the International Private Equity and Venture Capital (IPEV) Valuations Board, an international valuation organization.
Editor: What is fair value, and how are assets held by hedge funds, private equity funds, limited partnerships and banks classified?
Larsen: Because there was no common definition of fair value in the U.S., in 2006, FASB issued Statement 157 to harmonize the various definitions of fair value and to expand the disclosure of fair value estimates. Many people misunderstood Statement 157 and somehow thought it required certain assets to be recorded at fair value. However, Statement 157 didn't require any assets to be recorded at fair value that were not already required to be reported at fair value.
Statement 157 did harmonize the definition of fair value and introduced the concept of "levels of input" to valuation estimates. Inputs to valuation estimates are characterized as Level One, Two or Three, each denoting the "observability" of the inputs in the marketplace. Simply stated, Level One determines fair value by using an active market price. Level Two determines fair value by looking at observable information in the marketplace. Level Three uses inputs that are not observable. Statement 157 has nothing to do with good assets, average assets, or toxic assets.
Hirschhorn: Common stock held by private equity funds are typically Level Three assets. They are not traded because there is not a market for them. Private loans are characterized as Level Three assets simply because they are not traded. In other words, not all Level Three assets are toxic, but all toxic assets are probably Level Three assets because they're illiquid. And, fair value accounting values those assets at what you would receive today in an orderly transaction, not in a fire sale.
Editor: Are there any recent developments from FASB that will affect the future of fair value accounting, which, in turn, will have a significant impact on private equity funds and hedge funds?
Larsen: Yes. Some are alternative asset specific, and some are much wider and include anything that's recorded at fair value. First, during 2009, the International Accounting Standards Board (IASB) issued an exposure draft on a fair value accounting standard that would apply to all assets recorded at fair value. The IASB draft used the same definition of fair value as in Statement 157 (now called FASB ASC Topic 820 (Topic 820)). Although the definitions were identical, when you peel back the layers of the onion, there are some differences.
Second, FASB and the IASB independently are addressing how financial instruments should be valued and recorded. They are trying to address substantive questions such as how bank loans should be valued and whether these loans should be at amortized cost. The financial instruments project is fairly massive, and there is disagreement not only between FASB and the IASB, but also with influencers such as the G20. Some preparers of financial statements (management) feel that certain assets, such as a bank loan that is "held to maturity," should be recorded at amortized cost. FASB's position is that all assets recorded on the balance sheet, including all financial instruments, should be recorded at fair value. And, it becomes much more complicated as you progress. Essentially, the unresolved questions include what should be recorded at fair value; how should it be calculated; and how should it be disclosed.
Editor: Can you tell us about ASU 2009-12 and ASU 2010-6?
Larsen: In September of 2009, FASB issued Accounting Standards Update (ASU) 2009-12. ASU 2009-12 said that investment companies or their investors reporting the fair value of assets on their balance sheets were permitted, in certain circumstances, to use net asset value (NAV) to determine the fair value of those assets. The certain circumstances included using net asset value derived from a rigorous application of fair value of the underlying assets, provided, however, that the asset value was "as of" the same measurement date as the investor's financial statements.
Even though ASU 2009-12 was issued only at the end of September 2009, there were enough questions surrounding it that in December 2009, the American Institute of Certified Public Accountants (AICPA) issued a Technical Information Services Update (TIS Section 2220, Long-Term Investments ) to provide guidance for both the preparers of the financial statements of limited partners, and their auditors. Importantly, the ASU will likely put a great deal of pressure on limited partners who, in turn, will put pressure on their general partners to ensure that underlying portfolio companies are valued robustly and rigorously, so that NAV is based on the fair value of underlying investments.
Also, ASU 2009-12 likely will drive a push to more timely reporting. In most limited partner agreements today, depending on whether reporting is done quarter-end or year-end, the general partner has 90 to 120 days to provide quarterly or annual financial statements. That cycle will likely come down to 10 to 20 days, because if the limited partner doesn't receive timely information from the general partner, the limited partners must estimate fair value themselves for internal reporting and financial statement purposes.
In January 2010, there was another Accounting Standards Update, ASU 2010-6, which requires improved disclosures about fair value measurements. It applies to everybody, i.e., banks, insurance companies, private equity, who records assets or liabilities at fair value. During 2009, when ASU 2010-6 was in its exposure draft stage, the part of the exposure draft that received the most comment was the part on sensitivity disclosures. Pursuing convergence, FASB was trying to model ASU 2010-6 after International Financial Reporting Standards (IFRS) 7, which requires not only expanded disclosure on fair value measurements, but also disclosure of the outcome of reasonably possible alternatives from a fair value point of view. So, if there are reasonably possible alternative inputs to a valuation estimate, you have to identify them, disclose them, and calculate their impact. Sensitivity disclosures became a huge discussion point because many commentators said it was irrelevant, difficult, and confusing. FASB decided not to include sensitivity disclosures in their new guidance.
ASU 2010-6 expands the disclosure of movements between Level One and Level Two and requires that Level Three assets have to be shown on a gross basis. Historically, those were shown on a net basis, but now it's on a gross basis. If you don't study the footnotes, you might miss that point. This ASU also expands some of the qualitative disclosures and describes in more detail which major classes of assets have to be disclosed. Fortunately, this requirement is not a major headache. The earth-shaking piece is the fact that sensitivity disclosures are not there. While the FASB was trying to harmonize its standards with the international standards, ironically they created another point of potential divergence - this time, the inclusion or exclusion of sensitively disclosures.
Editor: Can you highlight key differences between domestic and international standards?
Larsen: Another key issue is that the IASB basically has accepted the premise that there should not be special accounting standards for special industries. In other words, one size should fit all. Under international accounting standards, there is no investment company accounting; there's just accounting. Also, under international accounting standards, if you own control of an investment, you must consolidate your financial statements (combine all assets, liabilities, and profit/loss of all controlled investee companies in a common financial statement for all investee companies). Contrast that with U.S. accounting standards. In the U.S., we have different accounting standards for different types of business interests and for different industries. For example, investment companies, such as hedge funds or private equity funds, prepare their financial statements using a fair value basis. If you're an investment company that owns control of its investment, that investment is reported on your financial statements at its fair value. You don't consolidate your financial statements. The reason you don't consolidate your financial statements is because you are reporting the investment at fair value.
The international accounting standards don't allow recording controlled investments at fair value. Hence, for investors in alternative assets, international accounting standards arguably are irrelevant because they don't provide investors with the basic fair value information that investors need to prepare their own financial statements. If a private equity fund were to follow international accounting standards, it would have to consolidate the investments it controlled, which would mean it would not provide its investors with financial statements showing the fair value of investments. Because international accounting standards are not relevant for the ultimate investor, the limited partner (LP), there are very, very few private equity funds and hedge funds that follow international accounting standards. If the U.S. were to adopt international accounting standards, that would be problematic for the alternative asset industry. However, new information from the IASB indicates a desire to change the consolidation rules for investment companies.
Third, as I previously mentioned, despite the fact that the domestic and the international fair value definition is exactly the same, there are differences when you peel back the layers of the onion. When you read the underlying words that support the IASB definition of fair value, investments are effectively valued on a minority interest basis. But under the U.S. GAAP definition of fair value, an investment is valued based on value of the total investment.
The IASB proposal has two additional key provisions. First, the IASB prohibits the use of blockage factors. You can't value an entire block and include a blockage discount or premium, if appropriate. You must value investments on an individual share basis, which by definition is a minority interest position. Under U.S. GAAP, you would value the interest in the private company in its entirety taking into account the block owned. International standards would value a single share of the private company and multiply it by the number of shares owned. It's very subtle, but it's a major difference between the FASB and IASB approaches.
Finally, use of sensitivity disclosures is a stated goal of FASB. We don't know as yet whether sensitivity disclosures will be required or not. That will be subject to the IASB and FASB harmonization discussions. Currently we have divergent approaches.
Editor: Can you comment on the European alternate investment fund manager rules?
Larsen: In April 2009, the European Union (EU) issued alternative investment fund manager rules that are highly controversial. Issued at that time due to underlying EU politics, they have been debated intensively. The latest word on the subject is that a new version of the proposed rules will be issued shortly. Since the April 2009 version was issued, there have been at least 1,300 changes.
One key provision concerns the equivalency rule. Essentially, it states that European or EU investors cannot invest in a fund located in a jurisdiction that doesn't have the same legal regulatory framework as the EU. One interpretation is that equivalency requirements could prevent European capital from investing in other places around the world. That potentially could eliminate 40 percent of the world's hedge fund and private equity capital. Logically it doesn't make sense; it won't happen, but that's what's in the legislation right now. The speculation is that the only place that would have equivalent legislation is the EU itself. (N.B. It's not that Europeans will have the ability to choose one set of rules over another; it's that they will not be allowed to choose to invest in a U.S. fund or in any other jurisdiction that does not enact similar legislation.)
Editor: FASB and the IASB seem to be going in different directions and may not be able to achieve convergence on the issue of convergence. What are the implications if that happens?
Larsen: The ability of U.S. investors to invest is not driven by U.S. Generally Accepted Accounting Principles (GAAP). The ability to invest is driven by legislation, so it's not a GAAP question, which one could argue is separate and totally independent. If the EU adopts this alternative asset fund manager legislation with its 1,300 provisions, it essentially says to U.S. investors, if you want Europeans to invest in the U.S., your Congress must adopt equivalent legislation. That's the concept of equivalency.
On the GAAP side, I think that it's going to come back to the Obama administration through the SEC. Under the previous administration, the SEC seemed to say that the U.S would adopt IASB rules over FASB rules. However, that would cut the legs out from under FASB. Then, there would be no need to achieve convergence because FASB's positions would be pushed to the side. So, there's pressure to have the two sides working together. Whether FASB and the IASB can develop a single set of good quality financial standards worldwide, independently created without political pressure, is the question that remains to be seen. So, until that question can be resolved, if it can be resolved, the two different paths remain.
So that's a very long-winded way to say the jury's still out. Are we going to have convergence? It's really a question of does the U.S. government, does U.S. business believe that it's in its best interest. It seems like business is persona non grata, at least Wall Street is persona non grata, at the table of the current administration. There's nobody in the current administration that has any deep-rooted business experience, including on the Council of Economic Advisors. So, how does this come together? Do you give power to the IASB, which probably means that you never get it back? If you kill FASB, right now the SEC can help mold and guide things. But will they potentially have less power if you move toward the IASB version?
Editor: Can you tell us about legislation pending in the United States?
Larsen: There are two major pieces of legislation pending in the U.S. The first is the legislation that would cause certain asset managers to be registered with the SEC. Some people believe that it's no big deal because others already register on Form D. Some people believe that that could be very detrimental because once you are registered, that means government oversight. The venture capital industry seems to have been able to lobby its way out from underneath this legislation, so they're not necessarily included. Secondly we have legislation that will expanded banking regulations that have the potential to cause banks, and possibly insurance companies, to divest their private equity groups. What that means and how that plays itself out remains to be seen.
In addition, on both sides of the ocean there still is a desire to tax carried interest differently. The fundamental question is whether investing in a long-term asset should be taxed as a capital gain or as ordinary income. Some have said if you start taxing carried interest, entrepreneurs will not want to create companies through a venture capital fund, which means fewer jobs. Some have said that it will be destructive to the real estate industry because the real estate industry is driven by partnerships that, again, are taxed on a capital gains basis, similar to the carried interest rules.
In his State of the Union Address, President Obama said financial regulation is one of the key things that needs to be addressed, so the questions become how will that regulation come to bear, and how do the accounting standards interact with them? Knowing that this harmonization effort is going on behind the scenes, do we create a situation to harmonize with international accounting standards as they currently exist? If so, in some ways private equity and alternative asset investors are left in the cold because they will not benefit if we lose existing domestic investment company accounting. I think that there's going to be a lot occurring throughout 2010, and so it is a moving target. Everybody - investment managers, pension funds, funds of funds, general partners, banks, insurance companies, endowments - needs to be focused on keeping up to date with potential and actual regulatory and accounting changes. Financial advisors will need to prepare information for their clients in a way that makes sense and is compliant with the rules. Their clients need to know how the new legislation will impact them.
Editor: You previously commented on the blockage discount in relation to private equity firms. Would that blockage discount also be applied to corporations and operating companies that have investments in subsidiaries?
Larsen: No, because the accounting standards applicable to an operating company are different from the ones that apply to the investment companies. I'll try to demonstrate this difference with an example that illustrates the difference between consolidation accounting and fair value accounting. Say I'm an investor, be it a corporation or an investment company, and I invest in three companies. I buy 100 percent of Company A for $100. I buy 20 percent of Company B for $100, so effectively the fair value of the company is $500. I buy one percent of Company C for $100, so effectively the fair value of Company C is $10,000.
A year passes. Things have gone well for these three companies. Company A, a biotech company, passed its clinical trials. It spent $50 to move the clinical trials forward, which were successful. As the year ends, Company A only has $50 left, so in this simple example, it has lost $50 in equity. But let's say its fair value, hypothetically, is $200 because it passed the clinical trials which increases the overall value of Company A. Company B earned $100 during the year, so its equity went from $500 to $600. However, to determine fair value, the market values Company A based on a multiple of its earnings before taxes, interest and depreciation (EBITDA). Assuming EBITDA of $200 and assuming an EBITDA multiple of 5, the fair value of Company B is five times $200, to yield a fair value of the entire company of $1,000 at the end of the year. For Company C, which is a much bigger company, assume the same multiple of five to $4,000 of EBITDA, to yield a fair value of the entire company of $20,000.
After one year on a fair value basis, Company A, which is owned 100 percent, is now worth $200. Company B, which is owned 20 percent, now has a fair value of $1,000, multiplied by the 20 percent ownership gives $200. In Company C, which is one percent owned, the fair value is now $20,000, multiplied by 1 percent gives a fair value of $200. On a fair value basis, the fair value in the portfolio of three investments has increased from $300 to $600.
Now, if we focus on an investment company following IFRS, or an operating company (both of which are required to consolidate control investments rather than report them at fair value) the following results occur: Company A, which is 100 percent owned, would be consolidated. Using consolidation accounting, all the assets and liabilities are consolidated in a single set of financial statements. In other words, the $50 loss is added to the results of all other owned companies or activities. So the net impact is that the $100 that was invested in Company A, with everything commingled, is now worth $50. For Company B, the 20 percent ownership interest would be recorded on an equity basis. I own 20 percent of the $600 value of the company, so now I've gone from a $100 investment to $120. In Company C, I own one percent. I'm going to record that at cost on my financial statements, which is at $100. So under these scenarios, the $300 I invested is now only worth $270, i.e., $50 plus $120 plus $100, even though the fair value is $600. The divergent approach between reporting fair value for investment companies and reporting consolidated financial statements under IFRS and for operating companies results in a fairly major difference in reported results.
If a private equity fund follows IFRS, rather than reporting $600 (and that's the number that the pension fund needs because they have to record their interest in the private equity fund at fair value), arguably they'd report $270, which is a meaningless number for the investor (the pension fund). That means that IFRS is irrelevant.
Editor: What are the practical implications?
Larsen: At one level, as a venture capital fund, you believe that convergence means nothing to you because you hear constant discussion about it with no tangible result. But it does mean something. Let's say that I'm a venture capital fund. I'm going to follow UK GAAP, and I'm going to do things on a fair value basis. That is fine, but you still have to understand the convergence because any of your portfolio companies that you sell to a corporation that's following IFRS have to be IFRS compliant. If you take it public, you would have to have it IFRS compliant. So as we go down this convergence road, we all have to start learning how to speak IFRS in addition to U.S. GAAP.
Editor: What is your outlook on the sensitivity analysis issue? Is it dead, or will it be taken up at some point to get the convergence?
Larsen: Having been in discussions with the IASB staff on this issue, I think that fundamentally sensitivity disclosures probably make sense for homogeneous assets. When you get to non-homogeneous assets, it's exceedingly difficult to understand what sensitivity disclosure means. There have yet to be many institutions that implement the current IFRS sensitivity disclosures, and there's a lot more flexibility in the rules' interpretation outside the U.S.
Regarding the convergence issue, we must remember that the regulatory environment in the U.S. is quite a bit different than outside the U.S. When I say regulatory environment, I mean validating financial statements. Auditors in the U.S. arguably are regulated by the government through the Public Company Accounting Oversight Board (PCAOB), a private sector, nonprofit corporation created by Sarbanes-Oxley to oversee auditors of public companies. The PCAOB publishes an annual report identifying situations in which the auditor failed to follow applicable audit standards or properly apply accounting standards. Hence, U.S. auditors have a tendency to ensure they put belts and suspenders on things. So if the sensitivity disclosure rules were implemented in the U.S., the amount of effort going in to that sensitivity disclosure in the U.S. arguably would be much, much greater.