Missed Part 1? Review it today to stay up-to-date on FAS 157.
a Question: How about another tried and true method . last round price?
a Answer: Last round price is a necessary element of the equation, but not sufficient. We have always known that a given price is not necessarily fair value. For example, the transaction might be an interested party transaction. And if a strategic investor is involved, it might be overpaying because it is looking for access to the technology. But, absent special facts, last round pricing was generally deemed to be the end of the trail. It now appears that a multi-faceted approach is the only one which is going to pass muster when the accountants, in effect, grade the papers which their clients submit . pass/fail.
a Question: Is it useful to look at the Internal Revenue Service's pronouncements on fair market value?
a Answer: It may be useful to do so but the Statement indicates that the IRS's position are not relevant or at least have not been adopted for purposes of FAS 157. See Appendix C, Para. 50:
"For example, the definition of the fair market value in Internal Revenue Service Revenue Ruling 59-60 (the legal standard of value in many valuation situations) refers to "the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts." This is classic definition . Economics 101. However, this definition has a significant body of interpretive case law, developed in the context of tax regulation. Because such interpretive case law in the context of financial reporting may not be relevant, the Board chose not to adopt the definition of fair market value, and its interpretive case law, for financial reporting purposes."
a Question: If the stress in FAS 157 is on market transactions, what do you do about a situation, which is typical in private equity/venture capital, where there is no market? Is this a dumb question?
a Answer: No, but the FASB's answer seems to be that you need to put together a "hypothetical" market. See Para. 87 of Appendix C
"Within Level 3, unobservable inputs relevant to the asset or liability should be used as a basis for replicating the actions of market participants in a hypothetical transaction for the asset or liability at the measurement date. The Board understands that for some, a measurement using a hypothetical construct that relies on unobservable inputs raises concerns about the resulting fair value measurement. In particular, some believe that a hypothetical construct might not faithfully represent an actual economic phenomenon and, as such, would seem to be of questionable relevance to users of financial statements. Some Board members share those concerns. However, the Board agreed that concerns about fair value measurements that are predicated on hypothetical transactions in hypothetical markets derive from a threshold issue that relates principally to the selection of the appropriate measurement attribute, an area of focus in the Board's conceptual framework project. The Board plans to continue to address the issue of which measurement attribute should be required in individual accounting pronouncements on a project-by-project basis." (Emphasis added.)
a Question: Is there any way of validating, on the basis of reliable information, a "hypothetical" market?
a Answer: Tough, take VCs with pre-revenue companies in the portfolio. Most academically and professionally respectable methods of valuing illiquid assets deal with events and phenomena which often do not exist in the venture capital context. There is no point in running a discounted cash flow analysis if the company has no cash flow. Indeed, the VCs typically follow the "monkey see, monkey do" rule when investing in early stage. "What do we pay for a piece of x? . What did Greylock pay for a share of y?" Under those circumstances, the most reliable way to arrive at a valuation number is to take a look at comparables. And, to be "comparable," the review must be based on data assembled from contemporaneous transactions, and the industry has to be the same; there is enormous difference between emerging growth companies in the biotech arena versus information technology. Further, geography counts . West Coast pricing is often different than East Coast. Finally, the sample has to be complete. Survey evidence is not the answer in this context, when valuations (with legal consequences) are in issue. Many people don't bother to respond to surveys. In fact, the answers may be biased mainly because only those respondents who are, let's say, proud of what has happened in their transactions are likely to respond to a survey. Accordingly, if private comparables are the necessary element (because nothing else works as well) the VC Experts Data Center, in my view, is the only resource with hard, sine qua non data. The results are required by government fiat to be recorded in places which VC Experts has been able to plumb. The number of data points pass anybody's test for statistical completeness, over 1000 company pre- and post-money valuations searchable by region, quarter and year of the trade; and industry sector.
a Question: What are the specifics on the VC Experts Data Center? Can I see an example?
a Answer: Access to this data is premium content on VC Experts . and costs money. Contact Michael Ostendorff and get a demo on how the system works. Note that, I am the co-founder of VC Experts and own a bunch of stock . so treat my tub thumping with caution.
a Question: All very well and good. But the data VC Experts presents, is not itself the product of an active trading market in which the security itself is being bought and sold. Your data is like the residential "market" for coops and condominiums in New York City . reliant on comparable transactions during the current period.
a Answer: Exactly. But the thrust of FAS 157 is that you do the best you can do. The comparable transaction information from VC Experts, based on official data with the widest coverage of any data source, is (i) certainly better than a "market" based on pure hypothesis; and (ii) again, the best information available under the circumstances. How can the audit firm fail to accept data which is the best in breed . and available at reasonable cost?
a Question: Why can't you turn the fair value process over to the auditing firm and ask them to do the work. They are the professionals in this area?
a Answer: That is isn't even remotely allowable. The audit firm would compromise its independence if it got is hands dirty and coached the client on how to do the calculations. That is clearly a 'no, no.' Indeed in accordance with a well reasoned article in the PEI Manager Yearbook for 2007, auditors are "coming down hard on GPs and LPs to produce a burden of proof for how private investment valuations came to be." Note the language, "burden of proof." The auditor is in the position of the unnamed proctor who grades the examinations of students she may never have met in the course of the lecture series. It is a pass/fail system apparently; and if you don't pass, then you, the reporting entity, don't get the certificate . i.e., you fail.
a Question: You mention the LPs in the article you cite. Cannot the LP simply take the general partner's word for it as to the valuation of the portfolio positions?
a Answer: Apparently not. According to the American Institute of Certified Public Accountants ("AICPA") 2006 Release, "Alternative Investments - Audit Considerations," (a practice aid concerning AU 332 for audit firms), as interpreted by David Larson, a member of the Private Equity Industry Guidelines Group ("PEIGG"),
"'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 investment at fair value,' says Larson. 'The LP has to take responsibility for its fair value assessment.'" (Emphasis added.)
a Question: You can't be serious. Does it mean the LPs have to make an independent judgment as to the fair value of each position held in the portfolios of the funds in which they invest?
a Answer: Such appears to the case. Let me quote at some length from the article I mentioned.
"Now LPs, like GPs, too must have a policy and process in place to arrive at fair value. Already, LPs have to contend with GP reports that come to them in all shapes, forms, sizes and times, often without adequate information on a fund's underlying portfolio companies and without across-the-board valuation standards. The documentation, says Larsen, will vary based on the individual LP or GP and in part "The greater pressure on LPs to justify the valuation 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 Tom 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.'
"This creates two problems. One, 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 making the follow-calls to arrive at a number they are comfortable with - 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 PEIGG and the International Private Equity and Venture Capital Guidelines 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 to be evaluated."
a Question: What happens is the LPs say, "the heck with it" . and talk their auditors into going along for the ride.
a Answer: Potentially bad stuff if the LP is subject, as many are, to ERISA. Herewith an excerpt from a White & Case client alert.
"A July 1, 2008 letter from James Benages of the DOL's Boston office has made its way around the market. There, he considers a plan which was invested I a number of alternative investments ("Als"), and which apparently took a fairly common approach to the Form 5500 reporting thereof. For example, one particular Al was valued at cost by the applicable committee "based on the general partner's unaudited Capital Account Balance Statement" for the period in question "and the accompanying audited financial statements." Another was valued according to the general partner's unaudited determination of fair market value.
"The July 1 letter, which could be indicative of an approach generally being taken by the DOL office issuing the letter, states that (i) not only has the committee "failed to establish a process to determine the most accurate fair market value," but cost and fair market value have been "equate[d]" (ii) such failure violates ERISA's "solely in the interest" requirement, and (iii) as a result, in the DOL's view, the committee "is in violation of ERISA and will remain so until it takes corrective action." Before discussing Section 502(i) and the possibility of action by other governmental agencies and third parties, the July 1 letter kindly comforts that, if corrective action is taken, no lawsuit will be brought by the DOL.
"The issues implicated by the July 1 letter are significant. Many private equity and other investment funds provide valuations on the bases noted in the letter, and plan fiduciaries would not ordinarily be expected to have the information required to second-guess the available valuations or the expertise to do so even if they had the information. The DOL's approach seems to raise the specter that making an investment not practically susceptible to ready valuation is somehow a per se violation of Section 404(a)(1) of ERISA."
a Question: Any offshore Implications of FAS 157?
a Answer: Unfortunately, yes. According to the Financial Times of October 17th, p. 17, Hughes & Taft, Europe Poses Threat to Global Accounting Rules,
"Growing pressure on the International Accounting Standards Board could lead Europe into developing its own regional rulemaker, in a move that would kill off the long-running effort to develop a single set of global accounting rules.
"The FASB this week gave into pressure from the European Union and eased the rules on fair value accounting, but an EU-wide meeting next week could see it presented with a "wish list" of further demands to which it could not accede. .
"The wish list compiled at the EU meeting is likely to cover a series of issues limited to fair value accounting, the controversial process whereby financial institutions have to mark most of their assets at market prices. These have plunged as a result of the credit crunch, forcing many banks into losses and undermining the capital reported on their balance sheets."
a Question: Any recent progress on FAS 157?
a Answer: Maybe. On September 30th, the SEC and the FASB Staff published a "clarification," which discusses, in case of "disorderly" or "impaired" markets, "reasonable judgment based on specific facts and circumstances of each investment." The release talks about "a reasonable preparer," "multiple experts from different sources," "reasonable estimate(s)," "weighing the available evidence," "reasonable judgment." In fact, mirabile dictu, the Release mentions "rules of thumb" (quote in the Release) that can be "useful tools."
a Question: Does this solve the problem?
a Answer: Stay tuned.
a Question: A lot of folks are attacking FAS 157, in its entirety. There were three OpEd pieces in the Wall Street Journal in a row assigning principal blame to FASB for the meltdown. What do you think?
a Answer: There is, as usual these days, a hunt abroad for villains, and FASB is as good a candidate as any.
a Question: Aren't the attacks merely scape-goating?
a Answer: Let me quote from a paper I have presented recently on FAS 157, citing CFO.com:
"The new accounting rule on fair value measurement has caused a private equity firm to plunge into the red. American Capital Strategies reported a loss of $813 million for the first quarter of this year -- compared with earnings of $134 million last year -- a result of implementing FAS 157, Fair Value Measurements, it reported in a regulatory filing. .
"In its earnings announcement released this week, Wilkus emphasized that the company expects the assets -- that have experienced about $656 million of depreciation in this or a prior quarter -- to appreciate as they are hold to settlement or maturity. The filing explained that the company invests primarily in illiquid Level 3 assets, with the intention to hold the assets to settlement or maturity. 'This is the contrast to the premise under GAAP that assets generally should be valued on the basis of their current market value and, if no market exists, on a hypothetical market value,' the company stated.
"This in turn would reverse much of the current depreciation. 'The underlying credit quality of these assets remains in line with our forecasts made at the time the investments were underwritten, which include a recession,' he added. 'We believe that with the adoption of [FAS] 157, investors will need to focus on both reported GAAP fair values as well as values that we anticipate realizing on settlement or maturity of our investments, or Realizable Value. Our history bears this out."
"The point is that, under FAS 157, you must mark to (in case of Level 3 . illiquid positions) to market even though the "market" is hypothetical (no trading) and the owner plans to hold until maturity. In fact, if the "market" has dried up to zero, arguably the asset, whatever the intrinsic value, is worth zero."
a Question: And why are you concerned?
a Answer: My concern is that what goes down, as the saying goes, must come up. Assuming the debt instruments in American Capital's portfolio are in fact paid at maturity, the likelihood . indeed the certainty . is that a write-up will be required, meaning that, in future quarters, income will be inflated not from operating results but by reason of the necessity for reversing the previous write-down.
Then, let me add some additional elements to the script, borrowing from a series of events which then-SEC Chairman Arthur Levitt, among others, deplored in the pre-Enron nineties as overly creative accounting . compromising the integrity of U.S. capital markets, viz:
One of Levitt's exemplars was the "Big Bang" gambit. Let me illustrate with a bit of corporate history: The board of a struggling company, anxious to assuage "activist" investors barking at the Board's heels, fires the CEO and brings in a White Knight and a new team from the outside. Several informally linked events then occur. First, White Knight promises "change" (sound familiar?). Second, the company accrues a huge "non-recurring" charge to earnings, blamed by White Knight and his/her team on the departed management. The charge is, in fact, composed in large part of expenses which could have been matched to income in future quarters; but White Knight persuades the board to "bite the bullet now." The stock drops like a stone. The White Knight team is granted, as is the custom, stock options carrying an exercise price equal to the current trading price of the stock, which is in the cellar. The company stays on course for the next several periods; but, profits surge because significant expenses which have been accrued and bunched inside the Big Bang no linger to impact future revenues. Lo and behold, we have instant profits and the stock price surges as well. White Knight and the team exercise their options. carefully and with ample legal advice . and everybody, except for Arthur Levitt, is (was) happy.
My point is that FAS 157 creates the opportunity for Big Bangs which no one can criticize. FAS 157 can, in effect, require a "Big Bang," as with American Capital. The optionees can make out, as before, with their heads held high. "The Devil (FAS 157) made me do it." And the options are fairly priced: "We followed IRC Section 409A to the letter." They will sell the option shares when it becomes clear the securities in the portfolio which occasioned the markdown . because the market had experienced a nervous breakdown . were not in fact economically impaired. Like the junk debt which lost its political footing (versus its economic value) when Michael Milkin was indicted, the underlying values remain at least equivalent to initial cost. Under the FAS157 mandate, as the market in those securities sheds its clinical depression, a significant write-up is required. Again, everybody (except followers of Arthur Levitt's concerns) is happy.
In fact for a perceptive criticism of FAS 157 as it currently stands, let me quote from a memo from a knowledgeable client. He argues that:
"FAS 157 is an example of a regulatory or standards body being so focused on fixing yesterday's problem (Enron, in this case) that they make a change that contributes to the next problem. This, of course, is the nature of the government and standards boards, as they often do not feel that they have the political capital to address a problem until it has already blown up, and then do so in a way often oblivious to the next problem to occur (and perhaps making the next problem worse).
a Question:Other Problems?
a Answer:Yes.Cognate issue is reported in the Oct. 31stFinancial Times p. 19 and, to illustrate, I don't have to do more than quote the piece:
"Deutsche Bank has recorded a profit instead of a loss in its most recent results by using new accounting provisions designed to mitigate the impact of the financial crisis on European banks. .
"Deutsche reclassified almost ?25bn ($32.4bn) of assets as loans that it will now hold until maturity including ?7.1bn of funded leveraged finance loans - which the bank had intended should be sold on - and ?9.7bn in asset-backed commercial paper conduits.
"Through the shifts, Deutsche, which announced ?1.2bn of writedowns, avoided a further ?845m of writedowns on some assets. The changes helped the bank to raise net income by ?538m and meant Deutsche booked a quarterly net income of ?414m. That compares with net income of ?1.6bn in the same period last year.
"Other banks are examining how best to apply the new rules but face hurdles.
"Most importantly, banks have to prove they were intending to hold the assets as of July 1. Any bank that has been selling since then cannot reclassify. Auditors report tough fights with clients over this." (Emphasis added.)
a Question: So you would repeal FAS 157?
a Answer: Not a chance. Who can argue with "fair value" . vs. the old rules of thumb, which told investors next to nothing about underlying values. The job is to tweak the statement to avoid the eccentricities I (and others) cite, but not throw the baby out with the bathwater. As indicated above, FASB and the SEC's Office of the Chief Accountant in fact have, on September 30th, clarified FAS 157. Further, the Act (on pp. 89 and 90 of 451 pages) requires an SEC study to be filed 90 days from October 3rd. Let's hope that proves to be a workable solution, assuming the SEC and FASB continue to issue the equivalent of SEC 'no action' letters or IRS rulings, i.e. continuing guidance, as circumstances require, on the concrete meaning of "reasonable" in this context.
a Question: You have outlined all the problems. How about the solutions. What to do when the valuation turns out to be wrong (Murphy's Law) and there is a knock on the door from plaintiff's counsel, the SEC or, worst case, the U.S. Attorney?
a Answer: Strictly adhere to the following rules:
1. Use the second opinion wisely. You cannot lateral the ball off to an "expert" and escape responsibility. "Let George Do It." The ball is in your court. But, you can and should engage expert opinion:
2. Independence. The primary duty of managers under Delaware law is the duty of loyalty . which means the process must be overseen by people who are truly independent . no personal interest in one outcome vs. another.
3. Disclosure. The most important rule. Make sure you explain, in agonizing detail, what you did and how you did it. Go overboard, viz: "If we had used a different method, we might have come out with quite a different result . maybe 50% of the number we wound up with. We decided not to do x, y and z. We could have, but we didn't think that course was right. And we could be dead wrong, etc., etc., etc." Paint the worst case . and make sure it gets out. The advantages of a detailed, advance mea culpa? The PLSRA allows you to win a motion to dismiss; no one will go to jail; and almost no one will pay any attention to your confessions. The risk factors discussion is free protection . because hardly any investor reads it.
P.S. The concept of "multidimensional" financial disclosure is not only commonsensical (my common sense) but endorsed by a member of the FASB advisory committee.
4. Paper the file: more is better. My rule of thumb . 20 pages behind each conclusion.
5. Consult where applicable, a professionally prepared list of comparables. Where, you may ask does one find "professionally prepared lists?" For VC fund portfolios, the answer (bias admitted) is, as suggested above, VC Experts data, from government filings, charting pre- and post-money valuations, of 1000 (+/-) transactions reported on the Thomson Reuters PWC Money Tree reports. If not already a subscriber, contact, as indicated above, Michael Ostendorff (Michael@vcexperts.com) for a demo of the facility. Why a "professionally prepared list?" If there is an error, it's not your error . as long as you took pains to check out the expertise of the provider. And, finish this segment of the case statement off by incorporating in your file reference to Fu, "Survey on Private Equity Methods," Parts 1 and 2, VC Experts, Buzz of the Week, 1/23 and 1/25/2007. Vivian Fu, a student of mine, surveyed a census of GPs and calibrated the incidence of their use of various valuation methods, the study confirming that comparable transactions in the methodology of choice in the private equity sector. You are better off if you know how others approach the problem . what methodologies everyone else uses. In unity there is strength.
6. Survey the entire universe and record what you did. (See Para. 4 above). Thus, take a look at PEIGG, EVCA, etc. Let the record show that someone read all that stuff even if the guidelines are no more than: "Consider all the facts and circumstances and reach a conclusion in good faith." Put citations to all the guidelines in your file. Kill a lot of trees.
 Leong, "Damned If You Don't," PEI Manager Yearbook for 2007, 39.
 White & Case, "A Report on Another ERISA Reporting Issue for Private Equity and Other Investment Funds," Aug. 19, 2008.
 Wilson & Hughes, "New Rules Help D Bank Post a Profit" FT, Oct. 31, 2008, p. 19.
 Hughes & Wilson, "Rivals Face Hurdles in Copying Deutsche Move," FT, Oct. 31, 2008, p. 19.
 See, Bartlett & Auspitz, "Second Opinion," VC Experts Buzz of the Week, 2/12/2002, Buzz Archive.
 Shapiro, "Re-inventing GAAP," 6 The Deal No. 31 p. 32 (Oct. 20-26, 2008. Prof. Shapiro makes the obvious (to me) point that:
"In today's climate, the only way to describe an enterprise is through multidimensional accounting in which financial statements show balance sheets and income statements under various accounting conventions and relevant supplementary information is provided in understandable numerical form. The secretary of the Treasury and the chairman of the Federal Reserve Board stated that they did not have the information necessary to control "excesses" that recently surfaced. How can the public expect to have such knowledge?"
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
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To view the entire article in the Encyclopedia of Private Equity and Venture Capital please see article 10.15.7 FAS 157 Fair Value of Portfolio Companies.