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Comment: Another perspective on the impact of SFAS No. 157

Ross Hostetter, a managing director with international investment banking and financial advisory firm Duff & Phelps, examines the implications for private equity firms of the introduct

Ross Hostetter, a managing director with international investment banking and financial advisory firm Duff & Phelps, examines the implications for private equity firms of the introduction in the US of the new fair value standard, Statement of Financial Accounting Standards No. 157 – Fair Value Measurements.

What are the implications of the new fair value standard? How different is the new definition of fair value from historical definitions? How will it impact the valuation of the portfolio? What are you doing or have you done to get ready? Are you compliant?

The questions come from the senior management team, from board members, from limited partner investors both existing and prospective and even from constituents beyond those typically versed in the intricacies of financial reporting requirements. It seems that everyone is aware of the new fair value standard, Statement of Financial Accounting Standards No. 157 – Fair Value Measurements, and they want to understand the implications.

If these questions sound familiar, you are not alone. We are often asked to speak with alternative asset managers about addressing these very issues as they assess the implications to their funds of adopting SFAS No. 157. The challenge for management is to be prepared to answer the questions.

What are the implications? How do you respond? It is a new standard, the definition of fair value has changed, and new concepts have been introduced. Much discussion has taken place over the notions of exit price, market participant assumptions, active markets, new terminology including ‘Levels’ of inputs and the associated disclosures, and the treatment of transaction costs and blockage discounts (or the lack thereof).

All of these issues and others are deserving of attention in coming to terms with what has changed. What SFAS No. 157 did not do, however, is create any new fair value measurements. As such, if you are worried about fair value now, in all likelihood, you have been subject to a fair value requirement all along.

So when you are asked what is the biggest impact of the new standard, it is arguably not that the new definition of fair value is completely unfamiliar (after all, significant elements of historical definitions survived) or that traditional valuation approaches no longer apply (they do), it is arguably that everyone from auditors and regulators to the investor community and the financial press seem to be focused on the topic of fair value. The recent market turmoil only enhances the spotlight.

This focus creates both an opportunity and a sense of urgency for you to harness the momentum and revisit existing valuation policies that may have become stale or establish formal valuation policies that may have previously been unenthusiastically supported or even non-existent so that you are prepared to answer the questions that will inevitably follow.

The best way to be prepared is to have a well-defined and effectively executed valuation policy. A best practices valuation policy will include a number of key elements including a discussion about the requirement and responsibility to determine fair value, the definition of fair value that is applicable to the reporting entity, a discussion of the valuation process, and a detailed discussion about how specific securities are to be valued.

However, there is no more important element than establishing the valuation policy as a priority of the fund. Since this policy may well be the first line of defence against valuation conclusions that are subject to ever increasing scrutiny, it should not be a difficult task in this environment to get the support of senior management that is required.

The valuation policy should be a priority
The first and arguably most significant hallmark of a sound valuation policy is that it is a priority of fund management. This is quickly evident from the level of management that is charged with the responsibility of executing the valuation process. Whether a fund is large enough to justify a dedicated valuation team or if the responsibility is assigned to existing finance staff, the professional running the process should have the attention of senior management and the fund’s advisory committee as well as the participation of the investment managers that must be relied on to support the valuation process.

Delegating the process to junior staff and treating it simply as a ‘back-office’ compliance function may result in a policy that would not withstand scrutiny. Having a senior level officer responsible for the process will help ensure that the investment managers dedicate the appropriate amount of time and effort to the process and that valuation issues and concerns will be given the appropriate amount of attention by those ultimately charged with assessing the value of the portfolio.

The valuation policy should be well documented
The valuation policy should be well documented and include at least three elements. The first element is to clearly frame the requirements under which the valuations are required and the standard of value that will be applied. Next, the policy should outline the valuation process that will be followed each period and clearly define the roles and responsibilities of the various parties involved. Finally, the policy should provide a clear framework for valuing the various types of investments that will be included in the investment portfolio.

Framing the valuation requirements and standard of value is straightforward, but fundamental. The underlying agreements that outline the governance of the fund such as the partnership agreements will define who is ultimately responsible for valuing the portfolio and this should be directly referenced in the valuation policy. The standard of value and the related guidance should also be documented.

Typically, the standard of value is ‘fair value’, which effective for fiscal years beginning after November 15, 2007 will be defined in accordance with SFAS No. 157. Additional industry guidance may also be referenced, including for example the Private Equity Industry Guidelines Group’s PE Valuation Guidelines and/or the International Private Equity and Venture Capital Guidelines, both of which have been amended to reflect the impact of SFAS No. 157.

Outlining the valuation process to be followed each period is also relatively straightforward. The size of the fund and the number and type of investments may dictate the resources required, but there should be a single officer charged with running the valuation process. In some cases, a valuation team supporting the valuation officer may be warranted.

The valuation team establishes and co-ordinates the valuation process each period. This process would likely include having the valuations be initially prepared by the investment professionals responsible for monitoring the investments, as they will have the most knowledge of the background and latest developments with the investment. The valuations should then be passed to the valuation team for review.

Once reviewed and any issues have been resolved and approved by the valuation team, the valuations can then be recommended to the investment committee or advisory committee for approval. The valuation team should also be responsible for co-ordinating with any third party valuation advisors and auditors that may be involved in the review process.

The valuation team is responsible for running the process in a timely manner, ensuring consistency of valuation approaches across the portfolio, maintaining the appropriate level of documentation, and serving as the central point of contact for the investment professionals to address their valuation issues. Having a centralised valuation team following a well-documented process becomes increasingly important as the portfolio grows and more investments and investment professionals are brought into the process.

Finally, the valuation policy should address the framework for valuing the specific types of investments that are (or are likely to be) part of the investment portfolio. Further, the policy should be drafted to comply with the standard of value and related authority that is required of the fund. For most funds, the authority will now be SFAS No. 157.

It is not sufficient to simply include the new definition of fair value. The policy should set out the new framework and provide specific guidance relative to the types of investments held by the fund. For alternative asset managers, many of the valuation assumptions will fall in the category of ‘unobservable’, or ‘Level 3’ inputs in the new terminology, which makes it ever more important to be clear about how specific investment types should be valued. All else being equal, similar investments should be valued using similar valuation methodologies and similar issues or adjustments should be treated consistently across the portfolio.

A valuation format or memo to be followed for documenting the concluded value for each investment should also be established. In addition to the basic details of the investment and the supporting valuation models, the memo should include a detailed narrative describing the valuation approach, assumptions, and conclusions. This is the place to document explanations for why certain assumptions or approaches were applied in the valuation that may not be evident from simply reviewing the models.

Reasonable people using informed and objective judgment may well come to differing conclusions on the value of a particular security, in particular where Level 3 inputs must be relied upon, which makes it ever more important to be able to demonstrate that a well-defined and consistent policy was followed using supportable and defensible assumptions. The valuation memo is the place to articulate these points.

The valuation process should be open and transparent
The steps set out above will go a long way to making the valuation process open and transparent. Having multiple parties prepare and review the valuations, from the investment managers and the valuation team to the valuation committee and independent third party valuation advisors, assures that no single person has the authority to establish marks. Clearly defining the process that is to be followed for each investment also helps minimise the subjectivity and appearance of subjectivity in establishing the fair value of the portfolio.

The valuation policy is a working document
Once drafted, the valuation policy is not a static document. It should be reviewed and updated regularly to address changes in the investment portfolio and in the regulatory environment. Changes to the document should be reviewed and approved by advisory committee or the investment committee, and it should be regularly reviewed by the valuation team and the investment managers.

A sound valuation policy is critical and it pays dividends
A sound and thorough valuation policy requires a commitment of time and resources, but pays significant dividends. In addition to helping satisfy reporting requirements, a well-run valuation process will assist in the quarterly and year-end audit, provide an additional level of assurance to existing and prospective investors which can be an important element in fund raising, provide another level of diligence in monitoring the investment portfolio, and hopefully provide the management team an additional level of comfort as stewards of their fund. In a tumultuous market environment, it may be this last element that resonates most with fund managers. It is never too early to establish a valuation policy, but it can be too late.

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