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One of Obama's team first action could be the elimination of FAS 157 accounting rule

December 05, 2008 – Comments (1)

which is known as mark to market. It is one of the biggest rules blamed for the downfall of AIG and the overly depressed stock prices of other Insurance companies.

FOCUS TOPIC: FAS 157 AND THE DENOMINATOR EFFECT
http://www.feg-research.com/focus_topic.php?nID=92&issue=2008_09

This quarter we touch on two related topics:  the impact of FAS 157 on reported financials and the dramatic decline in the total portfolio assets that is  derailing private capital investment programs.  FAS 157 is the pronouncement by the Financial Accounting Standards Board (FASB) requiring all assets reflect an estimate of value as of the measurement date.  This standard is to be applied regardless of broader plans or strategies to hold, turnaround, or sell those assets near term.  Some argue that this standard makes accounting more subjective, while others find it less subjective.  Some find the resultant reporting  more relevant, others less, and some have claimed the new standard has damaged our financial system, where others see benefit.  Whichever position you take, valuations are now more discussed, more transparent and, as we are starting to experience, more volatile than prior to the adoption of FAS 157.  (For details of the pronouncement see www.fasb.org/st/summary/stsum157.shtml)

 

With regard to our overall financial system, the Troubled Asset Relief Program (TARP) legislation has given regulators the authority to suspend fair value reporting on the basis that it has contributed to the rapid decline of AIG, Lehman Brothers, and other financial institutions.  (For more information see www.cfo.com/article.cfm/12582016?f=home_featured?.)  While more transparent accounting of these illiquid positions likely contributed to the downward spiral, we do not believe FAS 157 was more responsible than any of the other contributing factors–30 times leverage, unregulated credit default swaps, and elimination of the up-tick rule.

 
Specifically FAS 157 requires a three-tiered reporting system.  The first tier contains marketable securities; the second tier contains assets that can derive a value directly from marketable securities; and the third tier encompasses those assets that require unobservable inputs to model valuations.  The statement’s main objective is to ensure that any financial statement creates and follows a consistent valuation process and places a priority on directly observable market-based inputs.  When applied to private investments, the vast majority of assets fall into tier three.   The application and issues vary by sector.

 
Venture Capital  The implementation of FAS 157 is likely to be less dramatic than other private capital strategies.  In many cases, venture-backed companies have no comparable public market due to the lack of revenues and early-stage nature of the investment.   As a result, cost or last round of financing will remain the best estimate of fair value.

 
Buyout  The impact of FAS 157 on the valuations of portfolio companies in buyout funds can and will be significant given the current market environment.  Most of the portfolio companies in buyout funds, unless exited through initial public offerings (IPOs) or private investments in public equities (PIPE), fall into tier three investments, which are classified as private portfolio investments that are supported by little or no market activity.  To value these investments, most private equity sponsors use earnings before interest, taxes, depreciation, and amortization (EBITDA) and apply a multiple based on the acquisition of a comparable company, possible sale opportunities, or multiples of comparable publicly traded companies.  Given the credit crisis and general weakness in the public markets, the multiples used for valuations over the next several quarters are likely to be significantly lower than the multiples paid over the last three years.  Near term earnings declines are also possible.  Based on multiple alone, if a company was purchased at 10x earnings and the general market dictates an 8x multiple, the holding value will drop by 20%.

 
Real Estate  Real Estate funds are just starting to see an up-tick in capitalization rates.  In addition to using higher cap rates (which equate to lower prices), industry participants are debating the need to consider commercial real estate debt in pricing the value of their equity holdings.  In an illiquid market, the lack of debt financing drives down the value of equity.  For funds with private debt that is not intended to trade independent of the equity investment, there appears to be an understanding that the debt values are not relevant.  Certainly if a near term financing is required, it can negatively impact the value of the investment.  In all cases, we would expect valuations to reflect a negative adjustment based on the current market’s higher capitalization rates.  There are estimates of an average 20% - 30% decline in value if an asset had to be sold today.  Even funds with fixed, term financing will reflect declines.  FAS 157 is especially harsh on development projects.  Obviously selling a half finished building is not an attractive prospect.

 
Energy Funds  Energy buyout funds are measured consistent with the other buyout funds using industry relevant earnings multiples.  Direct interest and royalty interest funds are a different situation.  These interests tend to remain cost-based in their early years, with established portfolios being valued based on a multiple of either historic or projected cash flow.  This discount rate is generally set for the long term, e.g., 10%, and could over or understate true value.  Forward looking measures that use projected cash flow may use the spot or forward curve pricing of the commodity.  There is no one right answer to the valuation question.  Investors simply need to select a method, defend the rationale for the selection, and maintain it.    

 

 

THE DENOMINATOR EFFECT

 

As noted, volatility in the public markets and concerns about portfolio liquidity pose challenges to implementing a private equity program.  In the current market environment, investors have found their allocations to private capital strategies pushed above target due to declines in the public markets.  Private capital funds typically report on a quarter lag, which means that, even with the adoption of FAS 157, falling values in the second half of 2008 have yet to be fully reflected in financial statements.  The simplified math is as follows: investors set a target allocation for their portfolio reflecting $X of Private Equity/$Y of Portfolio Value.  If Y decreases due to the public equity market, then the percentage of their portfolio to private equity rises, reflecting the smaller denominator.  Industry professionals frequently refer to this as the “denominator effect.”  Investors should also keep in mind that private capital valuations will likely fall when third and, more so, fourth quarter 2008 reports are published.  A resultant “numerator effect” might also take place moderating the impact of the denominator effect, albeit on a delayed basis.

 

The last occurrence of the denominator effect was in 2000-2001.  At that time, the impact was less dramatic and limited to a few investors.  Today many investors face this challenge and an unsettled economy.  The expectation of few near term distributions further complicates this challenge.  A natural response of over-allocated investors is to avoid making future commitments until the market rebounds.  Selling into the secondary market at a steep discount is also an option.   While careful consideration of liquidity is necessary, we encourage investors to continue committing to new opportunities in order to maintain vintage year diversification and to take advantage of current market opportunities.

 

 

Challenge #1: Is Vintage Important?

 

Experience tells us that performance can vary widely depending on the vintage year, or inception, of a fund.  The environment during the fund’s investment period influences the acquisition values, while the exit environment during the fund’s harvesting period influences valuations when companies are sold.  The graph below reflects the median private equity performance by vintage year since 1990 (more recent vintage years were excluded because those portfolios have not yet matured).  Without some discipline around the schedule of commitments, many allocate too much capital to what becomes a poorly performing vintage year and too little capital to strong performing years.  Hot markets pull in more capital (just as we have seen in 2006 and 2007), while uncertain markets like today drive capital out of the markets at just the time to find bargains.  Investors can also diversify risk by committing to various strategies with different cash flow and return patterns.

 

 

 

Because private funds inevitably invest through multiple market cycles and are structured as blind pools (investors do not know what will be in the portfolio at the time of commitment), knowing if a particular vintage year will be good or bad is virtually impossible.  The most reasonable solution is to commit at a measured pace and invest with experienced management teams that have a record of generating returns through market cycles.

 

 

Challenge #2: Why not sell?

 
Some institutions facing liquidity crises will sell their interests in private equity funds.  Anecdotally, these institutions include banks, hedge funds, and endowments.   A secondary market emerged and grew substantially over the past ten years, from $2.4 billion in dedicated secondary funds in 1998 to $12.7 billion in 2007.1  The secondary market includes various buyers seeking to acquire the original investor’s interest in a private equity partnership.  Pricing grew more competitive over the last several years due to an increasing number of buyers.  Pricing fell sharply in 2008 as some sellers were forced to move quickly to gain liquidity.  For example, Cogent, a secondary transaction intermediary, reports that the average price for private equity secondary transactions fell from 104% of NAV in 2007 to 81% of NAV in 2008.2

 
An institution wanting to sell its private equity interests today likely sits at the wrong side of the negotiating table.   Prices are falling, and supply appears greater than demand.  For investors who need cash or who cannot meet capital calls, the secondary market generates cash today and reduces their private equity allocation.  The price is steep, however, as the original investors cover fees and write-offs in the early years of the fund and might be selling before the portfolio matures and benefits from the original investment strategy.

 

 

Improving the Model—Spending Policy as a Guide

 
Endowments and foundations frequently set the spending policy as a percentage of total market value.  According to the 2007 NACUBO study, approximately three out of every four institutions between $25 million and $500 million use a moving average for their market value.3 The moving average reduces volatility in annual spending and imposes a discipline to not spend too much in rising markets, nor too little in falling markets.

 

Investors applying the same principle to the private equity implementation should see less volatility in the annual commitment rates.  A measured approach naturally allows for new commitments at a time when others may be leaving the private equity market and moderates investment when capital  returns to private equity.  A 12 or 20 quarter (three or five year) rolling average gives investors a reasonable determinant to use as the denominator for their implementation model.  The three- to five-year period is consistent with many spending policies.  

 

The example follows to illustrate the effects of the rolling average.  As of the beginning of the year, this institution planned to commit $15 million annually to reach and maintain their private equity target allocation of 15%.  The first chart depicts this institution’s revised commitment schedule (including previous commitments) based on the value as of September 30, 2008, reflecting a large decline in the value of the total portfolio.  The model projects annual commitments of $9 million (represented by the orange columns), which is a 40% decrease from what was planned just one year ago.  The second chart illustrates the institution’s commitment schedule using a rolling 12-quarter average as the denominator.  The projected annual commitments needed to reach and maintain the target allocation of 15% increases from $9.0 million (using the September 30 market value) to $11.5 million (using the 12-quarter average), an increase of 28%.  This still represents a $3.5 million, or 23% decline in commitments from what was planned at the end of 2007.  The rolling average should mitigate the fluctuation in the commitment amounts.  The reduced volatility in the projected commitment amounts should result in more consistent vintage year diversification and greater discipline to making commitments at a measured pace.   

 

 

 

 

 

In the chart below, the dashed lines represent the private equity allocation assuming the total portfolio value falls or increases 10% or  20% from the September 30 value.  The private equity model projects an invested private assets allocation range of 12% to 19%, which is well within a reasonable +/- 5% of the 15% target.   

 

 

 

Both of these options should account for the individual liquidity needs of the investor.  If cash is needed to meet spending requirements or to cover future capital calls in this challenging environment, then a more detailed evaluation of other options might be warranted.  The solution should reflect the liquidity needs and comfort level with the portfolio’s liquidity.

 

Summary

Opportunities for strong performance often present themselves when investor emotion overrules a thoughtful and rational investment approach.  The proposals mentioned previously add further discipline to the model framework that FEG frequently uses to implement a client’s private equity strategy.  The use of a rolling average market value approach and defined target ranges can help ensure vintage year diversification during periods of market volatility.

 

1 Information available from http://www.venturexpert.com.  VentureXpert.  Accessed on 4 November 2008.

2 Cogent 2008 First Half Report.  Cogent.  (August 2008).

3 “2007 National Association of College and University Business Officers (NACUBO) Endowment Study.”  NACUBO.  (January 2008).