A raging bear market has given rise, yet again, to the dreaded denominator effect. If there’s to be a timely, countervailing numerator effect, institutional investors may have to take matters into their own hands.
The denominator effect is, of course, the phenomenon in which shrinking portfolio values (denominator Y) carry investors closer to their target allocations (percentage Z) without their general partners having invested another dime in portfolio companies (numerator X). Or X/Y=Z.
Past downturns saw investors shut off the taps as they waited either for portfolio valuations to recover, or for their limited partnership interests to bear fruit in the form of returning cash or stock (occasionally generated by secondary sales).
This downturn promised some balm for the denominator effect. Thanks to the now-widespread adoption of fair-value accounting consistent with FAS 157, LBO firms are supposed to report net asset values to their limited partners more in tune with the ups and downs of market tremors and quakes.
Indeed, the latest recommended valuation protocol from the Private Equity Industry Guidelines Group (PEIGG), released in March 2007, suggests that general partners adjust fair value when “market, economic or company specific conditions have significantly improved or deteriorated since the time of the original investment.” It’s hard to imagine any GP, contemplating this year’s 39 percent drop in the S&P 500 through mid-October, concluding that market and economic conditions hadn’t deteriorated markedly. Secondary buyers have certainly gotten the memo.
A mid-year study by secondary market intermediary Cogent Partners found bids for buyout fund interests coming in well below net asset value, with average high bids dropping from 109 percent of NAV last year to 85 percent in the first half of 2008. David B. Tom, a director at secondary buyer
Soaring discounts on the secondary market suggest buyout shops may not be marking down their companies as quickly as they might. VCFA Group’s Tom, for one, said the GPs in the portfolios he’s evaluated held valuations fairly steady in their second-quarter statements, following a number of write-ups in the first, a six-month period of time that saw a 13 percent drop in the S&P 500 index, including a 3 percent drop in Q2. (In fairness, adoption of FAS 157 in the first quarter may have spurred many of those write-ups). “People tend to write up quickly and write down slowly,” Tom added, an observation that seems at odds with GPs taking fair-value accounting fully to heart.
In an email, David Larsen, a managing director at financial advisory firm Duff & Phelps and a PEIGG board-member, said he credits most buyout firms with “working hard to consistently determine the fair value of their investments in a difficult market situation,” and added that he doesn’t necessarily believe investments are overvalued. Still, in an earlier phone interview Larsen said he believes that investors can’t take NAVs from GPs at face value if they’re to ensure their own financial statements are GAAP-compliant. And Larsen is in some powerful company: Last year, said Larsen, staff at the Financial Accounting Standards Board made it clear they also believe LPs need to perform additional analysis on their GP-supplied NAVs. The American Institute of CPAs responded with the creation of an NAV task force, of which Larsen is a member.
That task force is working on a set of draft recommendations, not yet finalized and not yet made public. Those could, by year-end, enter the books as part of the institute’s widely-followed rules for how investors and their auditors determine fair value of their alternative assets, Larsen said. Here are some of the questions that LPs, under the draft recommendations, would be required to ask of the NAVs supplied by buyout firms:
• Was the NAV of the LP interest robustly determined?
• Did the GP base the NAV on fair-value principles?
• Is the NAV up to date?
• If interests in a particular fund are trading at a discount or premium to NAV on the secondary market, why is that? Are there reasons that would impact the fair value of the limited partnership interest?
Investors can’t be thrilled at the prospect of spending yet more time and money to make sure their financial statements are GAAP-compliant. On the other hand, those that want to stay beneath their target allocations to private equity may find themselves eager to examine the timeliness of buyout fund write-downs.
Corrections: The original version of this story mistakenly included the phrase “numerator effect” at the start of the second paragraph. Also, the S&P 500 index dropped 3 percent in Q2, not Q3 as originally stated in the story.
If you do not receive this within five minutes, please try and sign in again. If the problem persists, please
email: