FAS 157 Poised To Weigh Down Valuations

The rule, which went into effect at the end of last year, comes at a particularly bad time for valuations. With the economy swooning and the public markets reeling into bear market territory, companies are by and large worth less now than they were six or even three months ago.

Through July 15, the Dow Jones Industrial Average, the S&P 500 and the Nasdaq Composite Index had all fallen by at least 18 percent since the start of the year. Under FAS 157, that translates into a similar drop in value for many private companies: One of the main methods auditors use when applying FAS 157 is to set the values of private companies based on the valuations of their publicly-traded peers.

To be sure, many companies have bucked the economic cycle and will be written up. And auditors can use a variety of other methods besides publicly traded comparables, such as looking at recent sales of similar companies, or valuing the present value of future expected cash flows. But these too, in general, point toward lower values, given the economic malaise and credit contraction, especially in battered sectors.

The upshot? Many buyout firms are likely to be reporting sharply lower valuations, and therefore interim returns, to their investors in the months ahead. For those running out of money, that could mean a far tougher time on the fund-raising trail since prospective investors like to see a recent track record of big wins, whether realized or unrealized. Limited partners, meantime, will arguably be getting a more reliable, more real-time gauge of the value of their private equity portfolios, more akin to the way they track their publicly traded stocks and bonds. That will make it easier to carry out incentive plans for investment professionals, and, for foundations, to assess how much they must dole out in grants every year. Paradoxically, it may also let investors commit more money to buyout firms in the months ahead, since a shrinking private equity portfolio creates a bigger cushion beneath their target allocations.

Change In Habits

Most buyout firms have made a habit of holding their companies at cost until some financing event, such as an exit, demands a revaluation. General partners and their investors have ridden out economic troughs while experiencing few undulations in the value of their holdings.

The feeling among many LBO professionals is that portfolio companies, along with other illiquid assets, are difficult to value with accuracy. Some further argue that they plan to hold on to these companies for years, making the price that they would fetch on the open market today practically meaningless.

But over the past few years a growing cadre of LPs, GPs and auditors began arguing that GAAP-compliant accounting required firms to mark their portfolio companies to market and to provide quarterly interim valuations to investors. The movement gained momentum after the bursting of the dot-com bubble, when venture capitalists were noticeably slow to write down the value of their telecom and tech companies. The introduction of FAS 157 brings that movement to its conclusion, and sources say that LBO firms will be following the new rule in noticeably larger numbers starting with the 2Q reports due in August. For LPs, that could launch a roller coaster of volatility, beginning with a stomach-churning drop.

Indeed, the recent drop in public market valuations has already been felt in some quarters. Last month, The Blackstone Group reported a $116.7 million loss from its buyout arm for the quarter ended March 31 (down from a profit of $208.9 million a year before). The firm attributed most of that loss to a write-down in its stake in German cellular phone provider Deutsche Telekom, whose stock has dropped by 20 percent in 2008.

Blackstone Group acknowledged that write-down only through clenched teeth, booking it “notwithstanding the increased profitability of the company,” according to its quarterly earning announcement. Tony James, the firm’s president, separately told the press that FAS 157 forced his firm to mark “assets as if they’re all being sold in today’s hostile environment, despite the fact we have no intention or obligation to do so. We hold our assets for the long term and expect their value will rise as we come out of the cycle.”

Similarly, for the quarter ended March 31, Warburg Pincus swallowed a $200 million FAS 157-induced write-down on its $800 million investment in bond insurer MBIA Inc. MBIA’s stock has plummeted by 75 percent in 2008, including a 65 percent drop since April 1, to about $4.50 per share as of July 15. Warburg Pincus made two investments in MBIA about six months ago, buying into the company at just over $15 per share (taking into account warrants). Warburg Pincus declined to comment, but a source close to the firm said the write-down “doesn’t change our view of the business.”

Investors we spoke to appear sanguine about FAS 157, and downplay the likelihood of a major drop in valuations.

Tim Smith, the chief financial officer for publicly traded funds-of-funds manager Conversus Capital, said his firm received fully GAAP-compliant reports from GPs in December 2007. So far this year, with some interim reports in hand, the firm hasn’t experienced a lot of volatility, although he said that could definitely change as the year wears on. “The fourth quarter will be the telling point,” Smith said. “But we don’t expect a big change.”

William Hupp, the CFO for funds-of-funds manager Adams Street Partners, said that “there’s no doubt about FAS 157 causing volatility.” But he predicted that the degree of volatility would be muted, at least compared with the eye-popping drops in valuations among publicly traded asset managers heavily exposed to CLOs.

Of course, Adams Street Partners and Conversus Capital may have a particularly aggressive set of GPs when it comes to FAS 157. “Two firms that have the same holding in Company A will value that holding differently,” said Jeff Yager, a partner in the financial services group of accountancy McGladrey & Pullen, which performs valuations for buyout firms. “It’s still subjective.”