Learning To Love FAS 157—For Your Own Good

It’s no secret that Financial Accounting Standard 157 (FAS 157) hasn’t thrilled all of the people all of the time.

Many private equity firms consider it a hassle to comply with FAS 157, and it’s no surprise. Many private equity firms already have processes for valuing their companies, making them uneasy about changing their ways. But methods for calculating fair value were inconsistent. FAS 157 provides guidance to help private equity firms, among others, value their portfolios. FAS 157 creates a single definition of fair value, establishing a framework for measuring fair value while requiring enhanced disclosures surrounding fair value measurements. FAS 157 defines fair value as the price an organization would receive when selling an asset or the price that would be paid to transfer a liability to another entity at a specific point in time.

There are obvious reasons why FAS 157 has been challenged by the private equity community. After all, private equity professionals are experts at buying, holding and exiting businesses. And, in some instance, private equity firms go into investments knowing that the asset will lose money before turning profitable. It does seem unusual to value an asset quarterly when private equity investment periods range from a minimum of three years to as long as ten years; strategic and operational improvements take time. Applying FAS 157 creates volatility on a quarterly basis that can be distracting to investors, in addition to adding more work for the private equity firms. The bottom line is most everyone in the industry recognizes the issues that FAS 157 causes.

Nevertheless, FAS 157 is here to stay and private equity firms have no choice but to comply. Instead of dwelling on the negative, Grant Thornton is more interested in exploring what private equity firms can do to turn FAS 157 compliance into a competitive advantage. It doesn’t have to be a hamstring.

Perhaps one of the surprise benefits to embracing FAS 157 is the positive impact it will have on relationships with limited partner. LPs are reducing their allocations to private equity and many private equity firms are finding it difficult to raise new funds. In fact, The Boston Consulting Group predicts that between 20 percent and 40 percent of the 100 largest private equity firms will disappear in coming years because they will not be able to successfully raise new funds. There’s no question that competition for dollars is fierce.

LPs considering which funds to invest in may use FAS 157 as one distinguishing factor. Of course a track record of solid returns will remain the most important determining factor, but if the track record is equal, an LP will absolutely feel more comfortable investing with the private equity firm that has greater transparency. The adoption of FAS 157 gives private equity firms more credibility with their LPs.

In turn, greater transparency gives LPs more credibility with its board members. And LPs benefit from being able to understand and explain what their investments are worth at any given point. It is understandable for private equity firms to worry about being judged on investments that haven’t reached their stride yet, but on the flipside LPs investing in the asset class are sophisticated enough to understand that private equity firms need time to draw out the value of their portfolios and the quarterly reports can’t be used as an indicator by themselves.

Management Team Relations

FAS 157 should also facilitate greater transparency between private equity firms and their management teams. Private equity firms will track management decisions more closely over time. FAS 157 makes it easier for private equity firms to see which strategies are working and give private equity firms an early warning if a particular portfolio company is headed in the wrong direction.

FAS 157 will undoubtedly help private equity firms identify and account for losses earlier and create less opportunity for surprise at a later date or perhaps upon exit. Of course, private equity firms engage in ongoing communication with their portfolio companies, but FAS 157 forces private equity firms and portfolio company managers to communicate more about forecasting and budgeting of the company. As a result, portfolio company managers are much more likely to disclose any potential troubles earlier on to avoid being in the hot seat if something doesn’t work out as planned.

FAS 157 is also helping private equity fund managers to better understand the companies they invest in and their competition. Fund managers are now looking for and pouring through more data than ever before. This can really help private equity firms better understand a portfolio company’s market position.

Larger market players were early adopters of FAS 157, and it doesn’t seem to have gotten in the way of the firms raising fresh capital or making new investments. For example, China’s sovereign wealth fund, China Investment Corp., is considering investing an additional $500 million into The Blackstone Group, despite the fact that the firm suffered huge write-downs. (In May 2007, China Investment Corp. invested $3 billion into the firm.) In addition, Blackstone Group recently raised €3.1 billion ($4.4 billion) for a new real estate fund. Big banks such as Goldman Sachs and Morgan Stanley have had private equity arms and have been required to report this since FAS 157 became effective.

However, there are best practices the private equity firms must follow to reap all the benefits of FAS 157. And all the griping about FAS 157 comes because many private equity firms, especially middle-market firms, are struggling with implementation. FAS 157 doesn’t lay out hard and fast rules, but instead guidelines, so complying can get a little tricky. The most important thing to do is come up with a process that is thorough, accurate and consistent. It can be an arduous task, but those three things will make this process more meaningful for all involved.

In addition, there are some key steps that will make the process smoother. Designate a member of the senior management team to be responsible for oversight of the valuation process. Make sure deal teams submit very detailed memos to the finance department, which at the minimum need to contain an update on financial performance, any realizations, follow-on investments, the methodology and comparable company analysis. Once a procedure is put in place, document it and follow it.

However, it is important to note that middle-market firms face unique challenges. Due to the smaller size of companies that middle-market and lower-middle-market private equity firms tend to invest in, there are fewer competitors, which makes finding comparable businesses to gauge values against scarce. Most published reports focus on larger or better known companies, not the middle-market businesses. This makes many of middle-market firms’ assets Level 3 assets, which are considered illiquid, with market prices so scarce that companies must develop internal models to gauge their value.

Although this leaves much ambiguity, it is important that private equity firms working with Level 3 assets remember to be thorough, accurate and consistent with their valuations. Rule of thumb: Value Level 3 assets in the fairest way possible. Common Level 3 inputs include cash flow forecasts, default probabilities, loss severities, real growth expectations and the true anticipated holding period.

If private equity firms remember to be thorough, accurate and consistent they will be putting themselves at an advantage in the long term, even if it creates a tiny headache in the short term.

Two Sidebars

Facts About FAS 157

• FAS 157 was issued in September 2006, and became effective for financial assets and financial liabilities for financial statements issued for fiscal years beginning after Nov. 15, 2007.

• As a result of mark- to-market accounting being blamed for exacerbating the financial crisis, FASB has issued seven amendments to FAS 157. Its latest, FAS 157-g, addresses the issue of how investors should ascertain the fair value of their investments for financial statement purposes in “alternative investment” vehicles, like private equity funds. 157-g will amend how FAS 157 provides guidance for estimating the fair value of investments in companies that have calculated net-asset-value-per-share in accordance with the AICPA’s Audit and Accounting Guide for investment companies.

Which Level Do Your Assets Fall Into?

• Level 1: assets have readily observable prices and trade in active markets.

• Level 2: assets do not trade actively nor do they have easily obtainable prices.

• Level 3: assets are considered illiquid, with market prices so scarce that companies use internal models to gauge their value. In other words, placing a value on these assets is subjective and largely depends on assumptions or opinions.

Harris Smith is a managing partner in the private equity division of Grant Thornton LLP. He oversees all services to private equity firms and is responsible for developing strategic relationships with private equity firms and their portfolio companies.