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Comment: Evolving fair value standards for limited partners


New accounting guidelines assist limited partners in measuring the fair value of interests in alternative investments.

New accounting guidelines assist limited partners in measuring the fair value of interests in alternative investments. Mark McMahon, a director in the portfolio valuation group at international financial advisory and investment banking firm Duff & Phelps, argues that fund managers wishing to cultivate enduring investor relationships and avoid potential reputational risk will make efforts to assist LPs throughout this process.

Significant attention has been dedicated to fair value issues faced by general partners of alternative investment managers, but limited partners, whether funds of funds, pension schemes or endowments, are subject to the same standard of care regarding the valuation of LP interests as GPs are for their investments.

This has resulted in greater due diligence requirements for assessing to what degree net asset value, as reported by GPs, can be relied upon in estimating the fair value of an LP interest, and what potential modifications may be necessary to enhance this measure. GPs should to be aware of new guidance issued on this subject and be prepared for what should likely be a significant effort in assisting LPs in their compliance efforts.

In the past, the valuation of LP interests has been a relatively straightforward exercise from the GP’s perspective, with the most recent net asset value relied upon heavily, and often exclusively, in estimating fair value for the LP.

The emergence of a secondary market for LP interests, combined with the recognition that fund lock-up provisions, gates, and other terms should be considered in any fair value estimate, have led accounting standards bodies, notably the Financial Accounting Standards Board and the American Institute of Certified Public Accountants, to issue limited guidance on how LP interests should be valued for financial reporting purposes.

Specifically, the AICPA’s draft proposal includes guidelines to determine whether NAV can be relied upon as a starting point for measuring fair value. Points of consideration for LPs include a determination of the adequacy of a fund’s policies and procedures for estimating fair value, the portion of the underlying securities that trade on an active market, and whether the GP has adopted FASB 157.

If NAV is established as a reasonable starting point for determining fair value, these guidelines continue to encourage LPs to consider not only performance, but also fund-specific terms, structure and governance attributes that may also impact fair value. Modifications in the form of updated prices for publicly traded securities and changes in subscriptions, distributions and redemptions, are generally universal.

However, additional adjustments may be warranted to capture the impact of differences in accounting policies, the departure of key investment personnel, and the value of other capital balances necessary to calculate NAV.

So what should GPs do to address the growing fair value compliance needs of LPs while nurturing lasting relationships with investors?

First, funds should confirm that their governance structure incorporates current industry best practices. These include the adoption of FASB 157, documentation of clear and effective valuation policies and procedures, and demonstration of a rigorous process for determining fair value, potentially vetted by a third-party expert.

Second, funds should provide increased transparency to LPs regarding all fund governance issues.

Third, GPs should calculate NAV in a manner that reflects the new fair value needs of their LPs. This may include disclosures related to the valuation of not only fund investments, but also other capital balances such as debt and certain liabilities.

Finally, GPs should consider accelerating the timing for reporting fair value estimates to accommodate the disclosure needs of their LPs.

For some LPs, the additional cost related to fair value compliance may be prohibitive and lead to a re-allocation of capital away from alternative investments. For those able to absorb the additional expense, they are wise to add resources that should assist them in making prudent investment decisions while also helping to ensure they are providing the standard of care expected of their stakeholders.

For GPs wishing to cultivate enduring investor relationships and avoid potential reputational risk, their own efforts to assist LPs throughout this process will be rewarded.

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