InterWest News
Proposed Changes To FAS157 May Irk PE Firms Even More
Dow Jones Venture Wire
Laura Kreutzer
4 September 2009
The Financial Accounting Standards Board has proposed changes to its Topic 820 - formerly known as Rule 157 - that could further complicate the lives of private equity firms.
Topic 820 governs fair value measurements under U.S. Generally Accepted Accounting Procedures (GAAP).
Among the proposed changes to the rules that private equity firms could find most unsettling is one that would require them to provide a sensitivity analysis for Level 3 assets, which are assets in their portfolio that cannot be measured using observable inputs.
Under Topic 820, there are three different levels of assets: Level 1, which are based on market prices; Level 2, which are based on market prices of similar entities; and Level 3, which are most common in private equity portfolios.
In addition to the fair market valuation, the proposed rules would require that firms valuing assets using Level 3 inputs must also disclose how that valuation would increase or decrease if they changed one or more of the inputs to a "reasonably possible" alternative.
In a press release, FASB said that it proposed the changes because users of financial statements requested more information about fair value measurements for Level 3 assets due to their greater degree of uncertainty and subjectivity.
For private equity firms, including possible alternative valuation scenarios presents practical challenges as they deal with their auditors and their limited partners.
"If you look at firms that use best practices, they approach valuations based on multiple methods, such as a [mergers and acquisitions] transaction, possible IPO or a recapitalization with another private equity sponsor," said David Larsen, managing director at financial advisory and investment banking services firm Duff & Phelps Corp. "They will look at it from multiple perspectives to come up with a point estimate. They've already incorporated reasonable alternatives. The question now is, do they have to disclose those alternatives and open themselves up to second guessing?"
For example, say a private equity firm came up with a valuation of $100 million for a portfolio company, but under other possible circumstances the valuation could range from $50 million at the low end to $150 million at the high end.
"It opens a Pandora's box of questions," said Larsen. "The auditor could say, 'Well, why didn't you pick $50 million and the LP could start asking, ‘Why didn't you pick $75 million or $150 million?'"
Larsen expects that private equity firms will raise their concerns about the proposed changes during the comment period, which ends on October 12.
FASB may see particularly strong objections from venture firms, especially those that invest in early-stage companies, given the different inputs and degree of subjective judgement that go into valuing a start-up company that may not even be producing revenue.
"In the world of early-stage investing, there's a huge range of what's reasonably possible and there's no way to audit that, because you come up with meaningless ranges," said Stephen Holmes, chief financial officer at venture capital firm InterWest Partners LLC. "My first read of [the proposal] causes the hair on my head to stand up."
