More than a decade ago, the American Institute of Certified Public Accountants (AICPA) published guidance on measuring the fair value of alternative investment fund interests. This guidance was in response to new Financial Accounting Standards Board (FASB) rules issued in 2006 which dictated that fair value was based on a market-participant-buyer perspective. Many interpreted this guidance as requiring fund interests to be valued using secondary-market or discounted pricing. Such an approach would have been detrimental to investors. In response, FASB modified its fair-value rules to take into account investor concerns. FASB’s modified guidance allowed net asset value (NAV) to be used in certain circumstances to estimate the fair value of a fund interest. The AICPA in turn formed a task force that provided more specific guidance in interpreting and applying the FASB NAV rules.
Fast-forward to today. Alternative investments are becoming more mainstream as they find their way into investment vehicles such as interval funds, ’40 Act funds, collective investment trusts, target date funds, European long-term asset funds and other investment vehicles that require monthly or daily fair-value reporting. This requirement is arguably problematic, as private fund managers generally report to investors quarterly in arrears. Luckily, the AICPA created a framework, congruent with FASB fair value rules, that allows private investment fund interests and co-investments (direct investments in private debt and equity alongside a manager) to be fair-valued on a more timely and more frequent basis.
Rigor vs Simplicity
Over the past decade, many investors in alternative asset funds have taken a simplified approach to applying the FASB and AICPA guidance. Some use the last reported NAV from a fund manager as their fair-value estimate, other investors cash-adjust last reported NAV, and a minority of investors cash-adjust and market-adjust last reported NAV from a manager to bring it current to the reporting or measurement date.
In times of market dislocation or market volatility, the simplified approach would not necessarily result in a reasonable or reliable value. Astute retail investors would be able to leverage the fact that NAV is reported in arrears. For example, if a retail investor in a fund made up of alternative asset interests was deciding to buy or sell on March 31, 2020, and they knew that reported NAV was based on last reported NAV of September 30, 2019 (December 31 results are generally not reported until April), the investor would sell short, as they knew that values would come down due to the impact of COVID-19 when the March 31 NAV was ultimately reported in May of 2020.
Funds that report value or allow transactions on a daily or monthly basis require more rigor in the valuation process. The AICPA provided a framework for this rigor.
Measuring the fair value of a fund interest or co-investment on a daily or monthly basis includes some complexity but can be mirrored to the AICPA Technical Information Service section (TQA) 2220. The basic monthly or daily valuation framework is as follows:
- Verify or validate through upfront due diligence and ongoing monitoring that the investment manager (general partner) provides NAV where the underlying investments are reported at fair value (as defined by FASB Accounting Standards Codification Topic 820) and have been adjusted for carried interest or incentive fees.
- Identify a starting point for the daily/monthly valuation model using last reported NAV.
- Adjust the starting point or last determined daily or monthly fair value to the current date by taking into account:
- Cash flows (capital calls and distributions)
- Market movements through a market adjustment factor (a market adjustment factor is calculated by identifying an appropriate index and correlation coefficient)
- Significant idiosyncratic (company-specific) value changes which are known or knowable.
- Working capital, fees and expenses
- True-up adjustments
- Updates to correlation coefficients based on quarterly manager reporting
- Each day/month the fair value moves forward based on known and knowable information.
A number of nuances need to be considered when implementing a daily/monthly fair value measurement process based on stale (in arrears) quarterly manager-reported values. The key takeaways are:
- It is possible to establish a rigorous valuation framework that provides daily/monthly values; and
- It is necessary to implement a rigorous daily/monthly valuation framework to provide investors with contemporaneous information and to ensure that buyers and sellers are not advantaged or disadvantaged.
The AICPA was ahead of its time in providing a framework that allows daily/monthly values for alternative investment funds and co-investments to be measured on a consistent and reliable basis.