Impact of Recent Fair Value Accounting Rules on Governmental Pension Plans

Presented by Tom Heseltine, Partner

Course Objective
Discuss recent accounting guidance and their impact on alternative investments Discuss how current economic conditions are impacting valuation of alternative investments and potentially the financial reporting of your System Your responsibility in evaluating the valuation internal controls and processes of your alternative investments
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The Fair Value Definition

Fair value is the price that would be received or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Why Fair Value?

Limited Partners in alternative investment funds need consistent, transparent information to exercise their fiduciary duty. Fair value provides such information. An arbitrary reporting basis such as cost does not allow apple to apple comparisons.

The Fair Value Objective

The FASB believes that, in order to be useful, accounting information should be both relevant and reliable

Alternative Investments Valuation Obstacles

Valuing alternative investments is difficult because these investments are not publicly traded. Performance is derived from estimates of market prices, instead of true market price data. Estimates are created from various approaches such as book value, appraisal of the investment etc.
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FAS 157
Defines fair value for financial reporting Establishes a framework to measure fair value under GAAP Expands disclosures on fair value measurements Provisions are not applicable for governmental pension systems but has impacted public pension systems

The Fair Value Hierarchy

Observable Inputs Based on market data obtained from sources independent of the reporting entity Unobservable Inputs Reflect reporting entitys own assumptions about the assumptions market participants would use

Fair Value Hierarchy Input Quality

Level 1
Direct (unadjusted) quoted price form an active market for identical assets

Level 2
Quoted prices for similar assets Other observable inputs (interest rates, yield curves, etc.)

Level 3
Unobservable inputs not derived from the market
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Common Level 3 Inputs

Cash flow forecasts for private companies Default probabilities and loss severities for private placement debt or asset-backed securities Growth expectations (revenue, earnings, etc.) Required returns on illiquid investments Anticipated holding periods for illiquid investments
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What Are Common Level 3 Assets?

Mortgage and asset backed securities Private placement corporate debt Equity investments in private companies Forward contracts, commitments and guarantees Other derivative contracts
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Disclosure Requirements
For all assets measured under SFAS 157:
The level within the fair value hierarchy in which fair value measurements in their entirety fall The valuation techniques used to measure fair value

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Disclosure Requirements

(Contd)

For measurements using significant Level 3 inputs:

Beginning balance Total gains or losses (both realized and unrealized) Purchases and sales of assets Transfers in and/or out of Level 3

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Active vs. Inactive Markets

An active market will generally:
Provide reliable pricing Provide reasonably narrow observable ranges within bid ask spreads Be supported by actual market transactions that are typically daily Be provided by sources actively involved in the relevant market Enable a participant to corroborate pricing on a historical basis

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Valuation of Illiquid Alternative Investments

FAS 157 contemplated an orderly transaction between market participants not a distressed market with no or limited activity FAS 157-e was issued to clarify how a reporting entity determines fair value when the market for financial assets that historically had been active and is now inactive and how to handle value an investment when the last price is not current.
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Valuation of Illiquid Alternative Investments

FAS 157-e established a two step process: 1) Determine whether a market is inactive by identifying how many transactions have occurred and if few what does that mean, assessing whether price quotes are current or not and determining if quotes vary dramatically from broker to broker and there are abnormally wide bid/ask prices. If these conditions exist then we go to step 2.
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Valuation of Illiquid Alternative Investments

2) If considered inactive the fund itself is now responsible for pricing that security. This leads to several challenges. Does the fund have the resources and ability to properly perform this function Should be considered a higher risk and should be further scrutinized by their auditors and should be a higher risk to your plan

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Valuation of Alternative Investments

Examples of inputs used when estimating fair value include:
Net Asset Value (NAV)

Transactions in principal to principal or brokered markets Features of the alternative investment Expected future cash flows appropriately discounted

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Valuation of Alternative Investments (Contd)

A reasonable assumption is that the net asset value (NAV) of the fund and the nature and duration of the restrictions on redemption, would be significant inputs to any estimation of fair value.

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Valuation of Alternative Investments (Contd)

In situations where there are no recent redemptions it is less clear that NAV is an appropriate measure because no transactions exist to indicate investors willingness to relinquish their investments in the fund.

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Valuation of Alternative Investments (Contd)

Historically industry practice generally had been to carry interests at the NAV most recently reported by the investee fund manager with little or no further review of the amounts reported by the investee fund.

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Valuation of Alternative Investments (Contd)

Recent guidance clarified this practice and requires the investor entity to undertake a robust review and understand and evaluate the NAV reported by the investee fund manager. The exit price concept under FASB 157 further challenges an investor entitys decision to continue to value such investments at NAV.
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Valuation of Alternative Investments (Contd)

Therefore the task of estimating fair value is twofold:
1. The reporting entity would evaluate whether the reported NAV has been appropriately determined and therefore represents a good starting point in estimating fair value Then the entity would evaluate all relevant factors and attributes of the interest in the alternative investment and determine whether the reported NAV represents fair value or whether the NAV should be adjusted to fair value.
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2.

Valuation of Alternative Investments (Contd)

To assist in assessing the reliability of the NAV reported the investor entity should develop the following controls:
Initial due diligence Ongoing monitoring procedures Financial reporting controls

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Valuation of Alternative Investments (Contd)

Some factors to consider:
The investee funds fair value estimation process and control environment and any changes to those processes or the control environment The investee funds policies and procedures for estimating fair value of the underlying investments and any changes to those policies and procedures
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Valuation of Alternative Investments (Contd)

The use of independent third party valuation experts to argument and validate the investee funds procedures for estimating fair value The portion of the underlying securities held by the investee fund that are traded on active markets The professional reputation and standing of the investee funds auditor Qualifications if any of the auditors report on the investee funds financial statements
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Valuation of Alternative Investments (Contd)

Evidence that the reported NAV is based on application of FASB 157 Whether there is a history of significant adjustments to the NAV reported by the investee fund manager as a result of the annual financial statement audit Findings in the investee funds advisor or administrators SAS 70 report if any

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Valuation of Alternative Investments (Contd)

Factors to consider when assessing whether NAV should be adjusted:
Significant time has elapsed between the calculation date and the investors reporting date. The investor entity has become aware of changes in the value of the underlying investments since the calculation date of the reported NAV

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Valuation of Alternative Investments (Contd)

Market changes or other economic conditions have changed to favorably or unfavorably affect the value of the investees portfolio after the calculation date of the reported NAV Significant changes have occurred in the composition of the underlying investment portfolio after the calculation date of the reported NAV
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Valuation of Alternative Investments (Contd)

Significant balance sheet items not carried at fair value Features of the investor entitys agreement that may affect its fair value but which are not captured in the NAV
Redemption restrictions (lock-up terms, etc) Early withdrawal fees Suspended withdrawals Fund closed to new investors
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Accounting and Auditing Standards

FASB Statement No. 157 Fair Value Measurements and 157-e Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active Proposed amendment FAS 157-g Estimating the Fair Value of Investments in Investment Companies FAS 159 The Fair Value Option for Financial Assets and Financial Liabilities

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Accounting and Auditing Standards

FSP FAS 157-4 Determining Fair Value When the Volume and Level of Activity Have Significantly Decreased and Identifying Transactions That are Nor Orderly AICPA Industry Audit and Accounting Guides including Auditing Investments in Securities Where a Readily Determinable Fair Value Does Not Exist
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Additional Implementation Guidance and Other Resources

AICPA Alternative Investments Audit Considerations

SEC Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 AICPA Audit and Accounting Guide Investment Companies
http://www.aicpa.org/download/members/div/auditstd/Alternative_Inves tments_Practice_Aid.pdf

Center For Audit Quality Measurements of Fair Value in Illiquid (or less liquid) Markets

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Additional Implementation Guidance and Other Resources

PCAOB FASB, ISB National Council of Real Estate Investment Fiduciaries (NCREIF) Fair Value Measurements and Disclosures Implementation Guidance for Real Estate Investments Private Equity Industry Guidelines Group (PEIGG) and Updated US Private Equity Valuation Guidelines Global Investment Performance Standards (GIPS) Alternative Investment Management Association Guide to Sound Practices for Hedge Fund Valuation

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Impact of Current Economic Conditions

Audits related to valuation of alternative investments for the period 12/31/08 were the most difficult in recent history and resulted in significant adjustments Valuation for the period ending 12/31/09 will continue to difficult due to the continuing struggle of the current economy and the impact on the underlying investments Preliminary amounts reported to the Systems for the period ended 12/31/09 may be materially different than the final amounts reported Use of quarter or 6 month lags in reporting may not be reasonable in todays environment. Requires additional oversight by governmental pension systems to verify the reliability of interim and preliminary valuation by the alternative investment manager or general partner

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Investor Managements Responsibility for the Valuation Process and Related Internal Control
Management is responsible for making the fair value measurements and disclosures included in the financial statements. As part of fulfilling its responsibility, management needs to establish an accounting and financial reporting process for determining the fair value measurements and disclosures, select appropriate valuation methods, identify and adequately support any significant assumptions used, prepare the valuation, and ensure that the presentation and disclosure of the fair value measurements are in accordance with GAAP. AU Section 328.04
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Managements Responsibility (Contd)

At a minimum, management should have sufficient understanding of:
The nature of the underlying investments held by the alternative investment fund; The portfolio strategy of the alternative investment fund and the method and significant assumptions used by the fund manager to value underlying investments.

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Internal Control and Monitoring of Alternative Investments

Initial due diligence before investing in the fund. Controls might include face to face meeting with the funds management, onsite visits, reference checks and inspection of legal documents. Ongoing monitoring after investing in the fund. Period meetings with fund management, on-site visits, review of SAS 70 reports (if available), review of fund reports and monitoring of fund performance
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Internal Control and Monitoring Duties (Contd)

Maintenance of an investment policy, formation of investment committee, and review of audited financial statements for alternative investment funds. Benchmarking results to relevant indexes

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Internal Control and Monitoring Duties (Contd)

Use of Investment Consultant monitors the investments through analyzing investment performance, attending all advisory board meetings, attending annual meetings, ongoing communications with the partnerships and ongoing communications with other limited partners.
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The Valuation Policy

The valuation policy should be a priority The policy should be well documented The valuation process should be open and transparent The policy is a working document A sound valuation policy is critical and it pays dividends

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Best Practices
Recognize that valuation matters (it will really matter when something has gone awry) Disclose the valuation process and conclusion (potential investors/creditors take comfort in transparency)
Transform compliance work into a competitive advantage

Designate a member of senior management to be responsible for oversight of valuation process

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Best Practices (Contd)

Document valuation procedures If it has not been documented, it has not been done. Create contemporaneous and consistent documentation of valuation rationale and conclusions After the fact valuations will invariably be perceived as selfserving whether they are or not

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REMEMBER THIS

Fair value is an art, not a science.

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Questions?

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Contact
Tom Heseltine, CPA, Partner Clifton Gunderson LLP 9515 Deereco Road, Suite 500 Timonium, Maryland 21093 410-453-0900

Tom.Heseltine@cliftoncpa.com

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