David Toll took some time earlier this morning to discuss fair-value accounting, which is something that private equity firms have assiduously avoided for years. Instead, most firms just carried portfolio companies at cost until liquidity – believing that conservatism was the most responsible course of action. Plus, low expectations are easier to exceed.
Last September, however, the Financial Accounting Standards Board issued FAS 157, which basically told private equity firms (both buyout and venture) that this discounting would no longer be considered GAAP-compliant. Not necessarily a huge deal for VC firms, since they often revisit company values due to follow-on financing rounds. But buyout firms were none too pleased.
This rule goes into effect for different firms at different times, based on their fiscal years. Overall, however, it should raise short-term private equity benchmarks by at least a few percentage points.
But the big issue isn’t aggregate IRRs. Instead, it’s what LPs should do about those firms that refuse to comply. There’s at least one such shop based in New York – and certainly more I haven’t yet heard about. If just a small percentage of an LPs portfolio funds do not abide by FAS 157, there’s no real harm done – save for the difficulty of judging compliant fund IRRs against non-complaint fund IRRs. But if a significant percentage declines, then the LP itself might not be able to get certified as being GAAP-complaint by its own accountants. And that would be a major problem for almost all LPs – and particularly for public systems that are legislatively required to conduct annual audits.
Just last month, Ernst & Young dropped the University of Texas Investment Management Co. as its client, citing discomfort with how UTIMCO valued its private equity and hedge fund investments. I don’t expect this to be a widespread problem, but all GPs should really put their investors’ convenience over their own stubbornness on this matter. After all, in the end, everyone’s going to know exactly how the fund performed – discounts or not.