Wow, that’s a dramatic title. But think about this:
FAS 157, the new US accounting standard dealing with “fair value measurements”, requires that investors take a valuation discount for securities which are restricted as to resale.
The example most often given is that of restricted stock acquired as part of a PIPE (Private Investment in Public Equity) transaction. If you hold stock which cannot be sold until a registration event, say, 120 days in the future, FAS 157 requires that you value that investment at a discount to the exchange traded price of the company’s unrestricted stock.
That sounds fair enough. We were stunned, however, to chair a recent conference on hard to value securities and hear an audit partner at a mid tier (but well known) audit firm state that, in his opinion, hedge funds are “restricted”.
The argument is simple: even the most “liquid” hedge fund only allows investors to get out once per month. Many have quarterly liquidity, some annual, and some allow redemptions even less frequently. We also have initial lock ups of 12 or 24 or even 36 months, let alone soft lock ups whereby a redemption fee is payable in the first couple of years. What about “rolling” redemption provisions, whereby you can redeem provided no more than x% of the fund tries to exit at the same time, at which point your redemption will be scaled back. Then we have redemption gates...the list goes on, and on, and on. Hedge funds, as we all know, are hardly liquid investment vehicles.
The auditor, therefore, stated that FAS 157 requires any hedge fund investor to take these “restrictions” into account. Time to crack open the calculator for discounted cash flow 101.
It goes without saying that the implications of this accounting treatment would be enormous.
- Every hedge fund investor, whether a fund of funds, a pension plan, a corporation or an endowment, would have to discount their portfolio to take account of the current liquidity profile. What???
- An investor allocating $50 million to a fund with a three year lock up would immediately need to take a 15-20% discount to reflect the “restriction” that prevents sale for the next three years. What???
- A fund of funds which raises new capital and invests it, exactly pari passu, across the existing portfolio would see its NAV fall - some funds would have lock ups, and the new investments would be further away from their next redemption opportunities. What???
FAS 157 actually says that “a fair value measurement for a restricted asset should consider the effect of the restriction if market participants would consider the effect of the restriction in pricing the asset.”
We’ve highlighted the final phrase, because it’s self evident that hedge fund investors do not consider the impact of a redemption “restriction” when valuing a hedge fund: irrespective of redemption frequency or lock up, investors value their positions at the NAV. This reflects the fact that hedge funds, whether offshore companies or onshore limited partnerships, are open ended investment vehicles. They offer their investors the ability to repurchase their holdings at predetermined points in the future.
We can also raise other, more “technical” points. Unlike PIPE deals, hedge funds do not have an exchange traded, “unrestricted” equivalent which could be used as the reference point for a FAS 157 discount. We can also say that any investor buying a fund with a three year lock up obviously recognises the existence of that three year lock when they subscribe: the subscription price, therefore, must take account of the time value of that “restriction.” The only thing that would create a “restriction” would be if the fund changed redemption terms post investment, or simply suspended redemptions.
FAS 157 is hardly the most logical of accounting pronouncements. This is the standard, after all, which prohibits blockage discounts even if you own 50% of a publicly traded company. It is also the standard which defines “fair value” as the exit price of an investment, but still allows funds to mark at the mid rather than the bid (at least international accounting standards require longs to be marked at the bid, and shorts at the ask).
These issues, however, fall into the category of minor quirks compared to the notion that hedge funds are “restricted” assets and must be discounted dependent on the time to the next redemption opportunity. The fact that at least one audit firm has put this question into play means that it needs to be addressed across the industry, and addressed quickly.
Which leads us to a final point, for those of you who have a perverse interest in accounting literature. Press A if you think a hedge fund is a “level 1” asset, press B if you think a fund is “level 2”, and press C is you think a hedge fund is “level 3”.....