PwC Proposal on Fair Value Accounting

PwC has recently released an interesting discussion paper proposing changes to fair value accounting.  They do not propose eliminating fair value accounting - thankfully - but they do suggest that, for banks, only "credit related" losses be reflected in net income (this is, of course, the headline number that everyone focuses on for publicly traded entities.)  Other changes in current market value unrelated to the borrower's ability to repay a loan, such as write downs due to an illiquid or dysfunctional market, would be recorded in "other comprehensive income".  OCI is essentially a bucket for items that companies don't want to pass through their reported, "business" P&L.

Interesting reading, albeit more focused on banks rather than hedge funds.  However, the underlying theme is that only realized gains are "real", while unrealized gains are transitory and have less validity as measures of true business performance.  According to PwC:

"Removing liquidity and other transitory charges from the net income of institutions with a “buy and hold” business model may reduce distortion from excessive market pessimism in distressed markets and excessive market optimism in euphoric markets." 

The implication for hedge funds reverts back to a theme we have commented on frequently: that one of the flaws of the typical hedge fund structure is that investment managers can pay themselves on unrealized appreciation as well as realized P&L.  This remains a key issue that should be at the forefront of investor re-evaluation of the hedge fund model going forward.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Comments

[Phil]

While I understand the comment, I wonder whether having compensation paid out of realized profits really works for typical hedge funds. If you take the typical hedge fund trading in highly liquid securities, requiring compensation to be paid out of realized profits would seem to be a recipe for incenting portfolio managers to trade out and then back into their positions frequently, so as to trigger realized profits. All that does is generate commission revenue for the brokers covering them - good for sell side firms, but not for fund investors. Isn't the problem really only limited to the assets in illiquid markets, where the realized vs. unrealized distinction is more material?