Risk Without Reward

Rothstein Kass Paper on FAS 157

Having just posted comments on FAS 157 ourselves, the audit firm Rothstein Kass has just published a paper providing implementation guidance on the new fair value accounting standard as it applies to hedge funds.  

For those with interest, this paper, along with other accounting and best practice resources, is available on the Resources section of Castle Hall's website.

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Hedge Fund Operational Due Diligence.

The latest term in the accountant's lexicon..."NAV Divergence"

We recently spoke with a senior manager working for the New York office of one of the Big 4 accounting firms.  He casually mentioned what appears to be the latest addition to the accountant's lexicon: NAV Divergence.

Under this concept, a hedge fund prepares its NAV under one set of accounting (or more accurately valuation) standards.  This is used to cut the "trading NAV", which will be the price used for subscriptions, redemptions and, of course, the payment of the manager's management and incentive fees.

The slight snag is that this "trading NAV" won't be the same as the NAV reported in the financial statements, prepared under US GAAP.

There is actually a long standing precedent for this practice: hedge funds reporting under International Financial Reporting Standards (IFRS) are required to price long securities at the bid and short securities at the ask, to reflect the prices the fund would actually receive in a sale (or equally pay to cover a short.)  Some hedge funds disagree with this policy (despite the fact that it seems to be a very appropriate valuation method), and disclose in their offering documents that they will price securities at the mid or at the last sale.

In these circumstances, the financial statements are prepared under IFRS, but a footnote disclosure identifies the difference between the financial statement NAV and the trading NAV.

It now seems that this concept has crossed the Atlantic and may quickly become an issue for US hedge fund investors - or more widely investors in hedge funds which report under US GAAP.

How could this arise?  Under the new FAS 157 accounting standard, hedge funds must value their assets at fair value, being the exit price in a situation other than a forced or distressed sale.  What happens, however, if a hedge fund disagrees with FAS 157 and determines, for example, that it would be inappropriate to calculate the "fair value" of illiquid side pocket investments and hence decides to hold them at cost for "trading NAV" purposes.

As another example, what happens if a hedge fund holds a large block of a thinly traded small or micro cap stock and wants to take a blockage discount?  This is explicitly disallowed by FAS 157: perhaps the hedge fund, however, could specify in its offering materials that it can make use of blockage discounts and hence calculates the 'trading NAV" on that basis.

To us, this seems to be a double edged sword.  In some instances, GAAP may well be wrong - the example of blockage discounts is an excellent example.  There is a very good argument that a fund should take some discount from open market prices when it holds many days (or months) of trading volume in what is nonetheless an exchange traded equity.  The problem, however, is how to calculate that discount: how can investors compare one fund which takes a 5% discount to another which takes a 25% discount in pretty much similar situations.  NAV Divergence allows individual funds essentially to set their own accounting policies, each of which must be analyzed and then monitored by investors.

The side pocket example also gives rise to problems.  It may make sense for the underlying fund not to value its side pockets - but what about a fund of fund that holds a position in that manager?  The fund of funds must record its investments at fair value if it is to calculate an accurate NAV for its own investors: holding valuable side pocket investments at cost will understate the fund of fund's own NAV.  We can see all kinds of thorny issues here.

The biggest problem, though, comes when GAAP may well be right, but the hedge fund nonetheless wishes to use an alternate method of valuation.  In recent times, plenty of funds may have disagreed with broker quotes or other pricing information available for toxic CDO, CBO and other structured paper.  What happens if the fund is able to disregard this information and use its own "fair valuation" model for purposes of the trading NAV?

At the moment, one of the biggest protections against enduring misvaluation of complex securities is that, at least once a year, the fund must provide pricing evidence sufficient to convince the auditors that the financial statements are presented in accordance with GAAP and are, within the range of materiality, true and fair.

Against this background, "NAV Divergence" seems to us to be a very slippery slope.  If auditors allow different NAV's for side pockets and blockage discounts, the same logic could very well allow funds to use "alternate" valuation methods for hard to value securities.  Under this process, a fund could concoct, with impunity, its own pricing policy entirely separate from the GAAP process which underpins the financial statements.

We are not saying that GAAP is always right.  However, investors have a right for a level playing field and GAAP, at the moment at least, is the best option we have.  

It goes without saying that investors should not accept funds who use NAV Divergence to revalue their books at prices higher than that permitted under GAAP.  It also goes without saying that the auditors should not sign off on accounts prepared on this basis as it makes a mockery of the entire audit process.

Let's hope both the investor and auditor community can head this one off at the pass.

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Will FAS 157 destroy the hedge fund industry?

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”.....