Closing the Books on 2012 for Alternative Investment Managers

November 08, 2012

As the close of the calendar year quickly approaches, many alternative investment managers are holding preliminary discussions with auditors about the impact of recent regulatory and accounting guidance. Some have even started planning for interim testing as early as November.

To better understand the implications of comments from the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC), A&M offers several simple, yet effective, operational themes that can help smooth the path to closing the books on 2012.

Understand What You Own

Managers are well versed in the investment qualities of their portfolios, but are often, understandably, lacking in important knowledge regarding Fair Value. Most accounting guidance relates to Level II and Level III measurements, which are typically instruments or securities that trade very infrequently or not at all and, consequently, are often priced by reliance on traditional valuation models, reference to infrequent trades or recently issued, similar securities. Given these inherent complexities, it is critical to understand the Fair Value hierarchy of your portfolio in detail, particularly those investments that are material and have the potential for reclassification.

Regulatory bodies have increased their attention on “hard to value” Level III measurements while, at the same time, broadening their focus to Level II measurements. A leading practice is to analyze the portfolio and perform “deep dives” prior to year-end on your most risky assets. The definition of “risky” and the basis for any analysis will depend on the composition of your portfolio. Management should take a close look by assessing the portfolio in the context of the Fair Value hierarchy. One should expect material Level II measurements to receive as much scrutiny as those in Level III. Two important events support this position.

First, during the December 2011 AICPA National Conference on Current SEC and PCAOB Developments, both the SEC and the Public Company Accounting Oversight Board (PCAOB) reiterated a number of recent releases and “Dear CFO” letters regarding management’s responsibilities regarding Fair Values obtained from broker quotes and third-party pricing providers.

Publicly available SEC comment letters to registrants regarding their use of pricing services in connection with valuation include:

Describe in detail:

• The accuracy and completeness of the observable inputs (including interest rate, spread, and prepayment information) used by such pricing services in valuing securities;
• Internal controls to ensure that models and assumptions used by pricing services reflect those used by market participants; and
• Internal controls for prices received from pricing services.
   

Explain whether the information you receive is the actual quantitative inputs used in the pricing services valuation techniques and, if so, how you evaluate this information.

Explain whether you receive quantitative input information for all services or a sample.

Second, in May 2011, the FASB issued Accounting Standards Update No. 2011-4 Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (ASU 2011-4), requiring several new disclosures, most of which were implemented by companies earlier this year (although some are not required for non-public entities). These disclosures include:

• Information about Level I and Level II transfers
• Categorization by level of the Fair Value hierarchy for items that are not measured at Fair Value in the statement of financial position, but that require disclosure
• Information about the sensitivity of a Fair Value measurement categorized as Level III to changes in unobservable inputs and any interrelationships
   

Again, a complete understanding of what you own helps reduce the risk of responses that do not provide clear evidence of a robust internal process for assessing the reasonableness of the approach used by the pricing service, which can help reduce or eliminate additional SEC comments.

It is important to note that, at the same time, auditors also must respond to comments from the PCAOB regarding audit evidence and substantive testing of valuations and will, therefore, be simultaneously updating their understanding and testing of controls related to Fair Value, often by leveraging in-house specialists.

Let Your Valuation Memo Do the Talking

Just as “less can be more,” sometimes “more can be more.” Help yourself optimize communications by drafting valuation memos that serve not only as an informational update, but also as a “road map” of robust and consistently applied internal processes and controls to potentially uninformed outside parties. This effort can also highlight steps taken to address specific regulatory concerns. As valuation memos now serve as more than just guides to outside parties performing due diligence on your Fair Value conclusions, consider addressing the following issues:

• How did management review Level II measurements? Was there sufficient observable data to support the classification of Level II?
  Unless the value indication is overwhelming, management should have corroborative market data other than multiple broker sources and pricing services to support a Level II classification.
• What rigor underpins the analyses performed on Level III measurements?
  For investments valued through reliance on internal models, provide all observable and unobservable market inputs, including sources, and discuss any back-testing performed to ensure their continued integrity.
• Describe how you assessed prices from third-party providers (broker quotes), such as:
  • Walk-throughs with service providers and any available auditor reports, such as those under Statement of Standards for Attestation Engagements No. 16, Reporting on Controls at a Service Organization;
  • Documentation and supporting market data relied upon for Fair Value conclusions;
  • Analyses of yield and price movements for specific securities versus performing a broad analysis of the portfolio; and
  • Analysis of outliers to identify suspect sources.
• The very nature of Level III measurements dictates that some inputs will have no benchmarks or observable market data. It is best to clearly highlight these situations and identify benchmarks that, while not ideal, nevertheless provide support for your conclusions.
• When discussing quantitative support for any adjustments to unobservable inputs such as discount rates and comparable metrics, avoid generalizing and stating that management “believes this is appropriate” or “believes it is reasonable.”
   

You Do the Talking

The quickest, most effective way to avoid last minute problems is to create an organizational chart and pick up the phone. Both can pay huge dividends, yet often are put off until the last minute or avoided altogether.

From an organizational perspective, placing all necessary files in a central repository saves time when responding to outside inquiries. Any valuation-related files, such as a documentation of price challenges to third-party servicers and related responses, should be centralized in one location. Below is a sample list of documents to consider including in such a repository:

• Price challenges and responses
• Credit agreements
• Offering memorandums / prospectuses
• Indentures
• Compliance certificates
• Current financial statements
• Models / projections
• Underlying calculations referenced in valuation memos
• Market data / benchmarks
• Latest servicer / payment reports
• Shareholder reports
   

Additionally, management should communicate with investors and auditors regarding any new issues that may influence valuation processes and conclusions, including the impact of ASU 2011-4. It is important to note that this guidance is not intended to result in a change in the application of the requirements outlined in Topic 820, but rather clarify the intent of those guidelines and the disclosures surrounding Fair Value measurements. Managers should assess the expected impact of ASU 2011-4 on a given portfolio and existing valuation processes, as this new guidance is likely to be a point of focus at year-end.

Conclusion

As Fair Value guidance continues to evolve, both investors and regulators will continue to demand more rigor and transparency throughout the valuation process. Many alternative investment managers have already started addressing these new issues, while others may be just starting. Regardless of your current level of preparedness, keeping these themes in mind can provide operational and reputational benefits well beyond year-end.
 

Key Contacts:

Mark McMahon
Managing Director
Phone: +1 212 763 1615

Maria Nizza
Senior Director
Phone: +1 212 763 1635
 

Related Information:

Valuation Services