At the request of subscribers, Compliance Week offers a Remediation Center, in which readers can submit questions—anonymously—to securities and accounting experts. Compliance Week’s editors will review all questions and then submit them—confidentially, of course—to specialists who can address the issues. The questions and responses will then be reprinted in a future edition of Compliance Week. Below is one of the Q&As; ask your own questions by clicking here.

DETAILS

Ma

Dr. Ma is a managing director in Houlihan Lokey’s New York office, where her primary responsibilities as part of the firm’s Financial Opinions & Advisory Services business include providing valuations, financial opinions, and expert witness testimony. She leads the firm’s Illiquid and Complex Securities Valuation practice and is a member of the firm’s Technical Standards Committee.

Dr. Ma has over 20 years of extensive training, academic expertise, and hands-on experience in commodities, derivatives, securities, fixed incomes, structured transactions, hedging strategies, and risk-management issues. She has a deep understanding of the economic, operational, and institutional aspects of the securities and derivatives markets.

Since the beginning of the current global credit crisis in July 2007, Dr. Ma has been focused on valuing illiquid securities including asset-backed securities, collateralized debt obligations, collateralized loan obligations, mortgage derivatives, auction rate securities, distressed debt instruments and private equity investments for financial reporting, transaction advisory, restructuring alternatives, and litigation support purposes. On October 29, 2008, she served as a panelist in the Securities and Exchange Commission’s roundtable concerning mark-to-market accounting. Dr. Ma participated as the valuation expert, focusing on potential improvements to the current accounting model and implications of possible changes.

Dr. Ma joined Houlihan Lokey from NERA Economic Consulting, where she established and led the Employee Stock Options Valuation practice. Before that, she was a partner at Ernst & Young.

Dr. Ma may be reached via e-mail at cma@hl.com or at (212) 497-7970.

Remediation Center

Click Here to Return to the Remediation Center

Submit a Question to the Remediation Center

Warning, Disclosure

Compliance Week’s Remediation Center is an information service only. Answers to questions should not be construed to be legal guidance. Consult with your auditors, internal counsel, external counsel, and/or other securities experts on all critical compliance and governance matters.

Specialists are solicited by the editor to answer Remediation Center questions based on their knowledge of the subject matter and their ability to provide commentary in their particular area of expertise. In some cases, the experts who answer questions in the Remediation Center may also be Compliance Week subscribers, or may work at firms that advertise in Compliance Week.

QUESTION

I’m a financial reporting executive at an investment company, a “fund of funds” where we count many hedge funds among our investors. Suffice to say those hedge funds had a rough 2008 and have been redeeming their holdings too quickly for my taste. We’re selling lots of assets at cut-rate prices to raise cash, but still keeping others on our books for the future.

How should I report the fair value of the assets we’re keeping? Do I really have to value all our holdings at rock-bottom prices, just because we’re dumping some of them to raise cash? Is there any wiggle room at all here?

ANSWER

Since the beginning of the year, fair-value accounting (for example, SFAS 157 under U.S. GAAP and IAS 39 under IFRS) has been subjected to a harsh spotlight, with many supporters and detractors offering commentary. We’ll focus on one potential issue arising from the current interpretation of fair-value accounting standards to answer your question.

Let’s start with three currently undisputed interpretations. First, “fire-sale” prices are not determinative of fair value. Second, the fair value of a given asset should theoretically be the same even when held by multiple investors, allowing for reasonable differences in estimation by different holders. Third, the intent and the financial ability of an investor to hold an investment to maturity is currently taken into consideration when testing for asset impairment, but not in the measurement of fair value under the current accounting standards.

On the surface, these three general observations seem to be reasonable. However, when they are applied to the hedge fund and private equity world, they may result in non-compliance with fair-value accounting or inequitable wealth transfers among fund investors.

Consider an example. Two funds hold in common a particular illiquid fixed-income security. One fund is subject to significant impending redemption requests (call it the Needy Fund), while the other has enough liquidity to demonstrate the financial ability to hold the investment to maturity (the Richie Fund). Current accounting standards would suggest that both funds value the security at the same level, allowing for small differences in the measurement approach taken by both funds.

Assume this particular asset has just traded hands in the secondary market, and both funds have knowledge of this transaction. Further, assume that the whole market knows that this transaction was initiated by a desperate market participant who needed immediate cash.

Under fair-value accounting rules, neither fund should necessarily mark its holding to that distressed transaction price in calculating its Net Asset Value. But since Needy Fund must raise cash immediately to meet its redemption requests, it may be forced to sell the asset at or below that distressed price level. If Needy Fund follows the fair-value accounting standards and ignores the distressed or fire-sale prices, its calculated NAV may be overstated, and investors who redeem their interests would receive more cash than appropriate given the liquidation price of the portfolio. That puts non-redeeming fund investors at a disadvantage.

In a contrary example, assume Needy Fund sells the asset at that fire-sale price, but the market is not aware of the distressed nature of the transaction. Now there are two transactions in the marketplace. Richie Fund’s auditors require the cash-rich fund to mark its asset at those distressed prices, resulting in an understated NAV. Then new investors in Richie Fund (if any!) would be able to pay a lower price to invest in the fund. That also puts existing investors at a disadvantage.

Fair-value accounting standards are guided by the principle that a fair value should not take into consideration the specific facts and circumstances surrounding the holder of that asset. Because of this, high-redemption situations that many hedge funds now face may cause a conceptual mismatch between the fair-value standards and what is “fair” to fund investors.

In short: sometimes a fair value just isn’t fair.

Topics