Limited partners (LPs) in private equity, real estate or infrastructure may struggle incorporating the value of illiquid investments into their financial reporting. Fortunately, there are many fair value reporting best practices LPs—and their service providers—may implement now.

The Evolution of Fair Value Reporting
Since the passing of FASB Statement No. 157, Fair Value Measurements (FAS 157), auditors have continually expanded their requests for information about the private investments held by LPs. Historically, most LPs met their reporting requirements by accepting a private equity, real estate or infrastructure fund’s reported net asset value (NAV) on a one-quarter lag and rolling it forward (rollforward value) for any capital calls and distributions between the fund’s reporting date and their reporting date, thus not reflecting changes in fair value due to market changes for the interim period.

Prior to FAS 157, auditors generally accepted rollforward values as good practice, but increasingly requested more information about the underlying assets—information LPs did not have.

In response, LPs began to request fair value reporting (versus, for example, tax-basis reporting) from all their private investment funds. It is noteworthy that prior to 2008, it is estimated that as many as 25% of private investment funds were still reporting non-GAAP financials. LPs also began to question external fund managers’ valuation policies and practices and requested written copies of funds’ valuation procedures. For LPs outsourcing their administration to J.P. Morgan, we began to gather and store the valuation policies for all fund managers in an LP client’s portfolio.

Even with this additional information, LPs and many auditors were still unsure if rollforward values were sufficient. As LPs continued to analyze what was possible given the data they had, they started deviating from the reported NAV for some of their funds, which led to more new best practices.

LPs began identifying assets that they held both in a fund and through direct investment. By identifying the cross-holdings and reviewing the direct investment valuation, LPs had better data to perform their own objective and independent valuation.

A follow-up question emerged: “What if I looked at underlying assets across my whole portfolio?”

No two valuations will be the same, but outliers should be followed up on. If one fund holds an asset at cost in a tax-basis report, and the same asset was held at three times cost in an audited GAAP report, there would be cause for follow-up. This best practice suggested LPs replace the fair value for an asset with the tax-basis value in their reporting. Upon request, J.P. Morgan can identify the cross-holdings in underlying assets or underlying funds across our LP client’s entire portfolio, facilitating the necessary drill-down.

Another best practice emerged for LPs invested in both a private investment fund and a fund of funds with the same fund holding. The fund is on a one-quarter lag in its reporting, but the fund of funds is on a two-quarter lag. LPs began to use the most recent fund reporting as a proxy for the fund of funds position.

In response to LPs’ need for timely market data, J.P. Morgan began to source updated publicly available prices for any public securities held in a private investment fund.
Well into 2008, most LPs and auditors would have agreed that if you had the analytics, procedures and policies listed above, you were among the best and would have no problem with your audit.

And then came an unprecedented financial crisis.

New Challenges in Fair Value Reporting
The most challenging realization for many LPs was that a one-quarter lag was too long. Too much had happened in the last 90 days of 2008 to simply accept rollforward value as a best practice. Some LPs started to panic.
• Do they take a reserve?
• Do they engage their own valuators?
• Do they hold off on their financial reporting until they get 100% of their fund’s reports?

Most LPs eventually realized the answer to these questions was a practical “no”. But they did have to do something. Most started a dialogue with each of their fund managers throughout the fourth quarter of 2008 and into the first quarter of 2009.

They looked at each fund on a case-by-case basis, assessing what each fund manager was doing to retain value and measuring their portfolio value in the interim period. Many LPs moved away from rollforward values. After clients provided their adjusted values to J.P. Morgan, we facilitated tracking their updated accounting and performance reporting.

A new debate emerged during this crisis. Traditionally, LPs have valued their assets at their intrinsic value. Any artificial price created by a distressed seller or a strategic buyer on the secondary market was considered a temporary price, and the asset would revert to its intrinsic value following the transaction. This practice seemed acceptable, as secondary transactions represented a small fraction of the total.

These past few months have seen record-breaking numbers of secondary transactions, leading to a debate over the fair value of the assets. Some believe intrinsic value still prevails, while others claim the flood of secondary transactions has permanently impaired value. This debate may continue well into 2009, but the general consensus is to consider all known data points in determining the value at which you choose to carry your assets, and the true fair value likely lies somewhere in between.

Some of the obvious benefits of this crisis have been increased dialogue, awareness and transparency. The only certainty is that LPs will have to continually adapt and they will constantly be challenged to rethink fair value reporting.