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If anyone thinks the accounting profession has learned anything following the Enron and Worldcom experiences, they haven’t spent much time thinking about the topic of “Fair Value Accounting.” It would be a trifle more accurate to call it “Fairly Insane Accounting.”

During our most recent audit cycle, I was lucky to be tutored in the new reality. If you are in the fund business, and you want to have GAAP statements, you have to accept the theory of “fair value”. No ifs ands or buts.

Protest all you want, but the auditors will just keep you on endless, circular conference calls until you capitulate. You’ll be paying the senior valuation partner to debate with you, and they won’t sign your audit until to give the “you’re right and I’m wrong” speech.

I will boil the issue down for simplicity, and the example I’m going to use is merely our own experience. But we use a Big 4 accounting firm, and I doubt that anyone in our broadly-based industry has much latitude on the subject. Let’s imagine that you did a transaction and as part of that transaction you received a 1,000 warrants to buy shares in a private company at $5. Imagine that the private company in question subsequently raised a new round of financing at $6.

Under this new approach to GAAP known as “Fair Value” accounting, you are required to record a gain of $1 per warrant on your financial statements. So, if you own 1,000 warrants you take $1,000 into income — even though there is no ready market to sell the warrants into, and as a private company, there is no public market quote to refer to.

And you can’t take a liquidity discount, either, which might come to your mind as you are holding a warrant to acquire a share in a company without a stock listing. Your accounting firm will advise you that the new investor that paid $6/share already took the private nature of the company into account when they invested. So the $6/share figure is the right number, or at least that’s what you’ll be told.

The accounting firm’s valuation partner will quote the Black-Sholes value, for example. And while the math behind it won a Nobel Prize, no one in the capital markets actually buys or sells warrants that way: they tweak here and discount there; drop the volatility by 2/3rds; make the price more bearable, and less theoretical.

Why does this matter?

In this day and age, the notion of “management prepared accounting statements” is ludicrous. Although your Big 4 accounting firm might not want the liability that comes from admitting that they prepared your financial statements, they certainly won’t let you ascribe a value of nil to a warrant of this nature, even though you can’t sell it at any price, in any market, to anyone. It has a theoretical value, they’ll proclaim, and point out that owning a warrant can’t be worth the same as not owning a warrant.

Sounds convincing, but it isn’t.

If I own something that cannot be sold, for which there is no ready market, how can that piece of paper be called a gain, and brought into income on my income statement?

The more relevant reason why this is bad for the limited partnerhsip community, and now public shareholders of buyout funds such as Blackstone (NYSE: BX), is that by bringing into income unrealized gains in illiquid private companies, management teams are generating accounting profits as a result, which leads to the fund manager receiving “promote” on profits that haven’t yet been made.

Following that?

The accounting profession requires fund managers to increase their reported income to account for the receipt of illiquid warrants in a private company, for example. By increasing the fund’s income by that notional $1,000, 20% will be steered to the fund manager for their “promote”. Even though the fund hasn’t earned that gain as of yet. The accounting industry requires us to receive profit sharing (under the 80/20 LP/GP split) on profits that haven’t actually been earned.

Welcome to the impact of fair value.

Same goes for firms such as Blackstone. Which means the IPO was priced, in part, on notional gains that had not yet been realized, and may never be. And they are not alone, of course.

This all came rushing back to me this weekend as I read about the challenges that banks, hedge funds and money managers were having as they tried to price the value of their subprime mortgage holdings. Whether they own a collateralized debt obligation or an actual pool of mortgages, my friends on the trading desks tell me that market has practically gone “no bid”.

A story today in the WSJ brings up an interesting question for the accounting profession. Here’s an excerpt:

A Wall Street executive who markets hedge funds and other alternative investments said the valuation of some collateralized-debt-obligations pools backed by other securities such as mortgages — which sport nominally top-notch credit ratings — has become highly uncertain. “Someone says they’re worth 50, and someone else says 90, and you can’t sell at 30 because there aren’t any bids,” he said.

Such uncertainty creates a challenge for Wall Street firms that have made loans backed by such securities. Should they be marked down? And should investors who hold them with borrowed funds be forced to sell assets to give the lenders an extra cushion of safety?

By the fraught psychology of the bond market, this could trigger more problems than it is supposed to prevent.

“When you have something like this, there’s a debate about where to mark these things,” said Alex Ehrlich, global head of prime brokerage at UBS AG, which has extended credit to some clients that hold such securities. “Nothing’s trading, so you have to exercise great care and caution in where you mark. We’re trying to be pragmatic. When you’re caught up in this situation, you know the market is dysfunctional; you have to come up with reasonableness standards. We try to come up with a theoretically fair value.”

If three different firms provide three different quotes: 30, 50, and 90 cents on the dollar, and the bank in question needs to put a pin in it for the quarter end, where do they land? It is convenient if your prime broker gives you a 90 cent quote, based on a DCF model of what the streams of cash are expected to provide for your tranche of security. But what if you couldn’t even sell that loan package for 30 cents, since it has gone “no bid”.

Do you tell your accountant that the market has gone “nuts”, and you just know that the loans are worth 90? Even if no one would pay that for them?

Bear Stearns (NYSE: BSC) managers were utilizing someone’s version of fair value accounting when they loaned US$1.6 billion to a couple of their sister hedge funds. Within a few days, US$1.3 billion of their loan was wiped out. So much for accurately accounting for the fair value there.

According to the global head of prime broking at UBS, no slouches when it comes to finance, the best one can do is come up with a “theoretical fair value”.

Now it might be convenient, and even necessary, but I’m not sure how accurate it is.

This situation is playing out right now at NYSE-listed ACA Capital Holdings (NYSE: ACA). The firm insures owners of CDOs against loss (probably seemed like a good business idea at the time), and has seen its portfolio grow from US$14.6 billion in 2005 to US$61 billion in 2007. Gives you a sense of just how fast this industry grew over a very short timeframe.

Like the rest, ACA needs to follow GAAP accounting. This can’t be a fun time to be bringing “fair value accounting” to bear on a CDO portfolio, as the indexes that try to reflect the credit quality of certain CDO vintages have traded down drastically in recent months. This from an article in Barron’s:

Equally unsettling has been the price action in the TABX-40-100 index, which reflects current expectations of the value of the kind of senior tranches of 2006 vintage CDOs that ACA has insured in abundance. The TABX is currently trading at around 43 cents on the dollar. This means that if ACA were to mark its $4.4 billion in 2006 CDO guarantees to this index, its GAAP net worth would fall from a positive $326 million to a negative $2 billion or so.

ACA officials insist that the TABX reflects current subprime-market fear and hysteria rather than any sober appraisal of true market fundamentals. Moreover, the company claims that the mortgage pools that the TABX references are far less diversified than those pools standing behind ACA’s guarantees. Finally, the TABX reflects the frenzied hedging of subprime-market participants who are subject to the liquidity risk of having their credit lines pulled. ACA, as long as it maintains its A-rating, has no such risk.

There’s some truth to these claims, but only some. GAAP accounting, but not insurance accounting, required ACA to make some mark-to-the-market adjustment to its CDO exposures, although the company has wide discretion on the measures it uses. Thus in the second quarter, ACA took a minimal after-tax charge of just $43.9 million, which is a far cry from the $2.4 billion adjustment that the TABX is indicating just on the firm’s subprime CDO book of 2006 paper.

So, even though there exists an index and a quote for the vintage of CDOs being valued by ACA and their accounting firm — a quote which is anything but theoretical — it seems as though ACA is able to largely ignore what they outside world is saying about the value of their portfolios. Just fill the file with a memo as to how they approached the valuation exercise, have the auditors review it for “reasonableness”, and save yourself from a US$2.4B writedown.

Kind of like owning a stock that’s down 57% and telling your spouse that the market just doesn’t understand the true value of your investment; over time, it’ll crawl its way back up again. “We’re just as rich as we were, honey. No need to change our retirement plans.”

These three stories are all about fair value accounting, and yet none of them seem to point in the same direction.

- Funds are required to bring into income profits they haven’t yet earned. Overstating profits and the near term value of their firms.

- Institutional investors are allowed to use their own modelling skills to determine what a CDO is really worth, even if the market has gone “no bid”.

- Companies are permitted to ignore third party pricing and to adjudicate the value of their own assets, even if “the market” is telling them it is worth exactly 43% of what they think it is.

Life isn’t black and white. I’ve long since figured that out.

But the accounting industry has done investors no favours with fair value accounting. Depending on who you are and what the topic is, there doesn’t appear to be any consistency in the theories being applied, nor to the fundamental principles of valuation and transparency.

Key lessons of the last 10 years are being ignored.

Arthur Anderson was sacrificed for naught.

Source: Accountants Failing Investors With 'Fair Value' Accounting