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Consolidated Reporting Amendments May Drag Down Valuations of Investment Partnerships

A standard approved by the FASB may impose requirements on private-equity firms and other investment managers to carefully analyze the business relationships with the funds they manage. The analysis may leave them with heftier balance sheets and extra leverage.

Private-equity firms and other investment companies might have to report significantly more leverage under an accounting standard approved by the FASB on July 16, 2014. The rule could also greatly reduce their returns on assets and equity, and with it their stock market valuations.

The FASB agreed to issue a final amendment to its standard for consolidating the class of off-balance-sheet vehicles called variable interest entities (VIEs), but publication of the changes will be delayed for several weeks while accounting board members and staffers review them with investors, companies, and auditors.

With the most recent changes to the November 2011 Proposed Accounting Standards Update (ASU) No. 2011-220, Consolidation (Topic 810): Principal versus Agent Analysis, private-equity firms and other investment partnerships can expect to face a requirement to analyze their interests in each of their investment funds. If the analysis determines that the firm is a principal in the fund, the fund’s assets and liabilities would have to be consolidated on the firm’s balance sheet. As the general partner, the firm could be considered the key decision maker in the arrangement and thus the primary beneficiary of the VIE.

FASB ASC 810, Consolidation, requires the primary beneficiary of a VIE to consolidate its assets and liabilities on the beneficiary’s balance sheet. The consolidation makes the primary beneficiary look much more leveraged than it would with the VIE. The bulkier balance sheets also decrease such profitability measures as returns on assets and equity.

Much depends on whether the firms earn most of their compensation from management fees or from performance fees, said a source close to the FASB who asked not to be identified. The so-called “2 and 20” arrangements that are typical for private-equity firms and hedge funds refer to the management fees that typically amount to 2 percent of assets and performance fees that are 20 percent of profits. The source noted that if a firm makes most of its profits from performance fees, its funds are more likely to be considered VIEs. If more VIEs are consolidated on the balance sheets of publicly traded private equity firms, it could affect their valuations.

In a comment letter responding to Proposed ASU No. 2011-220, the Securities Industry and Financial Markets Association, a trade group, complained that requiring the consolidation of investment companies would represent a “distortion” of economic reality that “will not yield meaningful financial statement reporting.”

FASB member Thomas Linsmeier said he was concerned that the final version of the amendment provided too much leeway for general partners to structure their fee arrangements. The flexibility will let the general partners avoid consolidating the reporting of their funds’ assets and liabilities even though the economics of the arrangements would suggest they should do so.

For that and other reasons, the seven-member board decided to provide for an “extended” review of its unanimous decision to approve the updated guidance. As board member Lawrence Smith remarked during the meeting, “The FASB doesn’t have a great track record” in its years of deliberations about consolidated reporting, citing numerous revisions the board has made to FASB Interpretation (FIN) No. 46(R), Consolidation of Variable Interest Entities (revised December 2003) — an interpretation of ARB No. 51, (FASB ASC 810-10), which was issued in the wake of the Enron scandal in 2003. As a result, Smith said, the board needed to take more time before giving its final approval to the updated guidance.

A spokesman for the FASB said in an email that the update is designed “to reduce the complexity of the guidance as it applies to limited partnerships and similar legal organizations, simplify the consolidation guidance to focus more on principal risk, and remove the indefinite deferral available to certain investment funds.” The amendment contains an explicit exemption for money-market funds.

The FASB’s review is expected to last a few weeks at most, and the final amendment may be published within the next few months. If approved as currently formulated, public companies will begin applying the revised standard for fiscal years beginning on or after December 15, 2015. Private companies and other non-public business entities would have an extra year.

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