Langham Hall Summer 2011: Should PE Investment Funds fair value or consolidate controlled portfolio investments?

Welcome to our end of Summer 2011 newsletter

The end of the third quarter seems to have brought with it an encouraging uptick in activity in the private funds market in Asia. In our own business we have noted the acceleration of a number of new fund launch initiatives, and whilst fund raising is still difficult it is encouraging to see many US and European investors making the trip to Asia for conferences and due diligence meetings. Best of all, the trend in Beijing and other PRC based fund managers coming to Hong Kong to build asset management platforms continues to grow.

With the financial reporting season now approaching, Paul Walters and Jonathan Chang from PwC explain in this newsletter the implications of a significant new development in IFRS for private funds.

Should PE Investment Funds fair value or consolidate controlled portfolio investments? What will the new IFRS proposal on investment entities mean to the industry

After a number of delays, an exposure draft for “Investment Entities” was published on 25 August 2011, introducing the concept of an investment entity into IFRS. This proposal would require investment entities to account for its portfolio investments at fair value. In contrast to current IFRS guidance, it is likely to change the reporting landscape of the many investment funds currently reporting under the IFRS as an investment entity would not consolidate any portfolio investment in which it has a controlling financial interest nor would it account for investments under the equity method where it has significant influence. When there is such a fundamental change to financial reporting, the implications of implementing such a change can be considerable to an organisation.

Based on the current IFRS frame work, many fund managers, most typically Buy-Out Funds, prefer the accounting available under US GAAP, as it recognises “investment companies” and allows funds to report all investments at fair value. When deciding on accounting standards to use, IFRS has sometimes been avoided due to the requirement to consolidate any “controlled” investments, which makes the financial reporting process very cumbersome. It also can make it difficult for investors to judge fund performance in cases where a fund’s net asset value under consolidation does not reflect the actual value of investors interests in the fund, such as where non-recourse arrangements within a legal structure are not reflected do to the group concept. In short, reporting under consolidation often does not reflect the commercial fair value of investments. In regions such as Asia, some practical and logistical considerations hamper the consolidation process – these include different local financial reporting standards, currencies, language, and timeliness and reliability of local reporting. For Real Estate and Infrastructure Funds, there is significant uncertainly whether they will be included within the exemption, which would depend on facts and circumstances, and indeed different preferences over the pros and cons of transparency to useful information from consolidation against simplicity and commercial net asset value under fair valuation on a project basis.

What would qualify as an investment entity?

The IASB’s proposal requires an entity to meet all of the following criteria to qualify as an investment entity:

• Nature of the investment activities is to invest in multiple investments for purposes of generating investment income, capital appreciation or both.
• Business purpose: The express “business purpose” of an investment entity is to invest for investment income, capital appreciation or both. A clear exit strategy pre-investment maybe a useful indication here.
• Unit ownership: “Ownership” in the entity is represented by units of investments, such as shares of stock or partnership interests.
• Pooling of funds: The funds of the entity’s owners are “pooled” so that the owners can collectively access professional investment management. There must be multiple investors who hold significant ownership interests that are unrelated to the entity’s parent (if any).
• Fair value measurement: All of the investment company’s investments should be managed, and their performance evaluated, on a “fair value basis”.
• Reporting entity: The “reporting entity” must provide financial information to its owners about its investment activities. The entity itself does not have to be a legal entity.

As part of the project to synchronise IFRS and US GAAP, the US standard setters (“FASB”) is expected to issue a similar proposal later this year. Whilst the criteria to qualify as an investment entity are expected to be substantially converged, there could be several significant financial reporting differences. In particular, IFRS requires the parent company of an investment entity to also meet the definition of an “investment entity” to allow the exemption at the parent level. For example if the parent itself is a bank or asset manager, if it does not meet the “investment entity” definition, it will need to consolidate its subsidiaries, including the Fund and its controlled portfolio investments.

The funds industry is likely to welcome the broad proposals increasing the scope of fair value reporting within IFRS , as it should allow qualified investment entities to report to their investors at a net asset value which reflects the true commercial value of their holding as well as making fund reporting across much of the globe more comparable. However, it may be that some investors prefer to see full line-by-line consolidated information for a fund’s investees for full transparency.

With such a fundamental change to financial reporting, one would need to consider the potential practical and commercial differences between fair value and consolidation reporting by investment entities, and the implications to its operations, IT systems, reporting process, and manage investor expectation of the audited financial information. Investor relation teams, as well as CFOs and COOs will need to be proactive and work collaboratively with their internal functions and service providers to deal with changes in reporting and communication with stakeholders.

For relevant IFRS updates connected to this subject, please see link below:http://www.ifrs.org/NR/rdonlyres/5F356A76-7981-4A9A-982B-DCE8B6771391/0/SNAPSHOTInvestmentEntitiesFINAL.pdf