Implementing fair value accounting in private equity: An analysis of the challenges, scale of impact and institutional consequences

Abstract

The fair value accounting framework ("FVAF") emerged as a solution to improve performance reporting for private equity because the industry's legacy accounting practice of holding investments at cost or last equity raise was concealing incidents of deterioration of value. Post-implementation of the FVAF, however, private equity investors face the conundrum whereby reported fair values for private equity investments prepared by fund managers (or "GPs") tend to be stale, smoothed (possibly manipulated) and in need of contextual analysis. This has led investors to either build up in-house competency or engage third-party agents to support with administration issues such as inspecting fair values, producing "roll forward" values and ensuring that identical investments made via more than one GP are valued the same. Reliability concerns over the veracity of fair values has also (i) invited regulators to examine and take enforcement action against GPs who are discovered to be misrepresenting performance, (ii) intensified year-end audits, and (iii) encouraged third-party valuer engagements. These discoveries point to a phenomenon whereby the FVAF is more than just an accounting tool -- it is an 'institutional' product that relies on the actions of various actors to make it 'fit for use'. The research also finds that much like any other product, the cost of 'manufacturing' better quality fair values takes the form of monitoring costs as well as fees charged by auditors and third-party valuers, all of which are borne by the investor and/or the GP. Interestingly, there is no common justification for the high institutional costs of producing fair values across various investor archetypes because of variation in uses: certain investors avoid using fair values to pay fees and price secondary transactions whilst others use these numbers to rebalance their exposures to certain asset classes in multi-asset portfolios. Investors also face the issue where an over-emphasis of using fair values to benchmark GP performance leads to counter-productivity because such encourages GPs to game their fundraising activities to coincide with demonstrable true and high fair values. Furthermore, the effectiveness of using fair values for grandstanding activities can have the unintended consequence of altering investment behaviour and encouraging short-termism because GPs may be inclined to make investments that deliver strong fair value gains in the short-term.

Date of Award	1 Aug 2023
Original language	English
Awarding Institution	The University of Manchester
Supervisor	Andrew Stark (Supervisor) & Christopher Humphrey (Supervisor)