Fair Value Measurements and Disclosures:
Best Practices for Implementation and Compliance
for the Alternative Investment Industry -
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Dear Clients and Friends:
Rothstein Kass is pleased to present this updated implementation and compliance guide relating to Financial Accounting
Standards Board (FASB) Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures (“ASC 820”).
As a leading international professional services firm providing audit, tax and consulting services to an array of sophisticated
and discerning clients, Rothstein Kass is proud of our association with the alternative investment community. Our collaborative
culture has enabled our firm to grow alongside the industry through extensive and frequent interactions with our clients, their
administrators and service providers. We believe that this guide represents a practical approach to implementing and complying
with the requirements of ASC 820, including sample financial statement footnotes and a Frequently Asked Questions section.
Well before the onset of the global credit crisis, the FASB had taken steps to reconcile disparate conceptions of “fair value”
as it appears in many different authoritative references through the GAAP hierarchy. A good portion of these efforts centered
on the development of consistent valuation standards for illiquid or “level three” holdings. In the months immediately following
the market meltdown, these issues were briefly pushed to the forefront as some hedge funds were forced to unwind profitable
positions to meet a raft of redemption requests from investors facing their own liquidity concerns. For many funds, the sudden
need for increased liquidity served as a harsh reminder of the importance of aligning fund objectives and strategies with those
of its investors to promote stability.
At the same time, misconceptions regarding the nature and practices of the alternative investment community made the industry
a likely target of ambitious regulatory reform intended to prevent future market upheaval. Thorough analysis has since shown
that hedge funds did not pose systemic risk, while effective advocacy has helped to promote understanding among legislators
and regulators. As a result, the final financial reform bill reflects an informed and reasoned approach to industry regulation.
Implemented in concert with enhanced fair value guidelines, these efforts should help to provide the greater level of transparency
that the market demands.
Transparency will be even more critical as asset flows from institutional investors allow a greater portion of Americans to gain
access to the alternative investment industry through retirement accounts. Amid intense competition, the percentage of illiquid
assets and the methodology for valuing these holdings will be important considerations for investors. Needless to say, the FASB
has tremendous relevance to the financial services industry. ASC 820, for example, offers a framework for comparability and
consistency that will help to establish institutional-quality best practices across our industry.
While our intention is to clarify the fundamental aspects of ASC 820, it is still clear that fair value remains an art, not a science.
We are confident that you will find this paper informative and helpful. Please reach out to me, Christopher Mears or any of the
Principals in our Financial Services Group if we can be of assistance.
Co-CEO and Co-Managing Principal
ASC 820 - Fair Value
Measurements and Disclosures:
Best Practices for Implementation
and Compliance for the Alternative
Investment Industry - 2010 Update
Overview Implementation Challenges for the It takes on an “exit price” approach. In
Alternative Investment Industry” dated the past, many measures of fair value
On July 1, 2009, the Financial Accounting September 2008, the FASB has made under U.S. GAAP were based upon the
Standards Board (“FASB”) launched several updates to the fair value guidance entry price or management’s “good faith”
a single source of authoritative contained in U.S. GAAP. The following measurement. Under current U.S. GAAP,
non-governmental guidance called the updated white paper contains the most the entry price cannot be presumed to
FASB Accounting Standards Codification up-to-date information from current be representative of the fair value at initial
(“ASC” or the “Codification”). The guidance contained in the Codification recognition. Transactions between related
Codification does not change United that effects the alternative investment parties or under duress (“forced sales”)
States Generally Accepted Accounting industry (e.g., hedge funds, private are examples that may preclude an entry
Principles (“U.S. GAAP”), but rather it is equity funds and fund of funds), herein price from approximating the fair value.
a new structure which takes accounting referred to as “fund(s).” In addition, there may be instances in
pronouncements and organizes them by which the initial transaction occurs in a
accounting topics. ASC Topic 820, Fair Notwithstanding the updates and market different than the market that a
Value Measurements and Disclosures clarifications made by the FASB to the fund would have access to in exiting the
(“ASC 820”) (formerly FASB Statement guidance for fair value measurements investment. For example, a broker may
No. 157 Fair Value Measurements, “SFAS and disclosures, one thing has not transact in an inter-dealer market where
157”) is now the sole source for guidance changed, the definition of fair value. that market is not available to the fund. In
on how entities should measure and Fair value is defined in ASC 820 as the addition, entry prices include transaction
disclose fair value in their financial “price that would be received to sell costs that may not be recoverable in an
statements. Since the issuance of an asset or paid to transfer a liability in exit price. These principles open the door
our previous white paper entitled an orderly transaction between market to potentially recognizing “day one” gains
“SFAS 157 Fair Value Measurements: participants at the measurement date.” and losses on transactions.
Rothstein Kass 1
Fair value continues to be measured observable inputs other than quoted to use its judgment to evaluate whether
using all assumptions utilized by prices used to value Level 1 securities, market inputs are “observable.”
marketplace participants, including while Level 3 consists of the most Transaction-based market inputs tend
risk assumptions considered by those “unobservable” inputs (e.g., highly to be more reliable. The range between
participants. The measurement of fair illiquid securities). ASC 820 emphasizes bid-and-ask prices can indicate as to
value assumes an orderly, hypothetical that valuation techniques used to whether the market is active or inactive.
transaction in the principal market for measure fair value shall maximize the A more active market will generally
the asset or liability. However, if the use of observable inputs and minimize dictate narrow ranges between the
volume and level of market activity for the use of unobservable inputs. bid-and-ask quotes with more illiquid
an asset or liability has significantly markets having larger spreads.
decreased, and transactions in a For example, if a fund utilizes observable
particular market are not orderly, ASC inputs in an orderly market to determine Determining Fair Value when
820 provides additional guidance on fair value, such as market prices from a Market is “Inactive” and
factors to consider in estimating fair an exchange or dealer market, the fund Transactions are “Not Orderly”
value. Moreover, if no principal market is precluded from using an internal
exists, and there are multiple markets, valuation model (e.g., discounted cash As a result of the recent financial crisis,
then the most advantageous market flow model) and cannot ignore readily the FASB issued additional fair value
is used. available market prices. However, the measurement guidance in April of
more illiquid the investment, the greater 2009 for estimating fair value when the
(Editor’s note: The use of the most the need exists to use multiple valuation volume and level of activity for an asset
advantageous market when multiple techniques to arrive at fair value. or liability has significantly decreased
markets exist goes against the grain of and when a transaction is deemed
“conservatism” but this is clearly what What Are Observable Inputs? “not orderly.” This guidance reinforces
the FASB intended.) the notion that fair value is based on
Observable inputs are inputs based orderly transactions under current
For illiquid securities where a market may on market data obtained from sources marketplace assumptions. Funds are
not exist, a fund must develop a fair value independent of the entity and should not compelled to rely on quotations
approach based upon a hypothetical not be limited to information that is only which reflect distressed transactions.
market which incorporates assumptions available to the entity making the fair However, it is also inappropriate to
potential market participants would use value determination or to a small group apply a “hold-to-maturity” approach to
in purchasing the security. of users. Observable market inputs should fair value or to use assumptions based
be readily available to participants in on “normalized” market conditions.
One of the most significant elements that market. In addition, observable When current prices are not indicative of
of ASC 820 is the use of a three-level market inputs should include a level orderly market transactions, funds should
fair value hierarchy. Level 1 consists of of transparency that is reliable and utilize alternate valuation techniques
the most “observable” market inputs verifiable. Observable market inputs are to estimate fair value under current
to arrive at fair value (e.g., liquid typically a by-product of having sources market conditions.
investments). Level 2 would broadly that are knowledgeable and active in the
include assets and liabilities valued using particular market. Management will have
2 Rothstein Kass
When determining fair value, funds should Significant judgment may be required customary for transactions involving
consider whether factors exist that indicate to determine whether there has been a such assets or liabilities under current
a significant decrease in the volume and significant decrease in the volume and market conditions.
level of activity for an asset or liability by level of activity for the asset or liability • There was a usual and customary
comparing those levels to normal levels of based on the weight of the evidence. marketing period, but the seller
market activity. Those factors include, but When the market has become less marketed the asset or liability to a
are not limited to whether: active or is no longer active, there is an single market participant.
increased likelihood of distressed or • The seller is in or near bankruptcy
• There are few recent transactions. forced transactions underlying market or receivership (that is, distressed) or
• Price quotations are not based on transactions. Therefore, quoted prices the seller was required to sell to meet
current information. become less reliable indicators of fair regulatory or legal requirements (that
• Price quotations vary substantially either value. In circumstances where there is, forced).
over time or among market makers (for has been a significant decrease in • The transaction price is an outlier
example, some brokered markets). the volume and level of activity for an when compared with other recent
• Indexes that previously were highly asset or a liability in relation to normal transactions for the same or similar
correlated with the fair values of the market activity, additional steps should asset or liability.
asset or liability are demonstrably be taken to determine whether other
uncorrelated with recent indications valuation techniques and inputs are The challenge for most funds is having
of fair value for that asset or liability. needed to meet the objective of a fair sufficient market intelligence available
• There is a significant increase in value measurement. to evaluate whether a transaction is
implied liquidity risk premiums, orderly or if it is a distressed or forced
yields, or performance indicators It is not appropriate to presume that all sale. In situations where funds do not
(such as delinquency rates or loss transactions in an inactive market are have enough information to conclude
severities) for observed transactions not orderly (that is, distressed or forced). one way or the other on whether it is
or quoted prices when compared If the reporting fund concludes that an orderly transaction, the fund should
with the reporting fund’s estimate of there has been a significant decrease consider the transaction price as an
expected cash flows, considering all in the volume and level of activity for input in estimating fair value. However,
available market data about credit the asset or liability in relation to normal it should not be the sole basis to arrive
and other nonperformance risk for market activity, the fund should then at fair value. All information that is
the asset or liability. consider whether circumstances exist available without undue cost and effort
• There is a wide bid-ask spread or that indicate that transactions associated should be considered.
significant increase in the bid-ask spread. with the quoted prices are not orderly.
• There is a significant decline or absence Such circumstances include, but are The best practice is to employ multiple
of a market for new issuances (that is, a not limited to whether: valuation techniques. A fund should place
primary market) for the asset or liability less weight on transactions which the
or similar assets or liabilities. • There was not adequate exposure fund does not have sufficient information
• Little information is released to the market for a period before to conclude whether transactions are
publicly (for example, a principal- the measurement date to allow for orderly when compared with other
to-principal market). marketing activities that are usual and transactions that are known to be
Rothstein Kass 3
orderly. The use of broker quotes and inputs other than the directly observable For exchange-traded instruments such
pricing services are common valuation quoted price. These “other market as securities sold short and exchange-
techniques employed by funds. The fund inputs” are often used in conjunction traded derivatives, common practice
must attempt to obtain transparency from with valuation models and include has been to use market quotations to
the sources of these fair value estimates interest rates, yield curves, prepayment determine the fair value of an identical
and make a determination of whether speeds, default rates and other market- liability when the instrument is traded as
the broker quotes are based upon corroborated inputs. an asset. However, in many cases, the
current information that reflects orderly availability of relevant observable inputs
transactions or a valuation technique that Level 3 Inputs - include those inputs to determine the fair value of a liability can
reflects market participant assumptions. that are not currently observable be limited or unavailable. Certain liabilities
(e.g., an option-pricing model using are unable to be traded in the open
(Editor’s note: The larger the variance historical volatility, a fund’s own data marketplace due to contractual or other
between the fair value estimate determined or assumptions such as a multiple legal restrictions which prevents their
by management and the broker quote that of earnings or discounted cash flow transfer. Furthermore, the unit of account
is considered not to be orderly, the higher projections, etc.). for an instrument traded as an asset can
the expectation to have additional support result in a difference in value from the unit
from multiple valuation methods.) Refer to Exhibit 1 for a matrix of the of account when traded as a liability. As
levels and examples of securities that a result, questions have arisen on how to
Fair Value Hierarchy typically fall within each level. determine the fair value of a liability in a
hypothetical transaction when the liability
The three levels of the fair value Application of Fair Value is restricted from being transferred, or
hierarchy and the material valuation Measurements to Liabilities when sufficient observable market data
inputs are as follows: is not available.
The fair value measurement premise for
Level 1 Inputs - include unadjusted liabilities assumes both of the following: In August of 2009, the FASB issued
quoted prices for identical assets or additional guidance to address the
liabilities in active markets (e.g., exchange- a. The liability is transferred to a market uncertainties and to enhance the
traded securities). An active market is participant at the measurement consistency in applying the fair value
defined as a market in which transactions date (the liability to the counterparty measurement principles to liabilities.
for the asset or liability occur with sufficient continues; it is not settled).
frequency and volume to provide pricing If a quoted price in an active market
information on an ongoing basis. b. The nonperformance risk relating for the identical liability is available, the
to that liability is the same before quoted price should be used and would
Level 2 Inputs - include quoted prices and after its transfer. represent a Level 1 measurement. In
for identical assets in markets that are circumstances in which a quoted price
not active (e.g., thinly traded securities), The notion of determining the exit price in an active market for the identical
quoted prices for similar assets (e.g., of a liability based on the price that would liability is not available, a reporting fund
restricted securities, private investments be received to transfer the liability has shall measure fair value using one or
in public companies, etc.), or market raised many implementation questions. more of the following techniques:
4 Rothstein Kass
a. A valuation technique that uses: should consider whether the quoted price existence of master netting arrangements,
1. The quoted price of the identical of the asset should be adjusted include when determining the fair value of financial
liability when traded as an asset. the following: liabilities transacted with counterparties.
2. Quoted prices for similar liabilities a. The quoted price for the asset relates (Editor’s note: Liabilities such as
or similar liabilities when traded as to a similar (but not identical) liability reverse repurchase agreements
assets. traded as an asset. and debt facilities are fixed and
determinable obligations of a fund
b. Another valuation technique that is b. The unit of account for the traded and should be presented at face value
consistent with the principles of asset is different from that of the unless the fair value option is elected
ASC 820. liability (e.g., the quoted price for the under ASC 825, Financial Instruments.)
asset includes the effect of a third-
Examples of valuation techniques party credit enhancement). Significance of an
consistent with the principles of ASC Unobservable Input
820 include an income approach, such When measuring the fair value of a liability
as a present value technique, or a using a valuation technique consistent The level designation in the fair value
market approach, such as a technique with the principles of ASC 820, funds hierarchy is based on the lowest level
that is based on the amount at the should consider whether market inputs input that is significant to the fair value
measurement date that a fund would pay are derived from orderly transactions, as measurement. However, the term
to transfer the identical liability or would well as whether internal valuations may “significant” is not defined by ASC
receive to enter into the identical liability. be more representative of fair value. 820. In assessing the significance of a
market input, a fund should consider the
When measuring the fair value of a liability Funds should consider the effect of sensitivity of the financial instrument’s
using the quoted price of the instrument their own nonperformance risk when fair value to changes in the input used.
when traded as an asset, a fund shall not determining the fair value of liabilities. This Assessing the significance of an input
adjust the quoted price of the asset for can result in a seemingly counterintuitive will require judgment considering
the effect of any restrictions preventing valuation result, as a decline in a fund’s factors specific to the financial
the transfer of the liability. It is assumed creditworthiness would result in a lower instrument being valued. The tone from
that the impact of any restrictions relating fair value measurement for a liability the top should be one of conservatism
to the transfer of a liability is built into the (e.g., a higher discount rate applied to in assigning level designations to
value of the liability at inception. However, expected cash flows), therefore resulting securities with unobservable inputs.
the quoted price of the liability when in the recognition of an unrealized gain. By the design of the principles-based
traded as an asset shall be adjusted for However, the fair value of the instrument standard, determining the significance of
factors specific to the asset that are not should be considered from the perspective a market input is a matter of judgment.
applicable to the fair value measurement of a market participant creditor; that is, Consequently, two unrelated funds
of the liability. Any adjustment to the the credit impairment of the debtor would assigning level designations to the same
quoted price when traded as an asset result in a reduction in value to the creditor. investment using similar unobservable
would preclude Level 1 classification. Funds should consider the impact of inputs may reach different conclusions.
Some circumstances in which a fund their nonperformance risk, including the
Rothstein Kass 5
Best Practices for Fair Value year-end financial reporting process. Compliance with the fair value
Measurements and Disclosures As a best practice, a fund should measurement and disclosure guidance
perform a soft close as of an interim should include:
Many have underestimated the scope, date (e.g., September 30), which would
complexity and time required to include the preparation of all footnote • Documenting policies and procedures
implement and remain current with the disclosures required by ASC 820. It is to comply with ASC 820, including
fair value measurement and disclosure important to note that if a fund engages monitoring active vs. inactive markets,
requirements contained in U.S. GAAP. an administrator for the preparation of aftermarket events and reliability of
Whether there is a need to implement its financial statements, management market data.
the fair value guidance in ASC 820 for should understand the processes and • Addressing system requirements for
the first time (a new fund), or comply data used by the administrator to prepare data aggregation.
with updates to existing fair value the required fair value disclosures. • Evaluating the level designations
measurement and disclosure guidance, The “Champion” of the implementation within the fair value hierarchy on a
management needs to establish an process should manage the coordination monthly basis.
effective protocol in determining fair with the administrator well before the • Performing a soft close as of an
value. We recommend management year-end close. interim date including the preparation
create a financial reporting team. When of all of the required financial footnote
implementing the guidance of ASC 820, In addition to providing a framework schedules and disclosures prior to the
the financial reporting team should first in determining how to arrive at fair year-end close.
understand (1) how to measure fair value value, ASC 820 also provides greater • Coordination with third party service
based on a fund’s portfolio, and (2) transparency to investors regarding providers (administrators, CPA firms,
the content and format of the required (a) the types of investments a fund pricing services and prime brokers).
financial statement disclosures. Also, is invested in, (b) the methods used
we recommend management assign to value those investments, (c) the Refer to Exhibit 3 for frequently asked
a “Champion” to the implementation risk exposures underlying those questions in applying ASC 820.
process who will effectively liaise investments, (d) movements between
between the investment management fair value hierarchy levels, and (e) the Valuation Policies
team, valuation committee, and other portion of a fund’s performance derived and Procedures
internal accounting and technology from Level 3 securities. Ultimately,
staff. Furthermore, once the financial the required fair value disclosures will Management will need to have a process in
reporting team is established, we become a tool that fund investors can place to allow it to gather the necessary
recommend that they reach out to their use to evaluate a fund’s portfolio. information to comply with the fair value
auditor and fund administrator to gain measurement and disclosure standards.
an understanding of how those outside Complying with the guidance in ASC To that end, management should
parties could add value to the process. 820 has many challenges. The fair value continually monitor a fund’s front- and
By including certain outside third parties measurement and disclosure guidance back-office accounting systems used
throughout the fair value measurement in ASC 820 has increased the complexity, to track and produce valuation data.
and disclosure process, a fund can internal resources and time required for This will allow a fund to make informed
avoid unwanted surprises during the year-end financial reporting. decisions on valuation techniques and
6 Rothstein Kass
the assignment of level designations for inputs and techniques used, including component of nonperformance risk,
the investments within a fund’s portfolio how the fair value measurement of however, other risks such as regulatory
(“tagging of investments”). assets and liabilities fit into the fair and other operational considerations
value hierarchy. may influence overall nonperformance
In our discussions with fund managers • Evaluating the effect of investment risk as well.
and administrators, the tagging of restrictions.
investments is performed either on a • Identifying risk assumptions reflected As part of the valuation process,
monthly, quarterly, or annual basis. in unobservable inputs. funds should consider the impact
The best practice is to tag securities • Identifying the reports that will provide of any nonperformance risks with
at a minimum on a quarterly basis. the required data to prepare the year- respect to their counterparties to
If resources permit, we recommend end financial statement disclosures, securities and derivative transactions.
tagging securities on a monthly basis. including reconciliations of those reports Generally, additional consideration
Level designations can change as to the books and records of the fund. of nonperformance risk will not be
dictated by continually evolving market • Back testing of realized transactions. necessary for exchange-traded
conditions. A fund’s accounting system securities since quoted prices will
should have the necessary data fields to (Editor’s note: As part of a fund’s review include the effects of market participant
allow it to tag each security and enable of its valuation policies and procedures, a assumptions on credit risks. In addition,
the fund to generate reports showing best practice is to “back test” all material exchange-traded derivatives, such as
the level designations by security. Level 2 and Level 3 investments by futures contracts and certain option
comparing the investment’s transaction contracts, are generally subject to
Management and auditors alike will need price in the subsequent period [realized market protections, such as daily
to review a fund’s valuation policies proceeds from the sale of an asset margin postings and guarantees from
and procedures on a periodic basis. In or disbursements made to settle a the exchange clearinghouse, which
general, these policies should address liability] against the fair values of those mitigates the impact of nonperformance
the following: investments reported in the most recent risk outside of those reflected within
financial reporting period.) the quoted prices. Therefore, the fair
• Methodology on level designation. value processes for exchange-traded
• Definition of an active market. Consideration of derivatives are generally not expected
• The level of average trading volume Counterparty Risks Within to involve significant nonperformance
and frequency that will deem an Fair Value Measurements risk adjustments. We expect that the
investment as thinly traded (i.e., consideration of counterparty risks
inactive), which may require a Level 2 The impact of nonperformance risks will be more significant for valuations
or Level 3 designation. is viewed by market participants as of illiquid securities and derivatives
• Determination of the principal and/or an essential component of a fair value transacted over-the-counter with
most advantageous market. measurement. Nonperformance risk financial institutions.
• Identifying aftermarket events and represents the risks that a party to a
their impact on fair value. transaction will not perform under its When funds rely on valuation inputs
• Quantitative and qualitative obligation. Generally, an entity’s credit other than quoted prices for the
documentation on the valuation risk represents the most significant valuation of illiquid securities, funds
Rothstein Kass 7
should consider the use of observable the valuation of its liability positions. The level of due diligence review of third
credit data that would be relevant from a Funds should monitor the credit risks party pricing services and quotes
market participant standpoint. The effect of the financial institutions they transact received from broker-dealers will depend
of significant nonperformance risks on with at each reporting period. Publicly on facts and circumstances such as:
the valuation of illiquid securities can available information such as published
influence the determination of inputs credit ratings, credit spreads, credit • Type and complexity of the investment.
such as projected cash flows and default swap rates, and SEC filings • Liquidity of the market and access
valuation discounts to reflect market may be utilized. Funds should consider to actual transactions and other
participant assumptions. the responsiveness of available credit observable inputs.
risk information to changes in market • Nature and complexity of pricing
For over-the-counter derivatives, the conditions as part of their monitoring methodologies and assumptions.
evaluation of a fund’s counterparty process, as certain data, such as • Historical accuracy.
credit risk exposures should include default rates, may not provide timely • Background and expertise of service
the consideration of master netting information relating to a counterparty’s providers in valuing the financial product.
arrangements (e.g., standardized current status of nonperformance risk.
International Swaps and Derivatives Best practices should include an
Association agreements), collateral Use of Third Party ongoing monitoring process to verify the
balances, contract settlement provisions, Pricing Services and Broker- reliability of the pricing methodologies,
and the attributes of the different Dealer Quotations assumptions and sources used. Back
derivative contract types. To the testing of pricing service valuations and
extent an enforceable master netting Understanding the nature and content broker-dealer quotations should be part
arrangement exists, a fund may need to of the services provided by the third of the ongoing monitoring procedures.
incorporate valuation adjustments at the party pricing services regarding
portfolio level to consider the effects of valuation information is management’s Accounting for Transaction Costs
nonperformance risks on the valuation responsibility. Management must
of derivatives held with a particular understand the methods used by third U.S. GAAP requires the capitalization
counterparty. However, funds should party service providers and determine of transaction costs in the initial cost of
carefully review any master netting whether the pricing data is transactional the asset or liability (i.e., the entry price).
arrangements to determine whether the or model-based. If pricing data is model- In contrast, the fair value of the asset
arrangements permit the netting to apply based, management must understand or the liability represents the price that
between different product types. For the significant inputs used and how would be received for the asset or paid
derivatives in a net asset position held they are impacted by changing market to transfer the liability (i.e., the exit price).
with a financial institution counterparty, conditions. In addition, management Since the fair value of an investment
the credit risk of the counterparty should must understand how and when does not include costs that are required
be considered as part of the assumptions changes to the methods and models to complete a sale transaction, such as
of what a market participant would pay used by third party pricing services will commissions or closing costs in many
for the asset positions. For derivatives be communicated and how they will instances, there will initially be an
in a net liability position, a fund should impact a fund’s level designations. unrealized loss for a security that has
consider its own credit risk as part of capitalized transaction costs. Therefore,
8 Rothstein Kass
day one recognition of gains and losses bid-ask spread. As a best practice, investments is generally based upon
on purchases of assets or liabilities, a fund’s accounting system should the price of the actively traded public
reflecting the difference between the generate an exception report based on equity price on an “as-if” converted
fair value and the transaction price, this quantitative threshold in order to basis less discounts applied to take
are permissible under U.S. GAAP. determine whether investments should legal restrictions into consideration,
be transferred out of Level 1. To perform liquidity risk, price volatility, and other
Considerations for this exercise, a fund should obtain the risk assumptions. In practice, we have
Level Designations trading history (e.g., last 30 days) of seen discounts typically range from
each investment held at month-end. 5% to 30% (with higher discounts on
a case-by-case basis). In situations
Typically, securities traded on an Aftermarket Events where the discount is significant or
active market, such as the NYSE, when convertible securities are not in
AMEX, or other major exchanges will In addition, ASC 820 requires consideration the money, these positions will typically
be classified as Level 1, provided that of aftermarket events (this would include move into Level 3.
(a) the market is the principal (or most normal trading days and when an
advantageous) market and (b) the fund accounting period ends on a non- In applying liquidity discounts, a fund
has the ability to access the principal business day, such as a weekend or must consider assumptions used to
(or most advantageous) market. holiday). A fund’s valuation policy should arrive at fair value from the perspective
However, when a security is thinly monitor the variances between the last of a market participant.
traded and its reported “fair value” is closing price at the measurement date
not representative of an active market and the aftermarket events. Variances (Editor’s note: Consideration of the
(or if trading is halted), the security over a threshold amount determined by quantity of the investment held by a
may need to be transferred into Level management should be reviewed and fund, or a fund’s intention to hold an
2 or Level 3. As discussed previously the fair value of the investment should investment, is not relevant in estimating
in the section entitled Determining be adjusted when variances are deemed fair value at the measurement date.)
Fair Value when a Market is “Inactive” material. Any adjustment to the price
and Transactions are “Not Orderly”, a provided by an exchange would move Derivatives Valued Using Models
fund should consider certain factors that security into Level 2.
to determine if there has been a In order for derivatives that are valued
significant decrease in the volume or Level 2 using models (e.g., interest rate swaps)
level of activity and if a transaction is Liquidity Discounts to qualify for a Level 2 designation, the
deemed not orderly. model used to measure fair value must:
Level 2 inputs are inputs other than
A fund’s valuation policy should include quoted market prices included within • Be widely accepted.
a quantitative threshold to determine Level 1 that are observable. Level • Be non-proprietary.
what constitutes an active market, 2 securities will include restricted • Use data that is observable.
which typically will be based on average stock, private investments in public
trading volume, frequency of observable equity (PIPEs) and certain convertible Certain inputs derived through
transactions, and evaluation of the bonds. The fair value of these types of extrapolation may be corroborated by
Rothstein Kass 9
observable market data and still maintain When considering a new round of Investments in Private
Level 2 status (e.g., extrapolating a five- financing into the fair value inputs, the Investment Companies
year interest rate yield into a seven-year following factors should be considered:
yield). However, if there are significant Since the issuance of SFAS 157,
judgments or adjustments made to either • Attributes and characteristics of questions regarding the use of Net
the model or data, the derivatives may the transaction. Asset Value (“NAV”) in determining the
be considered Level 3. For example, the • Complexity of the capital structure. fair value of alternative investments have
extrapolation of short-term inputs for • Proximity to reporting date. been raised by auditors, constituents,
longer-term inputs may require additional • Any changes in the portfolio company and financial statement preparers.
assumptions or judgments that are in the intervening period between Diversity in practice existed when fund
not observable, therefore moving the transaction date and reporting date. management and administrators used
investment to Level 3. • Again, cost can be considered (but not various techniques to adjust NAV in
on its own) since it cannot be presumed determining the fair value of its interests
Level 3 to be fair value. in certain alternate investments, such as
Private Operating Companies hedge funds, private equity funds, real
As a best practice, a fund’s financial estate funds, offshore fund vehicles,
Investments in private operating reporting team should document the and funds of funds. The widespread
companies, also known as private fair value measurement of its private diversity in practice resulted in arbitrary
equity investments, will generally be equity investments by performing an adjustments to NAV. In response to
categorized in the fair value hierarchy as ongoing review of the approaches used stakeholders concerns, the FASB issued
a Level 3 investment, given the lack of to determine fair value. A fund should an update to ASC 820 that provides
observable market inputs. Many funds incorporate multiple valuation techniques additional guidance for reporting entities
that invest in private equity companies to determine fair value of its investments that have investments in certain entities
have traditionally recorded the fair value in private operating companies such as a that calculate NAV to determine fair
of those investments at their initial cost, discounted cash flow analysis as well as value. The updated guidance in ASC 820
and subsequently made adjustments a market based approach that includes applies to investments if the investment
when there was a new round of information of comparable public meets both of the following criteria at the
financing. One of the talking points we companies. A market based analysis measurement date:
have used with clients over the years in should also include comparisons of
regard to private equity investments is public company performance multiples • There is no readily determinable fair
that “cost is not fair value, but fair value as part of its supporting documentation value for the investment (i.e., if active
can approximate the cost.” A fund’s of fair value. Furthermore, a fund market quotations are available for the
valuation policy should document the should include the use of multiple investment, then the quoted prices
fair value of private equity investments valuation techniques to supplement should be used).
through its use of internal analysis, and corroborate the fair value of a • The investment has all of the attributes
review of portfolio company financial recent round of private equity financing. of an investment company as specified
statements, and comparison of the fair in the Codification, or if it lacks one or
value of public securities to the fair value more of the specified attributes and it
of its investment in the private equity.
10 Rothstein Kass
is industry practice to issue financial “look through” to the investee fund’s • Qualifications, if any, of the auditor’s
statements using guidance that is investments as long as a reporting fund report or whether there is a history
consistent with measurement principles evaluates the effectiveness of each of its of significant adjustments to the NAV
of investment companies. investee funds’ processes over internal reported by the investee fund manager
controls and valuation practices of the as a result of its annual audit or
ASC 820 provides that a fund may investee and is able to conclude that the otherwise.
now use NAV as a practical expedient reported NAV is calculated in a manner • Evaluate the basis of accounting
when determining the fair value of its consistent with ASC 946. However, of the investee fund (i.e., U.S. GAAP,
interests in alternative investments before concluding that the reported International Financial Reporting
unless it is probable the investments NAV is calculated in accordance with Standards (“IFRS”), income tax
will be sold at a price other than NAV. the measurement principles of ASC 946, basis, cash basis, etc.).
Furthermore, a reporting entity is the reporting fund should consider
permitted to estimate the fair value of the following: Moreover, when determining whether the
certain alternative investments using investment will be categorized as Level 2
NAV without further adjustment if • Evidence gathered during the initial or Level 3 within the fair value hierarchy, a
NAV is calculated consistent with the due diligence and ongoing monitoring reporting fund must consider the length
guidance in ASC Topic 946, Financial procedures of the investee fund. of time remaining until the investment
Services - Investment Companies, • The investee fund’s fair value estimation becomes redeemable. As long as the
(“ASC 946”) (formerly the AICPA Audit processes and control environment, reporting fund has the contractual and
and Accounting Guide, Investment as well as its policies and procedures practical ability to redeem at the NAV in
Companies) as of the reporting entity’s for estimating fair value of underlying the near term at the measurement date,
measurement date. investments, and any changes to those then an investment may be classified
processes, the control environment, or as Level 2, even if a redemption notice
(Editor’s note: While funds will benefit policies or procedures. was not submitted. “Near term” is a
because of the reduced time and effort • The use of independent third party matter of professional judgment, and
required to use the practical expedient, valuation experts. historically has been defined by the
management must still take responsibility • The portion of the underlying securities FASB as a period of time not to exceed
for the fair value measurement of held by the investee fund that are one year from the measurement date.
alternative investments.) actively traded (i.e., Level 1 securities). However, a redemption period of 90
• Comparison of historical realizations days or less would likely be considered
A common question that is often raised to last reported fair value (i.e., back near term since any potential discount
is whether a reporting fund is permitted testing of securities). relative to the time value of money
to “look through” to the underlying • Whether NAV has been appropriately to the next redemption date would
investee funds’ investments to either adjusted for items such as carried not likely be considered a significant
determine fair value or for financial interest and clawbacks. unobservable input. It is important to
statement presentation. In cases where • The professional reputation and note that a redemption period of 90
a fund invests in an investee fund that standing of the investee fund’s days or less should not automatically
invests in other underlying investments, service providers such as its auditor be deemed near term. Other facts and
the reporting fund is not required to and administrator. circumstances, such as the likelihood
Rothstein Kass 11
or actual imposition of gates, and transact at the same reported NAV. U.S. GAAP also requires reporting
the liquidity of the investee fund’s The use of redemption gates and side entities provide additional disclosures for
portfolio, should also be considered by pockets are common techniques used its investments in certain investees that
the reporting fund in determining the to manage the liquidity of a fund in an calculate NAV regardless of whether the
appropriate level within the hierarchy. orderly manner. The mere existence of reporting entitiy uses NAV as a practical
In situations when there are material contractual provisions permitting the expedient. The disclosures are intended
adjustments to NAV to arrive at fair use of gates and side pockets might so users of financial statements can
value the result will typically be a not normally have an effect on fair value understand the nature and risks of the
Level 3 designation. unless those provisions are actually investments. The following disclosures
exercised. These considerations are must be made by each major category
For funds that are either precluded from likely to be evaluated by the reporting of investment for interim and annual
or elect not to use NAV as a practical fund as part of its initial due diligence reporting periods:
expedient to estimate fair value, such as procedures when making an investment
when a sale of an investment is probable in a particular fund. These features are • Fair value and a description of the
at an amount different from NAV, or an generally considered and accepted by significant strategies of investee(s).
adjustment to the reported NAV cannot market participants, and may not result • For investments that cannot be
be estimated, the specific attributes in any adjustment to NAV. However, redeemed, the estimated time that it
of the investment that independent reporting funds should still consider will take the investee(s) to liquidate the
market participants would take into these features in conjunction with other underlying assets.
account in valuing the investment must inputs available to value the investment. • Unfunded commitments to investee(s).
be considered. The features, risks • Redemption or liquidity terms such
and other restrictions related to each In summary, if market participants as notice periods and redemption
investment should be evaluated in the would be expected to place a discount times (e.g., 60-day notice period with
aggregate since those attributes may or premium on the reported NAV monthly liquidity).
be considered by a market participant because of risks, features or other • Temporary restrictions on redemptions
with access to the market for the factors relating to the investment, from otherwise redeemable investee(s),
investment when determining a price then the fair value measurement of the including how long the restriction has
for the investment. investment would need to be adjusted been in effect and an estimate of the
for that risk or opportunity. However, if time the restriction will lapse or the
The ability of a fund to provide liquidity market participants might accept the statement of the fact when the fund is
to its investors through subscriptions same risks, features or other factors unable to make an estimate. Examples
and redemptions are key considerations relating to the investment and might of restrictions would be lockups, gates
in evaluating whether an adjustment to transact at the reported NAV without and suspended redemptions.
NAV would be required. For example, if premium or discount, those facts may • Any other significant restrictions
the fund is an open-ended fund which suggest that no adjustment is needed on the ability to sell or redeem
permits investors to periodically transact to estimate fair value. an investment.
in and out of the investment, market • The fair value of any portion of an
participants may accept NAV as fair investment that it is probable that it
value since it is likely they would also will be sold at an amount other than
12 Rothstein Kass
the reported NAV, and any remaining determining when transfers between subsequently deemed to be inactive
steps required to complete the sale levels are recognized. Examples of and disorderly, and a private operating
or redemption. policies for when to recognize transfers company that completes an initial
• Any plans or intentions to sell a group between Levels 1 and 2 in the fair value public offering. Although not a “bright-
of unspecified investments that hierarchy could include the following: line,” industry practice has accepted
continue to qualify for the practical 10% of NAV as a starting point to
expedient and the remaining steps • The actual date of the event or determine transfers that are “significant.”
required to complete the sale. change in circumstances that caused Furthermore, when documenting a
the transfer. fund’s valuation policy, fund managers
Additional disclosures should be made • The beginning of the reporting period. should document the procedures that
to explain the overall risks and exposures • The end of the reporting period. are in place to analyze the movement
to economic concentrations of the of investments between Levels.
investee funds by geographic regions, Refer to Exhibit 2 for examples of sample
industries and types of securities. In financial statement footnote disclosures. Disclosures for Each “Class”
determining the appropriate major of Assets and Liabilities
categories of investments in private (Editor’s Note: As a best practice,
investment companies, a reporting fund we recommend that fund managers Beginning in 2010, ASC 820 requires a
should consider the activity or business prepare a quarterly rollforward schedule reporting entity to provide fair value
sector, vintage, geographic concentration, showing year-to-date transfers within all measurement disclosures for each
credit quality and other economic levels within the fair value hierarchy. We “class” of assets and liabilities. Previously,
characteristics of the investee funds. also recommend that fund managers reporting entities were required to
prepare a reconciliation from the above disclose fair value measurement
Accounting for Transfers mentioned rollforward schedule to information for its investments by “major
Between Levels the books and records of the fund categories.” Many reporting entities had
since auditors will usually request this interpreted “major categories” to be
Beginning in 2010, ASC 820 requires a information during their annual audit. the same categories that appear in the
reporting entity to disclose the amounts In order to prepare a complete and statement of financial condition. While
of significant transfers between Level accurate quarterly rollforward schedule, ASC 820 does not specifically outline
1 and Level 2 and also requires the fund managers must determine the level the criteria of a class, it does provide
reporting entity to disclose the reason designation for each investment at the guidance as to what the components
for the transfer between Levels in the end of each quarter.) of the class should entail based on the
fair value hierarchy. Significant transfers nature and risk of the assets and liabilities.
into Levels 1 and 2 are required to be As discussed earlier, investments may
disclosed separately from transfers be transferred between Levels during For equity and debt securities, a fund
out of each level. As it relates to funds, an accounting period. For example, should determine the appropriate
significance is typically measured certain events may give rise to a transfer classes for those disclosures on
against the fund’s net asset value. In between Levels in the fair value hierarchy the basis of the nature and risks of
addition, management should disclose such as the lifting of certain restrictions the assets and liabilities and their
and consistently follow its policy for on common stock, an active market classification in the fair value hierarchy
Rothstein Kass 13
(Levels 1, 2, and 3). Furthermore, investment strategies, commodity investment into significant concentrations
ASC 820 also requires that classes type, derivative underlyings, and credit [i.e. industry, geographic area, or vintage]
for equity and debt securities be rating categories, based on the risk in the three level hierarchy footnote
determined using major security concentrations that a fund determines disclosure table. As a practical matter, the
types. When preparing the fair value to be significant and relevant to its SOI and the footnote disclosure showing
measurement disclosure for each class investment strategies. In determining assets and liabilities by class should be
of assets and liabilities, we recommend the appropriate level of disaggregation, prepared simultaneously.)
that funds use as a starting point the a fund should also consider disclosures
same security types for classes that in other U.S. GAAP literature, such as However, depending upon the amount of
are used in the condensed schedule ASC Topic 815, Derivatives and Hedging. a fund’s Level 3 activity during a period, the
of investments (the “SOI”). However, a The methodology used to determine SOI may not provide enough meaningful
fund manager may consider separating classes under U.S. GAAP may vary disaggregation detail for use in the Level
a particular security type into greater across entities, but should result in 3 rollforward since the SOI represents
detail based on factors such as increased transparency to the users a snapshot of a fund’s investments
business sector, vintage, geographic of the financial statements. and is not an activity-based disclosure.
concentration, credit quality, and Therefore, a fund may need to consider
economic characteristics. For all other (Editors Note: We believe certain the magnitude of rollforward activity for
assets and liabilities, judgment is amendments to ASC 820 pertaining to a given class to determine whether it
needed to determine the appropriate the appropriate level of disaggregation did merits more granular detail in the Level
classes of assets and liabilities for not contemplate the disclosures already 3 rollforward.
which disclosures about fair value required for investment companies in
measurements should be provided. the SOI. When preparing the required Refer to Exhibit 2 for examples
Depending on the nature and extent disaggregation disclosures under U.S. of sample financial statement
of the fund’s holdings, a greater detail GAAP, fund managers should evaluate footnote disclosures.
and number of classes may be more whether the combination of the SOI
pertinent for investments classified as disclosure requirements and the ASC 820 Disclosures About Inputs and
Level 3 due to the greater degree of disaggregation disclosure requirements Valuation Techniques
uncertainty and subjectivity involved will provide sufficient transparency of the
in determining Level 3 fair value fair value hierarchy classifications to users ASC 820 clarifies the disclosure
measurements. of the financial statements. Moreover, requirements relating to inputs and
funds that disclose their investments by valuation techniques used to measure fair
In many cases, the industry in which major security type on the SOI should pay value. For fair value measurements using
the issuer of a security operates will special attention to certain investments significant other observable inputs (Level
be a meaningful class designation to that “cross-over” into various levels 2) and significant unobservable inputs
provide disaggregation in fair value within the fair value hierarchy. When (Level 3), a fund is required to disclose a
disclosures. However, other meaningful investments shown on the SOI contains description of the valuation technique(s)
class designations can include material amounts of Level 2 and Level and inputs used in determining the fair
market capitalization, geographic 3 positions, a fund manager should values of each class of assets and
concentrations, asset class tranches, consider bifurcating the amount of the liabilities. In addition, a fund shall disclose
14 Rothstein Kass
changes in valuation techniques and Other Considerations (Editor’s Note: The FASB decided to
the reasons for making the change. delay the effective date of disclosing
Activity in Level 3 Fair
Disclosures of valuation inputs should the Level 3 rollforward on a gross basis
consider quantitative information about until 2011 to give entities that required
the inputs (e.g., prepayment rates, significant changes to their information
Beginning in 2011, U.S. GAAP will
default rates, interest rates, discount systems adequate time to comply with
change the presentation requirements
rates, and volatilities), the nature and the new standard. We recommend funds
currently effective under ASC 820 relating
detailed characteristics of the item begin to evaluate the impact of this new
to the Level 3 rollforward table. Under
being measured, and how third-party disclosure requirement.)
the current literature, a reporting entity
information such as broker quotes,
is required to disclose a reconciliation of
pricing services, net asset values and
the beginning and ending balances for Fair Value Disclosure
relevant market data was considered Requirements for Derivative
significant unobservable inputs (Level
in measuring fair value.
3 investments) by indicating the gains Assets and Liabilities
and losses for the period, purchases,
As a best practice, funds should review Beginning in 2010, ASC 820 requires a
sales, issuances, settlements and
their disclosures for Level 2 and Level fund to provide fair value measurement
transfers in and/or out of Level 3 on a
3 investments to ensure that a robust disclosures for derivative assets and
net basis. The new guidance will require
description of the valuation inputs and liabilities on a gross basis. Previously,
purchases, sales, issuances, settlements
methodologies used are included in the funds were permitted to present the fair
and transfers in and/or out of Level 3
financial statements. In many instances, value disclosures for derivative assets
to be presented on a gross basis. Total
a qualitative description of valuation and liabilities on a net basis. However,
gains or losses for the period (realized
inputs may be sufficient to describe the activity of derivative assets and
and unrealized) will still be permitted to
the valuation inputs used. However, liabilities included in the Level 3
be presented on a net basis. Effectively,
funds should also consider disclosures rollforward continue to be permitted to
significant changes in Level 3 investments
of quantitative information on valuation be presented on either a gross or net
during the period will each be disclosed
inputs based on assumed market basis.
separately. Furthermore, the new
participant parameters when the
guidance requires the reporting entity
magnitude of subjectivity intrinsic to Refer to Exhibit 2 for examples
to disclose the reasons for transfers in
the investment valuations warrant a of sample financial statement
and/or out of Level 3 investments. Similar
greater degree of transparency in the footnote disclosures.
to the policy requirements for transfers
disclosures. When multiple valuation
between Levels 1 and 2, management
methodologies are used within an Effective Dates of New Fair
should disclose and consistently follow
investment class, we recommend
its policy for determining when transfers Value Measurement and
disclosing the aggregate fair values
between levels are recognized. Disclosure Guidance
by valuation methodology utilized.
Refer to Exhibit 2 for examples of sample As discussed in our previous white paper
Refer to Exhibit 2 for examples of sample
financial statement footnote disclosures. on fair value measurements, SFAS 157
financial statement footnote disclosures.
was issued in September 2006 and was
Rothstein Kass 15
effective for financial statements with per Share, or Its Equivalent (issued other premiums and discounts in a fair
fiscal years beginning after November September 2009; effective for interim value measurement.
15, 2007 and interim periods within those and annual reporting periods beginning • Disclosure of a measurement
fiscal years (the first quarter of 2008 for after December 15, 2009). uncertainty analysis for Level 3
a calendar year-end fund). The fair value • ASU 2009-05, Measuring Liabilities at fair value measurements.
measurement and disclosure guidance Fair Value (issued August 2009; • Disclosure of any transfers between
contained in SFAS 157, together with any effective for the first reporting period, Level 1 and Level 2 of the fair value
fair value measurement and disclosure including interim periods, beginning hierarchy as well as any transfers in
guidance issued subsequent to the after issuance). and out of Level 3.
issuance of SFAS 157, was included
in ASC 820 upon the launch of the FASB/IASB Convergence - A final standard is expected to be issued
Codification in July 2009. It should be Proposed Guidance on Fair Value in early 2011. As of press time, there
noted that post Codification, the FASB Measurement and Disclosure are many practice implementation
will no longer issue FASB Statements, issues relating to certain proposed
FASB Staff Positions (“FSPs”), FASB On June 29, 2010, both the FASB and the provisions of which the resolution of
Interpretations (“FINs”), or Emerging International Accounting Standards Board various constituent concerns is not
Issue Task Force (“EITF”) Abstracts. (the “IASB”) (collectively “the Boards”) yet determinable. Rothstein Kass is
New authoritative U.S. GAAP is now released separate exposure drafts on monitoring the progress of this topic
communicated via a new document proposed fair value measurements and will provide additional guidance
called an Accounting Standards and disclosures standards with the when the final standard is issued.
Update (“ASU”). When amendments objective to align U.S. GAAP and IFRS.
to the Codification contained in an In the FASB exposure draft, the FASB
ASU become effective, the Codification has proposed certain amendments to
guidance is updated. The following fair ASC 820 that would change fair value
value measurement and disclosure ASU’s measurement principles and disclosures.
were issued by the FASB subsequent to These proposed amendments may result
the launch of the Codification: in additional changes in the way funds
prepare their financial statements.
• ASU 2010-06, Improving Disclosures
About Fair Value Measurement (issued Proposed Changes
January 2010; effective for interim and The more notable of those proposed
annual reporting periods beginning amendments to U.S. GAAP include
after December 15, 2009, except for the following:
disclosures of gross activity in the Level
3 rollforward which will be effective for • Highest and best use valuation premise.
fiscal years beginning after December • Measuring the fair value of financial
15, 2010). instruments that are managed within
• ASU 2009-12, Investments in Certain a portfolio.
Entities That Calculate Net Asset • Application of blockage factors and
16 Rothstein Kass
Matrix of Levels and Typical Level Designations
Level Types of Inputs Types of Investments (Note 1)
Level 1 - Valuations based on quoted Unadjusted quoted prices from an exchange Exchange-traded securities, most U.S.
prices in active markets for identical assets or broker-dealer market that is deemed to government securities, certain other
or liabilities. be active. sovereign government securities, listed
derivatives, futures contracts and over-
the-counter (“OTC”) securities traded in
an active market.
Level 2 - Valuations based on quoted Adjusted prices from an exchange or Exchange-traded securities (Note 3)
prices in markets that are not active or for broker-dealer market that is deemed to and listed derivatives that are not actively
which all significant inputs are observable, be inactive, brokered markets for restricted traded, most OTC derivatives, restricted
either directly or indirectly. securities, registered debt and observable stock, corporate and municipal bonds,
market inputs, such as equity prices, yield certain corporate loans, certain high-yield
curves, implied volatility, interest rates, debt, certain residential and commercial
prepayment speeds, loss severities, credit mortgage loans, certain mortgage-backed
risks, and default rates (including those inputs securities (“MBS”), asset-backed securities
extrapolated from other observable inputs). (“ABS”), and collateralized debt obligation
(Note 2) (“CDO”) securities, investments in certain
private investment companies, futures and
forward contracts, physical commodities,
and certain deferred fee arrangements.
Level 3 - Valuations based on inputs that Models utilizing significant inputs that are Certain corporate loans, certain mortgage
are not observable and significant to the unobservable (e.g., historical volatilities), such loans, certain high-yield debt, distressed
overall fair value measurement. as Black-Scholes, discounted cash flows, debt (i.e., securities of issuers encountering
multiples of earnings or EBITDA including risk financial difficulties, including bankruptcy
assumptions consistent with what market or insolvency), certain MBS, ABS and CDO
participants would use to arrive at fair value. securities, investments in real estate funds
and certain private investment companies,
private equity investments, complex OTC
derivatives (including certain foreign
currency options, long-dated commodity
options and swaps, certain mortgage-
related credit default swaps, derivative
interests in mortgage-related CDOs, and
basket credit default swaps), and certain
deferred fee arrangements.
Note 1 - Level designations within the fair value hierarchy are based on the lowest level input that is significant to an investment’s fair value measurement.
Actual level designations of an investment may vary from the examples illustrated above based on individual facts and circumstances.
Note 2 - For Level 2 designations, any models used must be widely accepted, non-proprietary and the data used must be observable. Any significant judgments
or adjustments to the model or data will likely result in a Level 3 designation. In addition, quotes from brokered markets must represent a firm commitment to
transact or are developed from other observable market data.
Note 3 - Exchange-traded securities that are traded in an inactive and disorderly market or the prices from the exchange are adjusted due to aftermarket
events would generally be assigned a Level 2 designation.
Rothstein Kass 17
Exhibit 2 developed based on the best information represent the amounts that may be
available in the circumstances. The fair ultimately realized due to the occurrence
Sample Financial Statement
value hierarchy is categorized into three of future circumstances that cannot be
Footnote Disclosures levels based on the inputs as follows: reasonably determined. Because of the
inherent uncertainty of valuation, those
The illustrative financial statement footnote
Level 1 - Valuations based on unadjusted estimated values may be materially
disclosures that follow have taken into
quoted prices in active markets for higher or lower than the values that
consideration the requirements outlined
identical assets or liabilities that the would have been used had a ready
in ASC 820. Level designation within the
Fund has the ability to access. Valuation market for the investments existed.
fair value hierarchy should be based on
adjustments are not applied to Level 1 Accordingly, the degree of judgment
the lowest level input that is significant to
investments. Since valuations are based exercised by the Fund in determining
the fair value measurement of the security
on quoted prices that are readily and fair value is greatest for investments
and may vary from the designations
regularly available in an active market, categorized in Level 3.
illustrated in the disclosures below.
valuation of these investments does not
Significant Accounting entail a significant degree of judgment. In certain cases, the inputs used to
Policy Footnotes measure fair value may fall into different
Level 2 - Valuations based on quoted levels of the fair value hierarchy. In such
Fair Value - Definition and Hierarchy prices in markets that are not active cases, for disclosure purposes, the level
Fair value is defined as the price that or for which all significant inputs are in the fair value hierarchy within which
would be received to sell an asset or paid observable, either directly or indirectly. the fair value measurement falls in its
to transfer a liability (i.e., the “exit price”) entirety is determined based on the
in an orderly transaction between market Level 3 - Valuations based on inputs that lowest level input that is significant to
participants at the measurement date. are unobservable and significant to the the fair value measurement.
overall fair value measurement.
In determining fair value, the Fund uses Fair value is a market-based measure
various valuation approaches. A fair value The availability of valuation techniques considered from the perspective of
hierarchy for inputs is used in measuring and observable inputs can vary from a market participant rather than an
fair value that maximizes the use of investment to investment and are entity-specific measure. Therefore,
observable inputs and minimizes the use affected by a wide variety of factors, even when market assumptions are
of unobservable inputs by requiring that including the type of investment, not readily available, the Fund’s own
the most observable inputs are to be whether the investment is new and not assumptions are set to reflect those
used when available. Observable inputs yet established in the marketplace, and that market participants would use
are those that market participants would other characteristics particular to the in pricing the asset or liability at the
use in pricing the asset or liability based transaction. To the extent that valuation measurement date. The Fund uses
on market data obtained from sources is based on models or inputs that are prices and inputs that are current as
independent of the Fund. Unobservable less observable or unobservable in of the measurement date, including
inputs reflect the Fund’s assumptions the market, the determination of fair periods of market dislocation. In
about the inputs market participants value requires more judgment. Those periods of market dislocation, the
would use in pricing the asset or liability estimated values do not necessarily observability of prices and inputs may
18 Rothstein Kass
be reduced for many investments. This To the extent these securities are actively inputs, including, where applicable,
condition could cause an investment to traded and valuation adjustments are time value, implied volatility, equity
be reclassified to a lower level within the not applied, they are categorized in Level and commodity prices, interest rate
fair value hierarchy. 1 of the fair value hierarchy. Securities yield curves, prepayment speeds,
traded on inactive markets or valued interest rates, loss severities, credit
Fair Value - Valuation Techniques by reference to similar instruments are risks, credit curves, default rates and
and Inputs generally categorized in Level 2 of the currency rates. Certain pricing models
fair value hierarchy. do not entail material subjectivity as
Investments in Securities and the methodologies employed include
Securities Sold Short Derivative Contracts pricing inputs that are observed from
The Fund values investments in securities The Fund records its derivative activities actively quoted markets. In the case of
and securities sold short that are freely at fair value. Gains and losses from more established derivative contracts,
tradable and are listed on a national derivative contracts are included in net the pricing models used by the Fund
securities exchange or reported on gain (loss) from derivative contracts in are widely accepted by marketplace
the NASDAQ national market at their the statement of operations. Derivative participants. OTC derivatives contracts
last reported sales price as of the contracts include forward, futures, swap (such as forward and swap contracts)
valuation date. and option contracts related to interest which may be valued using models,
rates, foreign currencies, credit standing depending on whether significant inputs
Many OTC contracts have bid and of reference entities, and equity prices are observable or unobservable, are
ask prices that can be observed in or commodity prices. categorized in Levels 2 or 3 of the fair
the marketplace. Bid prices reflect value hierarchy.
the highest price that the marketplace Derivative contracts, such as options
participants are willing to pay for an and futures, which are listed on a Investments in credit default swaps
asset. Ask prices represent the lowest national securities exchange or reported are valued using pricing models widely
price that the marketplace participants on the NASDAQ national market, are accepted by marketplace participants.
are willing to accept for an asset. For generally categorized in Level 1 of the The pricing models take into account the
securities whose inputs are based on fair value hierarchy. contract terms (including maturity), time
bid-ask prices, the Fund’s valuation value, credit curves, recovery rates, and
policies do not require that fair value Depending on the underlying security current credit spreads obtained from
always be a predetermined point in the and the terms of the transaction, swap counterparties and other market
bid-ask range. The Fund’s policy for the fair value of certain derivatives participants. At December 31, 20XX,
securities traded in the OTC markets may be able to be modeled using investments in credit default swaps had
and listed securities for which no sale a series of techniques, including maturities within a range of X and XX
was reported on that date are generally closed-form analytic formula (such years, and were valued using recovery
valued at their last reported bid price as the Black-Scholes option-pricing rates with a range of XX% and XX%, and
if held long, and last reported ask model), simulation models, or a current credit spreads within a range of
price if sold short. combination thereof. Pricing models XXX and X,XXX basis points.
take into account the contract terms
(including maturity) as well as multiple
Rothstein Kass 19
Government Bonds spreads, and recovery rates based on absence of market prices, are valued
The fair value of sovereign government collateral values as key inputs. Corporate as a function of observable whole bond
bonds is generally based on quoted bonds are generally categorized in Level prices and cash flow values of principal-
prices in active markets. When quoted 2 of the fair value hierarchy. In instances only bonds using current market
prices are not available, fair value is where significant inputs are unobservable, assumptions at the measurement date.
determined based on a valuation model they are categorized in Level 3 of the fair CMBS and ABS are categorized in
that uses inputs that include interest value hierarchy. Level 2 of the fair value hierarchy when
rate yield curves, cross-currency external pricing data is observable and
basis index spreads, and sovereign Bank Debt in Level 3 when external pricing data
credit spreads similar to the bond in The fair value of bank debt is generally is unobservable.
terms of issuer, maturity and seniority. valued using recently executed
Sovereign government bonds are transactions, market price quotations At December 31, 20XX, the Fund
generally categorized in Levels 1 or (where observable) and market had investments in ABS with a fair
2 of the fair value hierarchy. observable credit default swap levels. value of approximately $XX,XXX,000
When quotations are unobservable, which are included in Level 3 of the
Municipal Bonds proprietary valuation models and fair value hierarchy. These securities
The fair value of municipal bonds is default recovery analysis methods are represent mezzanine and equity tranches
estimated using recently executed employed, utilizing default rates within in various securitization trusts. The
transactions, market price quotations a range of X.X% to X.X%, recovery underlying loans for these securities
and pricing models that factor in, where rates within a range of X.X% to X.X%, include small business loans and credit
applicable, interest rates, bond or credit and loss rates within a range of X.X% card receivables that were originated
default swap spreads and volatility. to X.X%. Bank debt is categorized in between 200X and 201X. The underlying
Municipal bonds are generally categorized Levels 2 or 3 of the fair value hierarchy. small business loans and credit card
in Level 2 of the fair value hierarchy. receivables have respective weighted-
Commercial Mortgage-Backed average coupon rates of X.X% and
Corporate Bonds Securities (CMBS) and Asset-Backed X.X% and weighted-average maturities
The fair value of corporate bonds is Securities (ABS) of X and XX years. To estimate their fair
estimated using recently executed CMBS and ABS may be valued based value, the Fund uses a cash flow model.
transactions, market price quotations on external price/spread data. When The significant inputs used for the cash
(where observable), bond spreads, or position-specific external price data flow model include the following inputs:
credit default swap spreads. The spread is not observable, the valuation is
data used is for the same maturity as either based on prices of comparable Mezzanine Equity
the bond. If the spread data does not securities or cash flow models that
Yields to X.X% - X.X% X.X% - X.X%
reference the issuer then data that consider inputs including default rates, Maturity
references a comparable issuer is used. conditional prepayment rates, loss Default X.X% - X.X% X.X% - X.X%
When observable price quotations are not severity, expected yield to maturity, and
Loss X.X% - X.X% X.X% - X.X%
available, fair value is determined based other inputs specific to each security. Severities
on cash flow models using yield curves, Included in this category are certain Prepayment X.X% - X.X% X.X% - X.X%
bond or single name credit default swap interest-only securities, which in the Rates
20 Rothstein Kass
Investments in Private Investments valued using an income At December 31, 20XX, the approximate
Operating Companies approach utilized discount rates within a fair values of the Fund’s investments in
The Fund’s investments in private range of XX% to XX%. Additional inputs private operating companies, by valuation
operating companies consist of direct relied upon in this approach include methodology, are as follows:
private common and preferred stock annual projected cash flows for each
(together or individually “equity”) investment through their respective Third Party Transactions $ X,XXX,000
investments. The transaction price, investment horizons. These cash flow
Income Approach $ X,XXX,000
excluding transaction costs, is typically assumptions may be probability-weighted
the Fund’s best estimate of fair value to reflect the risks associated with Market Approach $ X,XXX,000
at inception. When evidence supports achieving expected performance levels Blended Approach $ X,XXX,000
a change to the carrying value from across various business scenarios.
the transaction price, adjustments are Under the income approach, the
made to reflect expected exit values in privately-held nature of an investment Investments in Restricted Securities of
the investment’s principal market under may be reflected in the magnitude of Public Companies
current market conditions. Ongoing the selected range of discount rates or Investments in restricted securities
reviews by the Fund’s management through application of separate liquidity of public companies cannot be
are based on an assessment of trends discounts within a range of XX% to XX%. offered for sale to the public until the
in the performance of each underlying Fund complies with certain statutory
investment from the inception date Investments valued using a market requirements. The valuation of the
through the most recent valuation date. approach utilized valuation multiples securities by management takes into
These assessments typically incorporate within a range of X.X and X.X times consideration the type and duration
valuation methodologies that consider the annual earnings before interest, of the restriction, but in no event does
the evaluation of arm’s length financing taxes, depreciation and amortization the valuation exceed the listed price on
and sale transactions with third parties, (“EBITDA”), or another performance a national securities exchange or the
an income approach reflecting a metric such as revenues or net earnings. NASDAQ national market. Investments
discounted cash flow analysis, and The selected valuation multiples were in restricted securities of public
a market approach that includes a estimated through a comparative analysis companies are generally included in
comparative analysis of acquisition of the performance and characteristics Level 2 of the fair value hierarchy. At
multiples and pricing multiples or each investment within a range of December 31, 20XX, investments in
generated by market participants. In comparable companies or transactions restricted securities of public companies
certain instances the Fund may use in the observable marketplace. In addition, of approximately $XX,XXX,000 were
multiple valuation methodologies for the Fund generally applies liquidity valued using liquidity discounts within
a particular investment and estimate discounts within a range of XX% to XX%, a range of XX% to XX%.
its fair value based on a weighted and control premiums within a range
average or a selected outcome within of XX% to XX%, dependant upon the
a range of multiple valuation results. characteristics of the individual investment
These investments in private operating and its respective marketplace.
companies are generally included in
Level 3 of the fair value hierarchy.
Rothstein Kass 21
Investments in Private length of time until the investment
Investment Companies is redeemable, including notice and
Investments in private investment lock-up periods or any other restriction
companies are valued, as a practical on the disposition of the investment.
expedient, utilizing the net asset The Fund also considers the nature of
valuations provided by the underlying the portfolios of the underlying private
private investment companies, without investment companies and their ability
adjustment, when the net asset to liquidate their underlying investments.
valuations of the investments are If the Fund has the ability to redeem its
calculated (or adjusted by the Fund if investment at the reported net asset
necessary) in a manner consistent with valuation as of the measurement date,
U.S. GAAP for investment companies. the investment is generally included in
The Fund applies the practical expedient Level 2 of the fair value hierarchy. If the
to its investments in private investment Fund does not know when it will have
companies on an investment-by- the ability to redeem the investment or
investment basis, and consistently with it does not have the ability to redeem
the Fund’s entire position in a particular its investment in the near term, the
investment, unless it is probable that the investment is included in Level 3 of
Fund will sell a portion of an investment the fair value hierarchy.
at an amount different from the net
asset valuation. If it is probable that Note X — Fair Value Measurements
the Fund will sell an investment at an The Fund’s assets and liabilities
amount different from the net asset recorded at fair value have been
valuation or in other situations where categorized based upon a fair value
the practical expedient is not available, hierarchy as described in the Fund’s
the Fund considers other factors in significant accounting policies in
addition to the net asset valuation, Note 1. The following tables present
such as features of the investment, information about the Fund’s assets
including subscription and redemption and liabilities measured at fair value as
rights, expected discounted cash flows, of December 31, 2010 (in thousands):
transactions in the secondary market,
bids received from potential buyers,
and overall market conditions in its
determination of fair value.
Investments in private investment
companies are included in Level 2 or 3
of the fair value hierarchy. In determining
the level, the Fund considers the
22 Rothstein Kass
Assets (at fair value) Level 1 Level 2 Level 3 Total
Investments in securities
Banking $ 117,089 $ $ $ 117,089
Manufacturing 94,447 94,447
Consumer discretionary 87,491 2,191 89,682
Health care 81,038 81,038
Real estate 44,961 44,961
Manufacturing 38,571 38,571
Telecommunications 33,642 462 34,104
Preferred stocks 96,000 600 96,600
Exchange traded funds 19,567 19,567
Private preferred stocks 18,541 18,541
Corporate bonds 59,481 2,584 62,065
Government bonds 22,391 22,391
Municipal bonds 31,534 31,534
Senior debt 1,273 19,159 20,432
Mezzanine debt 9,518 9,518
Total investments in securities 635,197 95,541 49,802 780,540
Investments in private investment companies
Value 72,424 72,424
North America 53,909 53,909
Asia 1,191 1,191
North America 23,339 23,339
Europe 1,460 1,460
Private equity 38,223 38,223
Total investments in private investment companies 127,793 62,753 190,546
Interest rate swaps 60,439 60,439
Call warrants 45,193 1,879 47,072
Total return swaps 30,111 1,396 31,507
Call options 23,807 23,807
Put options 2,159 2,159
Total derivative contracts 25,966 135,743 3,275 164,984
Securities purchased under agreements to resell 12,450 12,450
Cash equivalents 3,567 3,567
$ 664,730 $ 371,527 $ 115,830 $ 1,152,087
Rothstein Kass 23
Liabilities (at fair value) Level 1 Level 2 Level 3 Total
Securities sold short
Common stocks $ 510,581 $ 4,653 $ $ 515,234
Preferred stocks 34,194 1,003 35,197
Total securities sold short 544,775 5,656 550,431
Credit default swaps 23,839 1,838 25,677
Total return swaps 24,660 24,660
Interest rate swaps 23,112 23,112
Contracts for differences 22,384 22,384
Forward contracts 22,072 22,072
Futures contracts 21,879 21,879
Call options 9,960 9,960
Put options 5,691 5,691
Total derivative contracts 37,530 116,067 1,838 155,435
$ 582,305 $ 121,723 $ 1,838 $ 705,866
(Editors Note: When considering disaggregating assets and liabilities by “class,” we recommend using line items contained in
the condensed schedule of investments (“SOI”) as a starting point. If one of the line items in the SOI contain significant amounts
in more than one hierarchy level, further disaggregation would be required. The example above assumes significant amounts of
common stock in Level 1 and 2 and asset-backed securities in Level 2 and 3.)
24 Rothstein Kass
Significant transfers into and out of each level of the fair value hierarchy for assets measured at fair value for the year ended
December 31, 2010 (in thousands) were as follows:
Transfers Transfers Transfers Transfers Transfers Transfers
Assets (at fair value) into (out) of into (out) of into (out) of
Level 1 Level 1 Level 2 Level 2 Level 3 Level 3
Investments in securities
Common stocks $ 39,019 $ (8,412) $ 8,412 $ (39,019) $ $
Preferred stocks 10,438 (10,438)
Exchange traded funds
Private preferred stocks
Corporate bonds 1,926 (4,510) 4,510 (1,926)
49,457 (8,412) 10,338 (53,967) 4,510 (1,926)
Investments in private
Interest rate swaps
Call warrants 6,616 (1,467) 1,467 (6,616)
Total return swaps
Total derivative contracts 6,616 (1,467) 1,467 (6,616)
Securities purchased under
agreement to resell
$ 49,457 $ (8,412) $ 84,849 $ (55,434) $ 5,977 $ (76,437)
Rothstein Kass 25
Significant transfers into and out of each level of the fair value hierarchy for liabilities measured at fair value for the year ended
December 31, 2010 (in thousands) were as follows:
Transfers Transfers Transfers Transfers Transfers Transfers
Liabilities (at fair value) into (out) of into (out) of into (out) of
Level 1 Level 1 Level 2 Level 2 Level 3 Level 3
Securities sold short
Common stocks $ $ $ $ $ $
Total securities sold short
Credit default swaps (562) 562
Total return swaps
Interest rate swaps
Contracts for differences
Total derivative contracts (562) 562
$ $ $ $ (562) $ 562 $
All transfers are recognized by the Fund at the end of each reporting period.
Transfers between Levels 1 and 2 generally relate to whether a market becomes active or inactive. Transfers between Levels 2
and 3 generally related to whether, for various reasons, significant inputs become observable or unobservable. See Note 1 for
additional information related to the fair value hierarchy and valuation techniques.
26 Rothstein Kass
The following table presents additional information about Level 3 assets and liabilities measured at fair value. Both observable and
unobservable inputs may be used to determine the fair value of positions that the Fund has classified within the Level 3 category.
As a result, the unrealized gains and losses for assets and liabilities within the Level 3 category may include changes in fair value
that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable
long-dated volatilities) inputs.
Changes in Level 3 assets measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:
Beginning Realized & Purchases, Ending Balance Gains (Losses)
Assets (at fair value) Balance Unrealized Sales and December 31, for Investments
January 1, 2010 Gains (Losses) Settlements 2010 still held at
(a) 2010 (b)
Investments in securities
Common stocks $ $ $ $ $ $
Exchange traded funds
Private preferred stocks (1,459) 20,000 18,541 (1,459)
Corporate bonds 2,584 2,584 547
Asset-backed securities 17,319 34,910 (23,552) 28,677 12,481
17,319 33,451 (3,552) 2,584 49,802 11,569
Investments in private
109,672 (9,024) 30,000 (67,895) 62,753 1,391
Interest rate swaps
Call warrants 2,934 4,094 (5,149) 1,879 (562)
Total return swaps 5,190 (41,209) 37,415 1,396 (1,834)
Total derivative contracts 8,124 (37,115) 37,415 (5,149) 3,275 (2,396)
under agreement to resell
$ 135,115 $ (12,688) $ 63,863 $ (70,460) $ 115,830 $ 10,564
Rothstein Kass 27
Changes in Level 3 liabilities measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:
Net Transfers Unrealized Gains
Beginning Realized & Purchases, Ending Balance
into and/or (Losses) for
Liabilities (at fair value) Balance Unrealized Sales and December 31,
(out) of Investments still
January 1, 2010 Gains (Losses) Settlements 2010
Level 3 held at December
Securities sold short
Common stocks $ $ $ $ $ $
Credit default swaps 8,719 (7,443) 562 1,838 (418)
Total return swaps
Interest rate swaps
Contracts for differences
Total derivative contracts 8,719 (7,443) 562 1,838 (418)
$ 8,719 $ (7,443) $ $ 562 $ 1,838 $ (418)
(a) Realized and unrealized gains and losses are all included in net gain (loss) on investments in the statement of operations.
(b) The change in unrealized gains (losses) for the year ended December 31, 2010 for investments still held at December 31, 2010
are reflected in the net change in unrealized appreciation or depreciation on securities, net change in unrealized appreciation
or depreciation on private investment companies, and net gain (loss) from derivative contracts in the statement of operations.
28 Rothstein Kass
The following footnote disclosure is a sample of a “gross” presentation of the Level 3 rollforward. This footnote disclosure is
required for periods beginning after December 15, 2010 (calendar year-end 2011 funds); however, early adoption is encouraged.
Changes in Level 3 assets measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:
Beginning Realized & Ending Gains
Balance Unrealized Balance (Losses) for
Assets (at fair value) Purchases Sales Settlements into (out) of
January Gains December Investments
Level 3 Level 3
1, 2010 (Losses) 31, 2010 still held at
Common stocks $ $ $ $ $ $ $ $ $
(1,459) 20,000 18,541 (1,459)
Corporate bonds 4,510 (1,926) 2,584 547
17,319 34,910 2,451 (26,003) 28,677 12,481
17,319 33,451 22,451 (26,003) 4,510 (1,926) 49,802 11,569
private investment 109,672 (9,024) 34,000 (4,000) (67,895) 62,753 1,391
Interest rate swaps
Call warrants 2,934 4,094 1,467 (6,616) 1,879 (562)
Total return swaps 5,190 (41,209) 37,415 1,396 (1,834)
8,124 (37,115) 37,415 1,467 (6,616) 3,275 (2,396)
$ 135,115 $ (12,688) $ 56,451 $ (30,003) $ 37,415 $ 5,977 $ (76,437) $ 115,830 $ 10,564
Rothstein Kass 29
Exhibit 3 8. Are the fair value disclosure large bid-ask spread from a broker-
requirements in ASC 820 required for dealer that has provided a legal
Frequently Asked Questions
feeder funds whose sole investment disclaimer on the quote?
is in a master fund?
16. When a fund receives multiple
9. Should a fund record its debt facility indicative broker-dealer quotes,
1. Are there any differences between the
at fair value and disclose the debt per are the quotes considered to be
fair value measurement and disclosures
the requirements of ASC 820? observable or unobservable?
guidance under previous U.S. GAAP
in SFAS 157 and the codified guidance
10. How does nonperformance risk 17. What would the level designation
under current U.S. GAAP in ASC 820?
impact the fair value measurement be for securities that rely on
of derivatives? indicative broker-dealer quotes
2. If a fund changes its valuation
with legal disclaimers?
methodology for a certain investment,
11. What factors should funds consider
when is the adjustment to the fair value
when applying the fair value premise Fair Value Hierarchy-
of the investment recorded?
to liability instruments? Level 1 Considerations
3. When is the use of a valuation model
12. Are repurchase agreements and 18. How does a fund determine the
to determine fair value acceptable
reverse repurchase agreements principal or most advantageous
under ASC 820?
required to be disclosed in the market?
fair value hierarchy level tabular
4. If there are multiple valuation
disclosure? 19. A fund purchases a security on
techniques available, how does a
Exchange A. The security is traded
fund determine the most appropriate
Third Party Pricing/Broker- on both Exchange A and B.
valuation technique under ASC 820?
Dealer Quotations Exchange B has more liquidity
and is more active than Exchange
5. What are the recognition guidelines
13. Where does pricing from recognized A. Does the fund determine the
for transfers between levels in the fair
third party pricing services and fair value of the security using
broker-dealers fall within the three- Exchange A or B prices?
6. What is the consequence when a
20. How can a fund determine, in
fund assigns incorrect levels to its
14. If a fund receives broker-dealer quantitative terms, the definition
investments according to the fair
quotes from multiple broker-dealers, of an active market?
can an average of the broker-dealer
quotes be used to arrive at fair value? 21. For exchange-traded equities, can
7. Are the fair value disclosure requirements
a fund use the consolidated tape to
in ASC 820 reported on the condensed
15. What level designation would a fund price the securities?
schedule of investments or in the
assign to an investment where the
footnotes to the financial statements?
fund can only get one quote with a
30 Rothstein Kass
22. Block Discounts — Can a fund take 29. In an illiquid market (such as the measurement and the use of NAV as
a “haircut” off the price of a position asset-backed security market) a practical expedient?
in a small cap company? there can be a disconnect between
the intrinsic value (e.g., the value 34. What fair value hierarchy level
23. Is a fund required to disaggregate determined by applying data designation would a fund assign
Level 1 investments in the footnotes to inputs to a valuation which may to an investment in a private
the financial statements by industry or presume the position would be held investment company when the
geographic concentrations if Level 1 to maturity) and what the current private investment company has
investments are already disclosed on quoted observable prices are for a portion of its investment held in
the SOI? the security in the marketplace. a side-pocket?
Can the intrinsic value be used in
Fair Value Hierarchy—Level 2 and lieu of the quoted prices when the 35. How does a fund conclude that
Level 3 Considerations current market is not active and NAV, as most recently reported
therefore has unusually large bid- by the investee fund manager, has
24. Should a discount be taken when ask spreads? been calculated according to the
determining the fair value of a measurement principles of ASC 946?
restricted stock? 30. If there are no recent transactions
for an asset-backed security and a 36. What should a fund consider as
25. Is it appropriate for a fund to adopt fund uses matrix pricing comparing part of the requirement to disclose
a policy of applying a standard asset-backed securities that have information about the inputs and
discount rate to its investments (i.e., similar attributes and vintages, valuation techniques for Level 2
restricted stock or private investments or a fund uses the ABX credit- and 3 measurements?
in public equity (PIPEs)) when derivative index to price the security,
measuring fair value? what would be the resulting level Fair Value Hierarchy—Level 3
designation for these approaches? Considerations-Investments in
26. Are total return swaps where the Private Operating Companies
underlying notional position is an 31. What level designation should a fund
actively traded security (i.e., Level assign to a deferred fee liability which 37. For an investment in private operating
1 security) considered Level 1 or is reinvested into the fund? companies, how does a recent round
Level 2? of financing factor into the fair value
32. When is it appropriate to designate inputs in arriving at fair value, as well
27. Where do options fall within the fair a fund of funds investment in a as the level designation within the fair
value hierarchy? private investment company as value hierarchy?
a Level 2 investment in the fair
28. What is the level designation in the value hierarchy? 38. Should transaction costs associated
fair value hierarchy for (PIPEs) with the acquisition of an investment
including the warrants typically 33. How does the probable sale of an be capitalized into the cost of the
attached to those transactions? investment for an amount other than investment or expensed as incurred?
NAV affect the investment’s fair value
Rothstein Kass 31
39. For a private loan receivable, does the sole source for guidance on how instances (e.g., elimination of blockage
ASC 820 require an adjustment to entities should measure and disclose fair discounts), adjustments to the fair value
the “fair value” based on movements value in their financial statements. ASC of the investment as a result of a change
of interest rates for similar loans in 820 includes (1) the original guidance in the valuation methodology will be
the marketplace (even though the contained in SFAS 157, as amended, recorded in the current accounting
underlying credit of the borrower has and (2) new fair value measurement period ending on the valuation date of
not deteriorated)? and disclosure pronouncements issued the investment.
subsequent to the release of SFAS 157.
40. Can a fund rely on other disclosures The goal of SFAS 157 was to provide a 3. When is the use of a valuation
within the financial statements in framework to increase consistency in model to determine fair value
lieu of applying the disaggregation developing fair value measures as well acceptable under ASC 820?
requirements to the disclosure of the as provide greater transparency to
Level 3 rollforward? investors through increased disclosure In most cases, the use of a valuation
in financial statements. ASC 820 retains model to determine fair value is acceptable
41. What is the expected impact of the that framework and requires the following only when quoted prices representing
proposed disclosure requirement of a for financial statement preparers: orderly transactions in active markets
measurement uncertainty analysis for are not available. The inputs used in
Level 3 investments? • Use of a three-level fair value hierarchy. the valuation model should include the
• No blockage discounts allowed for assumptions that market participants
Frequently Asked Level 1 investments. would use in pricing the asset in a
Questions • Increased financial statement current transaction even if the market
disclosures. participants’ assumptions are different
General Questions • Requirement to determine the principal from the fund’s inputs. A fund cannot
market or most advantageous market. ignore market data typically used by
1. Are there any differences between • Use of market-based assumptions market participants. The best practice
the fair value measurement and instead of entity-specific assumptions. is to back test models and calibrate
disclosures guidance under previous • Adjustments for risk of using certain the models’ assumptions to continually
U.S. GAAP in SFAS 157 and the valuation techniques or valuation inputs. improve the valuation process with the
codified guidance under current • Adjustments for nonperformance ultimate goal to arrive at an appropriate
U.S. GAAP in ASC 820? risk and credit rating changes in fair value.
No. The Codification does not change U.S. 4. If there are multiple valuation
GAAP; it creates a new structure which 2. If a fund changes its valuation techniques available, how does
takes accounting pronouncements and methodology for a certain investment, a fund determine the most
organizes them by accounting topics. when is the adjustment to the fair appropriate valuation technique
ASC 820, Fair Value Measurements and value of the investment recorded? under ASC 820?
Disclosures (formerly FASB Statement
No. 157 Fair Value Measurements) is now Fair value measurements are considered The valuation methods with the
accounting estimates. Except in certain most observable inputs should be
32 Rothstein Kass
given priority over those that have Accounting guidance effective for 2010 schedule of investments and should be
unobservable inputs. The overall will require funds to disclose significant included in the footnotes to the financial
theme of ASC 820 is to elevate the transfers between Levels 1 and 2. statements.
fair value measurement in its entirety All transfers in and out of Level 3 are
within the three-level hierarchy as required to be disclosed in the Level Some funds are evaluating the required
high as possible and to use the most 3 rollforward. Significance of Level 1 disclosures of ASC 820 in conjunction
observable and reliable market inputs and 2 transfers should be determined with the required disclosures of the
in a fair value measurement. However, based on a meaningful benchmark, condensed schedule of investments.
funds should place less reliance on such as a fund’s net assets. Funds may There is consideration of including the
observable inputs which are indicative elect a policy for determining the timing level designations in the condensed
of disorderly transactions. If one of recognizing the transfer, but they schedule of investments. To date, we
valuation method proves to be a better must apply the policy consistently. have not seen this approach in practice.
representation of market participant
assumptions than other methods, that 6. What is the consequence when a 8. Are the fair value disclosure
valuation method should be used. fund assigns incorrect levels to its requirements in ASC 820 required
However, multiple valuation methods investments according to the fair for feeder funds whose sole
can be combined to value an investment. value hierarchy? investment is in a master fund?
The weighting of each valuation
method will require judgment by the Assigning levels according to the fair Generally, the fair value disclosure
fund. Once the valuation methods are value hierarchy under ASC 820 is an requirements in ASC 820 are not required
chosen, the best practice is to use the important part of a fund’s year-end for feeder funds whose sole investment
methods chosen on a consistent and financial reporting internal control is in a master fund. Feeder fund footnote
contemporaneous basis. If a change in system. If a fund’s internal controls disclosures should include a reference to
methods or a change in the combination are not adequate to assign the correct the valuation and disclosures included in
of methods used will result in a better levels to its investments, fair value the attached report of the master fund.
fair value measurement, the change in footnote disclosures may be materially
approach is allowable. Any change in misstated. The resulting deficiency may 9. Should a fund record its debt
method is treated as a change in an be deemed a significant deficiency or facility at fair value and disclose
accounting estimate and the resulting material weakness which would require the debt per the requirements of
impact on fair value should be recorded a comment in a SAS 115 letter. ASC 820?
to income in the accounting period of
the change. In addition, when material, 7. Are the fair value disclosure Under US GAAP, a debt facility should
changes in valuation techniques will requirements in ASC 820 reported be presented at the amounts payable to
require disclosure in the footnotes to on the condensed schedule of the counterparty and not at fair value;
the financial statements. investments or in the footnotes unless the fair value option is elected
to the financial statements? under ASC 825, Financial Instruments.
5. What are the recognition guidelines If a fund does not elect the fair value
for transfers between levels in the The fair value disclosure requirements in option for the debt facility, the debt is
fair value hierarchy? ASC 820 are not part of the condensed not required to be disclosed under the
Rothstein Kass 33
requirements of ASC 820. However, if the net asset or liability balance with 11. What factors should funds
a fund does elect the fair value option, the derivative counterparty. However, consider when applying the
the liability to the counterparty will funds should carefully review any master fair value premise to liability
be measured at fair value using the netting arrangements to determine instruments?
guidance in ASC 820 (i.e., maximize the whether the arrangements permit the
use of observable inputs and minimize netting to apply between different When a quoted price in an active market
the use of unobservable inputs). product types. for the identical liability is available,
Considering that the debt facility may the quoted price should be used. If the
not be trading in the market place, there Depending on the provisions of enforceable quoted price in an active market for the
may be little or no observable market master netting arrangements, the identical liability is not available, a fund
data on the fair value of the debt facility. nonperformance risk adjustments may be shall measure fair value using one or
In this case, a fund will have to develop its determined at the counterparty level or by more of the following techniques:
own internal model, most likely using an contract type. Since certain disclosures
expected present value technique are derived from an instrument-by- a. A valuation technique that uses:
to arrive at its estimate of fair value. instrument level of detail, a reasonable 1. The quoted price of the identical
This would typically result in a Level allocation methodology may be needed liability when traded as an asset.
3 designation. to push down any top-side valuation 2. Quoted prices for similar liabilities or
adjustments for nonperformance risks at similar liabilities when traded as assets.
10. How does nonperformance risk the portfolio-level to the fund’s individual
impact the fair value measurement derivative positions. If the effect of the b. Another valuation technique that is
of derivatives? valuation adjustment is significant, it consistent with the principles of
may render the adjusted valuation as a ASC 820.
Funds transacting in multiple over- Level 3 measurement.
the-counter derivative positions may When measuring the fair value of a
need to incorporate portfolio-level Exchange-traded derivatives, such liability using the quoted price of the
adjustments to consider the effects as futures contracts and certain instrument when traded as an asset,
of certain risks on the valuation of options, are generally subject to funds should consider whether any
derivatives. The evaluation of a fund’s market protections, such as daily adjustments would be needed to reflect
credit risk exposures should include margin postings and guarantees intrinsic differences when the instrument
the consideration of master netting from the exchange clearinghouse is traded as an asset versus when the
arrangements, collateral balances, which mitigates the impact of instrument is traded as a liability.
contract settlement provisions, and the nonperformance risk outside of When measuring the fair value of a liability
attributes of different derivative contract that reflected in the quoted price. using a valuation technique consistent
types. To the extent the master netting Therefore, the fair value processes with the principles of ASC 820, funds
arrangement for a fund’s over-the- for exchange-traded derivatives should consider whether market inputs
counter derivatives portfolio allows for generally are not expected to involve are derived from orderly transactions, as
offsetting between different contract any significant nonperformance well as whether internal valuations may
types, the fund may be able to determine risk adjustments. be more representative of fair value.
the overall credit risk exposure based on
34 Rothstein Kass
Funds should consider the impact of 14. If a fund receives broker-dealer level of transparency behind the pricing
their nonperformance risk, including quotes from multiple broker- source, alternative valuation methods will
the existence of master netting dealers, can an average of the be required to support the fair value of the
arrangements, when determining broker-dealer quotes be used security.
the fair value of financial liabilities to arrive at fair value?
transacted with counterparties. 16. When a fund receives multiple
The first step in the evaluation of multiple indicative broker-dealer quotes,
12. Are repurchase agreements and broker-dealer quotes is to determine the are the quotes considered to be
reverse repurchase agreements principal market in which the fund would observable or unobservable?
required to be disclosed in the sell the asset or transfer the liability with
fair value hierarchy level tabular the greatest volume and level of activity. If In order to evaluate whether broker-
disclosure? no principal market exists, then the most dealer quotes are observable, a fund
advantageous market should be used. must evaluate the availability of those
Repurchase agreements are considered If the brokers providing the quotes are quotes to the marketplace as well as
investments stated at fair value and should participants in the principal or the most evaluate the consistency of the source.
be included in the fair value hierarchy level advantageous market, ASC 820 allows for Observable market inputs should not
tabular disclosure. Reverse repurchase funds to use a mid-point within the bid- be limited to information that is only
agreements typically represent a fixed ask price quotes received by the brokers available to the entity making the fair
and determinable obligation of a fund as a practical expedient. value determination (or to a small
and should be presented at face value. group of users). Observable market
Therefore, reverse repurchase agreements 15. What level designation would inputs should be readily available
are not included in the fair value hierarchy a fund assign to an investment and distributed to participants in
level tabular disclosure. where the fund can only get one that market. In addition, observable
quote with a large bid-ask spread market inputs should include a level
Third Party Pricing/Broker- from a broker-dealer that has of transparency that is reliable and
Dealer Quotations provided a legal disclaimer on verifiable. Management will have to
the quote? use their judgment to evaluate whether
13. Where does pricing from inputs are “observable.”
recognized third party pricing If the quote itself is not a firm commitment
services and broker-dealers fall from the broker-dealer to transact at the Transactional-based market inputs tend
within the three-level hierarchy? price quoted or if the broker-dealer is to be more reliable. The range between
not willing to provide transparency, the bid-and-ask prices can be used to identify
Prices from recognized third party input would generally result in a Level 3 whether the market is active or inactive.
pricing services or broker-dealers can designation. Observable market inputs A more active market will dictate more
fall within Levels 1, 2 or 3. A fund must should be readily available and distributed narrow ranges between bid-and-ask
gain an adequate level of transparency to to participants in that market. In addition, quotes with illiquid markets having
understand the inputs used by the pricing observable market inputs should include larger spreads.
services or broker-dealers that support a level of transparency that is reliable and
the prices provided. verifiable. If a fund is unable to obtain a
Rothstein Kass 35
A best practice is to utilize a back testing The principal market is the market in should be used to arrive at fair value.
program to validate the indicative broker- which a fund would sell the asset or The most advantageous market is the
dealer quotes. To the extent there are an transfer the liability with the greatest market which would assign the highest
adequate number of transactions and volume and level of activity. If a fund fair value to an asset or the lowest fair
the variances between the broker-dealer cannot identify a principal market, the value in transferring a liability. If the
quotes and actual market transactions most advantageous market should be fund cannot gain access to the most
are reasonable, back testing may help used to arrive at fair value. The most advantageous market, it would not
verify the reliability of the market input. advantageous market is the market be permissible to use that market to
that would assign the highest fair value estimate fair value.
17. What would the level designation to an asset or the lowest fair value in
be for securities that rely on transferring a liability. Transaction costs If the fund in this case transacts on
indicative broker-dealer quotes should be taken into consideration in both exchanges with neither being the
with legal disclaimers? determining the most advantageous principal market, the fund would again
market. In making that determination, use the most advantageous market.
An indicative broker-dealer quote is a fund must calculate the net amount If the fund only transacts on Exchange
typically provided by a broker-dealer received from the sale of an asset or the A, the fund would use the price from
or market maker to a trading party that amount paid to transfer a liability. If a Exchange A. If the fund does not have
is not firm and the broker-dealer is fund cannot gain access to the principal access to Exchange B, the fund would
not obligated to transact at the quote or the most advantageous market, it use the price from Exchange A.
provided. Therefore, a fund must evaluate would not be permissible to use that
whether the quote is readily available market to estimate fair value. 20. How can a fund determine, in
and distributed to the participants in quantitative terms, the definition
that market. In addition, a fund must 19. A fund purchases a security on of an active market?
evaluate whether the quote is reliable Exchange A. The security is
and verifiable. If a fund cannot obtain traded on both Exchange A and An active market is defined as a market
transparency to understand these B. Exchange B has more liquidity in which transactions for the asset or
issues as well as the inputs used to and is more active than Exchange liability occur with sufficient frequency
arrive at the quote, the quote would not A. Does the fund determine the and volume to provide pricing information
be an observable input and the related fair value of the security using on an ongoing basis. Currently, there
security would generally result in a Exchange A or B prices? has not been any quantitative guidance
Level 3 designation. issued by the SEC, FASB or other industry
When measuring fair value under participant on the definition of an active
Fair Value Hierarchy- ASC 820, a reporting entity must market. However, ASC 820 provides
Level 1 Considerations first determine the principal or most factors to consider in determining whether
advantageous market. The principal there has been a significant decrease in
18. How does a fund determine the market is the one where the fund has the volume or level of market activity. The
principal or most advantageous regularly transacted in the security. factors that a fund should evaluate include
market? If the fund cannot identify a principal (but are not limited to) the following:
market, the most advantageous market
36 Rothstein Kass
• There are few recent transactions. 21. For exchange-traded equities, can able to absorb the entire block without
• Price quotations are not based on a fund use the consolidated tape significantly impacting the market price
current information. to price the securities? of the security. If a fund determines
• Price quotations vary substantially either that the position is not actively traded,
over time or among market makers. The “consolidated tape” is a high-speed, a liquidity discount can be taken if, from
• Indexes that were correlated with the electronic system that constantly reports the perspective of the market participant,
fair values of the asset are demonstrably the latest price and volume data on sales the fair value exit price would include this
uncorrelated with indications of fair of exchange-listed stocks. The data discount. It is important to note that U.S.
value for that asset. reflected on the consolidated tape derives GAAP currently does not contain explicit
• There is a significant increase in implied from various market centers, including guidance on the use of a blockage
liquidity risk premiums, yields, or all securities exchanges, electronic discount for fair value measurements
performance indicators for observed communications networks and third- categorized within Level 2 or Level 3 of
transactions or quoted prices when market broker-dealers. Under ASC 820, a the fair value hierarchy. However, as part
compared with the fund’s estimate fund would not use the consolidated tape of their convergence project, the FASB
of expected cash flows. but choose the price from the exchange and the IASB are proposing to extend
• Wide bid-ask spread or significant that is either the principal market or if the prohibition of a blockage discount
increases in the bid-ask spread. no principal market exists, the most to all fair value measurements of
• Significant decline or absence of a advantageous market. financial instruments.
market for new issuances (that is, a
primary market). (Editor’s note: If a fund continues to 23. Is a fund required to disaggregate
• Little information is released publicly (for use the “consolidated tape” for pricing, Level 1 investments in the footnotes
example, a principal-to-principal market). it should set up an internal accounting to the financial statements by industry
system to document that any differences or geographic concentrations if Level
In determining an “inactive” market for against the principal market or most 1 investments are already disclosed
thinly traded securities, we recommend advantageous market are immaterial on the SOI?
that a fund download the trading volumes throughout the fiscal year.)
for those securities along with their To the extent the required Level 1
price feeds on a periodic basis. We 22. Block Discounts — Can a fund investments disaggregation information
also recommend that a fund develop take a “haircut” off the price of a is included elsewhere in the financial
a system that would highlight when a position in a small cap company? statements (i.e., the condensed schedule
security’s average trading volume does of investments), there would not be a
not meet a certain quantitative threshold It depends. The first step is to determine need to repeat the Level 1 investment
(to be determined by management). whether the security is actively traded. disaggregation information in the fair
This reporting system should generate ASC 820 prohibits the use of block value hierarchy level tabular disclosure.
an exception report for management discounts for securities traded in an In such cases, we recommend adding
to evaluate whether securities with low active market (Level 1). Under previous a reference to the fair value hierarchy
trading volume should be designated authoritative U.S. GAAP, a block discount disclosure indicating that the required
as Level 1 or 2 securities. was applied to the price of a large disaggregation of Level 1 investments
position when the market would not be are disclosed in the SOI.
Rothstein Kass 37
Fair Value Hierarchy—Level 2 The application of a standard discount valued using a widely accepted and
and Level 3 Considerations rate to investments such as restricted non-proprietary model where the
stock or a PIPE would not comply inputs, such as implied volatility,
24. Should a discount be taken when with ASC 820. A fund would need to are observable, the options would
determining the fair value of a consider the quality of the investment also typically be assigned a Level 2
restricted stock? as well as the changing circumstances designation. Options that are priced
surrounding its restrictions. Careful via a model using historical volatility,
A fund must assess the reason for the analysis of all relevant drivers of the other unobservable inputs, or include
restriction and whether the restriction discount, including but not limited to the significant judgments and adjustments
would be a consideration by market length of restriction, float and market to arrive at fair value, would typically be
participants when determining its fair capitalization of the issuer, liquidity of assigned a Level 3 designation.
value. If the starting point of valuation the market place and other qualitative
is the exchange-traded price of an and quantitative factors specific to 28. What is the level designation in
unrestricted stock, typically a discount the security should be evaluated in the fair value hierarchy for PIPEs
would be taken to arrive at fair value determining the appropriate discount rate. including the warrants typically
since a market participant would assess attached to those transactions?
a higher risk for the restricted position 26. Are total return swaps where the
and thus demand a higher than expected underlying notional position is an For a PIPE investment where the fair
internal rate of return. However, when actively traded security (i.e., Level value is primarily based on the price of
a member of fund management is on 1 security) considered Level 1 or the actively traded public equity similar
the board of directors of a holding and Level 2? to the unit of account, the PIPE would
therefore the fund has certain restrictions typically be Level 2. If a liquidity discount
on sales of the related security, a discount The unit of measure is the total return from the underlying public equity price
would not be taken since the restriction swap contract and not the underlying is significant, the securities may fall
would not be transferred to a buyer of stock. A total return swap contract into Level 3. In addition, for convertible
the security. If the restriction is on the where the underlying notional position securities that are not “in the money,”
security and such restriction would is actively traded would likely fall into where the fair value is based upon the
transfer to the holder (e.g., Rule 144 Level 2, provided that the inputs used to underlying borrower’s credit worthiness
stock), a discount should be taken. determine the valuation are observable. and other unobservable inputs, they will
fall into Level 3.
25. Is it appropriate for a fund to 27. Where do options fall within the
adopt a policy of applying a fair value hierarchy? Typically, warrants in PIPE transactions
standard discount rate to its will fall into Level 3 since the input of
investments (i.e., restricted stock Options that are traded on an exchange historical volatility into a model is not
or private investments in public in an active market would be assigned an observable input. Warrants can
equity (PIPEs)) when measuring a Level 1 designation. Options that are occasionally fall into Level 2 if they
fair value? traded on an exchange in an inactive are in the money and the underlying
market would typically be assigned public security is actively traded or
a Level 2 designation. For options an observable implied volatility can
38 Rothstein Kass
be obtained from market data. The in the inputs to the valuation technique. should consider the use of valuation
challenge is to determine the lowest A hold-to-maturity mentality does not adjustments that reflect more current
level input that is significant to the fair conform to ASC 820 since it reflects an assumptions about market conditions.
value measurement. For in-the-money entity-specific assumption. ASC 820
warrants, the volatility may not be a requires the fair value measurement to 31. What level designation should
significant input to its fair value and thus reflect an exit price in current market a fund assign to a deferred fee
result in a Level 2 designation. It will be conditions, including the relative liquidity liability which is reinvested into
up to the judgment of management to of the market. the fund?
evaluate the significance of the inputs.
30. If there are no recent transactions A deferred fee liability has the
29. In an illiquid market (such as for an asset-backed security and a characteristics of a host debt
the asset-backed security market) fund uses matrix pricing comparing instrument with an embedded total
there can be a disconnect asset-backed securities that have return derivative feature which is
between the intrinsic value (e.g., similar attributes and vintages, or a indexed either to the fund’s rate of
the value determined by applying fund uses the ABX credit-derivative return, participation in specific assets
data inputs to a valuation which index to price the security, what of the funds, or a combination of
may presume the position would would be the resulting level both. Since the unit of account of the
be held to maturity) and what designation for these approaches? deferred fee liability is different from
the current quoted observable the underlying investments of the fund,
prices are for the security in the Using matrix pricing of similar asset- the deferred fee liability may not be
marketplace. Can the intrinsic backed securities that have recent designated as Level 1, even if all of the
value be used in lieu of the quoted observable transactions or using the underlying assets and liabilities are
prices when the current market ABX credit derivative index as a starting actively marked on a daily basis. Funds
is not active and therefore has point are Level 2 inputs. Adjustments may also consider analogized guidance
unusually large bid-ask spreads? to Level 2 inputs will vary depending of investments in private investment
on the factors specific to the security companies measured at fair value using
The use of unobservable inputs is (e.g., comparability, vintage, volume). the practical expedient based on the
appropriate only to the extent that However, any adjustment to the Level 2 ability to redeem at or within a near term
observable inputs are not available. inputs that is significant to the fair value of the reporting date when determining
ASC 820 states that entity-level inputs measurement will drop the designation between Level 2 and Level 3 designation.
(i.e., unobservable) can be used as long to Level 3. Funds should obtain
as there is not contrary data indicating an understanding of the processes
that market participants would use involved in constructing the ABX credit
different assumptions. If such contrary derivative index or other forms of
data exists, a fund must adjust its matrix pricing to determine if the matrix
assumptions to incorporate that market pricing is responsive to changes in
information. A fund must also consider market conditions in a timely manner.
the risk inherent in the valuation If the outputs of the matrix pricing are
technique used and the risk inherent indicative of stale transaction data, funds
Rothstein Kass 39
32. When is it appropriate to designate automatically be deemed near term. sale from the investee or a buyer’s due
a fund of funds investment in a Other facts and circumstances, such diligence procedures).
private investment company as as the likelihood or actual imposition • Actions required to complete the plan
a Level 2 investment in the fair of gates, and the liquidity of the indicate that it is unlikely that significant
value hierarchy? investee fund’s portfolio, should also changes to the plan will be made or that
be considered by the reporting fund in the plan will be withdrawn.
The unit of account for an investment in a determining the appropriate level within
fund of funds is the ownership interest in the hierarchy. In situations when there are If it is probable at the measurement
the underlying investee fund itself (in other material adjustments to NAV to arrive at date that a reporting fund will sell an
words, the investment being evaluated fair value the result will typically be a investment, or a portion of an investment,
is the limited partnership interest or the Level 3 designation. at an amount different from NAV, the
offshore shares issued by the underlying portion that the reporting fund intends to
investee fund, not the underlying 33. How does the probable sale of an sell should be valued according to other
investee funds investments). When investment for an amount other provisions of ASC 820. Other provisions of
determining whether the investment than NAV affect the investments fair ASC 820 can include a market or income
will be categorized as Level 2 or Level value measurement and the use of based valuation approach. The remaining
3 within the fair value hierarchy, the NAV as a practical expedient? portion of the investment that is not
reporting fund must consider the length probable of being sold may be valued
of time remaining until the investment ASC 820 states that the use of NAV as a by using NAV as a practical expedient.
becomes redeemable. As long as the practical expedient cannot be used when
reporting fund has the contractual and it is probable that a reporting entity will However, if a fund enters into a plan
practical ability to redeem its investment sell an investment at an amount other to sell a group of investments, but the
in a fund of funds at the NAV in the near than NAV. A sale is considered probable individual investments to be sold have
term at the measurement date, then the only if all of the following criteria have not yet been identified, the individual
investment may be classified as Level been met as of the reporting entity’s investments will continue to qualify for
2, even if a redemption notice was not measurement date: the practical expedient.
submitted. “Near term” is a matter of
professional judgment, and historically • Management, having the authority to 34. What fair value hierarchy level
has been defined by the FASB as a approve the action, commits to a plan to designation would a fund assign
period of time not to exceed one year sell the investment. to an investment in a private
from the measurement date. However, • An active program to locate a buyer investment company when the
a redemption period of 90 days or less and other actions required to complete private investment company has
would likely be considered near term since the plan to sell the investment have a portion of its investment held
any potential discount relative to the time been initiated. in a side-pocket?
value of money to the next redemption • The investment is available for
date would not likely be considered immediate sale subject only to terms The fair value hierarchy level designation
a significant unobservable input. It is that are usual and customary for sales for an investment in a private investment
important to note that a redemption of such investments (for example, a company may be bifurcated between
period of 90 days or less should not requirement to obtain approval of the the general class or liquid portion of the
40 Rothstein Kass
investment and side-pocket portion of • The investee fund’s fair value estimation 36. What should a fund consider as
the investment. The side-pocket portion processes and control environment, part of the requirement to disclose
of the investment would generally be and any changes to those processes information about the inputs and
classified in Level 3 and the general or the control environment. valuation techniques for Level 2
class or liquid class may qualify for • The investee fund’s policies and and 3 measurements?
Level 2 classification. procedures for estimating fair value
of underlying investments, and any Funds should consider the significance
35. How does a fund conclude that changes to those policies or procedures. and risk factors associated with an
NAV, as most recently reported • The use of independent third party investment class in determining an
by the investee fund manager, valuation experts to augment and appropriate level of detail for the
has been calculated according validate the investee fund’s procedures disclosure of the valuation inputs and
to the measurement principles for estimating fair value. techniques used, with an emphasis
of ASC 946? • The professional reputation and standing towards investments with a higher degree
of the investee fund’s auditor. of subjectivity in the valuation process (i.e.,
A fund is responsible for the valuation • Qualifications, if any, of the auditor’s Level 3 investments). When determining
assertions in its financial statements. report on the investee fund’s the appropriate detail of valuation inputs,
Determining that reported NAV is financial statements. funds should consider quantitative
calculated consistently with ASC • Whether there is a history of significant information about the inputs (e.g.,
946, including measurement of all adjustments to the NAV reported by the prepayment rates, default rates, interest
or substantially all of the underlying investee fund manager as a result of rates, discount rates, and volatilities),
investments of the investee in the annual financial statement audit the nature and detailed characteristics of
accordance with ASC 820, requires a or otherwise. the item being measured, and how third-
fund to independently evaluate the fair • Findings in the investee fund’s advisor party information such as broker quotes,
value measurement process utilized by or administrator’s SAS 70 report, if any. pricing services, net asset values and
the investee fund manager to calculate • Whether NAV has been appropriately relevant market data was considered in
the NAV. Such an evaluation is a matter adjusted for items such as carried measuring fair value.
of professional judgment and includes interest and clawbacks.
determining that the investee fund • Comparison of historical realizations In many instances, a qualitative
manager has an effective process and to last reported fair value. description of valuation inputs may
related internal controls in place to be sufficient to describe the valuation
estimate the fair value of its investments If the NAV reported by an investee fund is inputs used. However, funds should
that are included in the calculation of not deemed to be calculated consistently also consider disclosures of quantitative
NAV. In making this determination, a with ASC 946, the reporting fund may information on valuation inputs based
fund might consider the following key need to determine an adjustment to on assumed market participant
factors relating to the valuation received reported NAV in order to use the practical parameters (e.g., discount rates, market
from the investee fund manager: expedient to measure the fair value of a comparable multiples, market yields,
private investment company. default rates, etc.) when the magnitude
of subjectivity intrinsic to the investment
valuations warrant a greater degree of
Rothstein Kass 41
transparency in the disclosures. We do company, a fund should consider (1) the 39. For a private loan receivable,
not believe that specific quantitative timing and pricing of a recent round of does ASC 820 require an
amounts based on unobservable data financing, and (2) whether any material adjustment to the fair value
such as revenue streams and cash events occurred subsequent to the based on movements of interest
flow projections provide meaningful transaction that would impact the fair rates for similar loans in the
information, especially when aggregated value measurement on the measurement marketplace (even though the
at the investment class level. In addition, date. Since capital structures of a private underlying credit of the borrower
we do not believe that inputs that are company can be complex, a full analysis has not deteriorated)?
specific to an individual investment to of the contractual terms of a recent round
a class which does not correlate to the of financing must be part of the fair value Yes. If the private loan receivable is
class as a whole, such as a quoted price measurement process. Generally, private a fixed rate or floating rate loan and
for a stock or debt instrument or a recent equity investments will be classified as interest rates for similar loans have
round of financing, provide meaningful Level 3. ASC 820 encourages multiple moved, a market participant would
quantitative detail to the investment class valuation techniques when dealing factor in that movement into the fair
as a whole. However, these inputs would with Level 3 investments. When using value of the private loan. This poses
be relevant from a qualitative basis and multiple valuation techniques, a fund’s challenges to funds that originate loans
should be disclosed in the discussion of management may place greater weight when their existing valuation policy
valuation inputs used. on the most recent round of financing is to generally carry loans at par unless
over valuation methods such as there is a default or impairment (which
When multiple valuation techniques are discounted cash flow projections, or a would require a write down). ASC 820
used within an investment class, we multiple of revenues or EBITDA derived requires that these funds look to the
recommend as a best practice for funds from market comparables. market to see what the current yields are
to disclose the aggregate fair values by for similar loans and adjust the carrying
the valuation methodology utilized. 38. Should transaction costs value of the loans to reflect market
associated with the acquisition participant assumptions. Funds should
Fair Value Hierarchy—Level 3 of an investment be capitalized also consider collateral values as part of
Considerations-Investments in into the cost of the investment the assumptions of expected recoveries
Private Operating Companies or expensed as incurred? for loans that are nonperforming.
37. For an investment in private Under ASC 946 a reporting entity should 40. Can a fund rely on other disclosures
operating companies, how does capitalize transaction costs into the within the financial statements in
a recent round of financing initial cost basis of the investment. lieu of applying the disaggregation
factor into the fair value inputs in A reporting entity would then measure requirements to the disclosure of
arriving at fair value, as well as the investment at fair value which may the Level 3 rollforward?
the level designation within the result in an immediate unrealized loss
fair value hierarchy? on the investment. Generally the other disclosures within
the financial statements do not provide
When determining fair value for its sufficient disaggregated detail of
investment in a private operating the activity of a fund’s investments
42 Rothstein Kass
by discrete classes of assets and We recommend that funds consider the to adopt new valuation procedures
liabilities. The disaggregation of significance of activity within meaningful to track the availability of alternate
fair value disclosures requires that classes during the reporting period as unobservable inputs on a recurring
significant judgment and consideration a primary metric in determining the basis. This may result in substantial
should be given to the nature and appropriate level of detail which should costs to retain the use of specialists
risks relevant to the asset and liability be provided for the disclosure of the or to develop the in-house expertise
classes measured at fair value on Level 3 rollforward. to identify the unobservable inputs
a recurring basis. We believe that appropriate for the circumstances. Funds
consideration of the Level 3 activity 41. What is the expected impact of the may be subject to additional scrutiny
components, such as significant proposed disclosure requirement about the potential impact on their
investment purchases or significant of a measurement uncertainty NAVs resulting from the presentation
valuation write-downs, provides a analysis for Level 3 investments? of alternative unobservable inputs.
more meaningful basis for granular As an additional risk management
disclosure for a class of shared The proposed guidance from the FASB practice, funds may need to implement
economic exposures (e.g., industry, and IASB joint project to converge fair documentation processes to justify
geographic, vintage, etc.) than value measurement and disclosure their use of a given input over other
an evaluation solely based on the requirements may require funds to available alternatives as part of the
significance of investment balances disclose a measurement uncertainty valuation process. Furthermore,
as of the reporting date. analysis for its Level 3 investments. funds may need to determine their
The analysis would reflect the effects own benchmark of “significance” in
For example, a fund may hold a on a Level 3 fair value measurement of disclosures of the pro forma effects
substantial amount of private equity the changes in one or more inputs to on the fair value measurements.
investments that had little or no different amounts that could have been
transaction activity during the reporting reasonably used in the circumstances There may be difficulties in performing a
period, and is marked substantially and that would result in a significantly measurement uncertainty analysis when
at the same value as from the prior higher or lower fair value measurement. the information needed to prepare the
period. A disaggregated level of detail disclosure is not available. The availability
may be of limited use to the financial The responses received during the of inputs may be limited to indicative
statement users. However, a fund comment period for this proposed pricing from single broker quotes where
may hold investments in a distressed guidance reflect a consensus of a fund is unable to obtain transparency
industry within its private equity expecting significant costs and in the valuation techniques and inputs
portfolio which has been written down additional burden to implement the used by the broker. Funds may also use
to zero. A more granular detail of the measurement uncertainty analysis external pricing services which utilize
classes subject to significant activity disclosure. Funds with significant proprietary valuation models but do not
in the Level 3 rollforward may provide positions in Level 3 investments are provide access to the components of
meaningful information to the users of likely to incur significant costs in the model.
the financial statements. performing additional calculations
and to aggregate the effects into The proposed guidance may be required
meaningful classes. Funds may need for a fund’s Level 3 investments unless
Rothstein Kass 43
other accounting guidance precludes
this requirement. A separate joint project
between the FASB and IASB on Financial
Instruments intends to exclude the
measurement uncertainty analysis for
“unquoted equity instruments.” Several
comments from constituents point
out the uncertainty of which types of
instruments (e.g., investments in private
investment companies valued using
NAV under the practical expedient) are
included with the definition of “unquoted
equity instruments.” Furthermore, the
inclusion of the scope exception for
“unquoted equity instruments” within the
Financial Instruments joint project may
result in uncertainty in the application of
the scope exception if the effective period
is a later period than the initial adoption of
the measurement uncertainty analysis.
A final standard is expected to be issued
during the first quarter of 2011. As of press
time, there are many uncertainties relating
to the implementation of the measurement
uncertainty analysis of which the final
resolution of various constituent concerns
is not yet determinable. Rothstein Kass
continues to monitor the progress of this
topic and will provide additional guidance
when the final standard is issued.
44 Rothstein Kass
About the Authors
Ralph Natilli, CPA, is a principal based in the Firm’s Roseland, New Jersey office and specializes in
providing financial reporting, tax and accounting services to clients in the financial services industry.
He has experience working with a variety of clients including domestic and offshore investment
partnerships, funds of funds, investment advisors and related management entities. He is a certified
public accountant in New York, New Jersey and Massachusetts.
John Barbagallo, CPA, is a senior manager in the quality control group and is responsible for the
Firm’s accounting research and development. In that role, John monitors and analyzes current projects,
activities and decisions of FASB and IASB and provides comprehensive summaries, interpretations
and presentations to clients and members of the Firm. John is a certified public accountant in New York
and New Jersey.
Richard Sumida, CPA, is a senior director based in Rothstein Kass’ Roseland, New Jersey office.
As a member of Rothstein Kass’ quality control department, Rich is extensively involved in the research
and consultation of complex accounting and auditing issues relevant to the Firm’s client practices,
particularly within the alternative investment and broker-dealer industries. Rich is a certified public
accountant in New York and New Jersey.
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About the Editors
Howard Altman, CPA, is Co-CEO and Co-Managing Principal and the Principal-in-Charge of the Financial Services Group at
Rothstein Kass. He has more than 30 years experience in the financial services arena, with particular emphasis on investment
partnerships, offshore funds, private equity funds, funds of funds, registered investment advisers and broker-dealers. A specialist
in issues related to hedge fund structures, operations and tax matters, he is recognized nationally for his knowledge of the hedge
fund industry, the issues affecting it and prospective trends.
Chris Mears, CPA, is the Principal-in-Charge of Rothstein Kass’ New York Metro Financial Services Group. He has over 17 years
of experience in financial services, with a particular emphasis on investment partnerships, offshore funds, and private equity funds.
Chris advises alternative investment clients at the initial organizational phase to address the accounting and tax matters that may
have an impact on the fund. After fund formation, he typically oversees all services provided to the fund by the Firm, including the
audit and ongoing consultation regarding many diverse operational, transactional and tax matters.
About the Contributors
Vincent Calcagno, CPA, is the Principal-in-Charge of Rothstein Kass’ Southern California offices, located in Beverly Hills and
Orange County. Vincent specializes in audit, tax and consulting engagements for investment funds, registered investment
advisors and broker-dealers. He has extensive operational experience in the financial services industry.
Timothy Jinks, CPA, is responsible for Rothstein Kass’ compliance with accounting, auditing and professional standards for all
offices, and he oversees internal consultation on technical matters, quality control reviews of financial statements, client
acceptance, peer reviews, PCAOB compliance, internal inspections and monitoring.
About Rothstein Kass
Rothstein Kass is a premier professional services firm that has served privately held and publicly traded companies, as well as
high net worth individuals and families, for over 50 years. The firm provides audit, tax and advisory services to clients including
hedge funds, fund of funds, private equity, broker-dealers and registered investment advisors. The Rothstein Kass Financial
Services Group is consistently ranked as a top service provider to the alternative investment industry. We are experts in the
field, working with clients within the hedge fund industry to anticipate opportunities on the horizon as well as help them to
respond to short-term competitive challenges.
Beyond audit and tax services, Rothstein Kass provides a full array of integrated services, including strategic business counseling,
regulatory compliance and SEC advisory services, insurance and risk management consulting and family office services.
Rothstein Kass has offices in California, Colorado, New Jersey, New York, Texas and the Cayman Islands.
46 Rothstein Kass
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