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					SFAS 157 Fair Value Measurements:
Implementation Challenges for the
Alternative Investment Industry




Disclaimer: This publication has been prepared for general information and does not constitute professional advice. You should not act
upon information contained herein without obtaining specific professional advice. No representation or warranty is given to the accuracy
or completeness of the information herein. The content of this publication is based upon our interpretation of SFAS 157 and information
currently available. As a result, certain aspects of this publication may be superseded as new guidance or interpretations emerge.
September 2008


Dear Clients and Friends:


Rothstein Kass is pleased to present this guide regarding the current implementation issues regarding
Statement of Financial Accounting Standards No. 157, Fair Value Measurements.

Well before the credit crisis began in 2007, the Financial Accounting Standards Board (FASB) was
working on this statement in order to pull together the term “fair value” as it appeared in many different
authoritative references throughout the GAAP hierarchy. Needless to say, the FASB has tremendous
relevance to the financial services industry.

As leaders in providing auditing, tax and consulting services to the alternative investment community,
Rothstein Kass, as a trusted advisor, has extensive contact with our clients, their administrators and other
service providers, consulting with them in regard to their implementation issues and questions.

We believe that this guide presents a practical approach to implementing the requirements of this new
standard, including sample financial statement footnotes and a Frequently Asked Questions section.

While our intention is to clarify the fundamental aspects of SFAS 157, it is still clear that a mantra we have
used for many years concerning fair value still holds true today:

“Fair value is an art, not a science.”

In conclusion, we hope you find this paper helpful. Please reach out to me, Christopher Mears or any of
the Principals in our Financial Services Group if we can be of assistance.




Howard Altman
Co-Managing Principal
Rothstein Kass
SFAS 157 Fair Value Measurements:
Implementation Challenges for the
Alternative Investment Industry
Overview
Statement of Financial Accounting Standards No. 157 (“SFAS 157” or the “Standard”) was issued in September
2006 and is an accounting standard that provides guidance on how entities should measure fair value. The
following whitepaper was developed to provide guidance to the alternative investment fund industry (e.g., hedge
funds, private equity funds and fund of funds), herein referred to as “fund(s).”

Under generally accepted accounting principles (“GAAP”), there are various pronouncements throughout its
authoritative literature that make reference to “fair value” for recognition or disclosure purposes, but until SFAS
157, there was not a single pronouncement that provided uniform guidance on how to arrive at fair value. The
Standard is principle based as opposed to having specific rules for specific situations. This will clearly provide
challenges that may be frustrating at times, since implementation decisions will require management to use their
judgment in applying the Standard.

Fair value is defined by the Standard as the “price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.” It takes on an “exit
price” approach. Prior to issuance of the Standard, many measures of fair value under GAAP were based upon
the entry price or management’s “good faith” measurement. Under the Standard, the entry price cannot be
presumed to be representative of the fair value at initial recognition. Transactions between related parties or
under duress (“forced sales”) are examples that may preclude an entry price from approximating the fair value.
In addition, there may be instances in which the initial transaction occurs in a market different than the market
that the fund would have access to in exiting the investment. For example, a broker may transact in an inter-
dealer market where that market is not available to the fund. In addition, entry prices include transaction costs
that may not be recoverable in an exit price. These principles open the door to potentially recognizing “day one”
gains and losses on transactions.

Fair value is measured using all assumptions used by marketplace participants, including risk assumptions
considered by those participants. The measurement assumes an orderly, hypothetical transaction in the
principal market for the asset or liability. If no principal market exists, and there are multiple markets, then the
most advantageous market is used. (Editor’s note: this goes against the grain of “conservatism” but this
is clearly what the FASB recommends.) For illiquid securities where a market may not exist, the fund must
develop a fair value approach based upon a hypothetical market which incorporates assumptions potential
market participants would use in purchasing the security.


                                                                                                                  1
The most significant element of the Standard is the development of a three-level fair value hierarchy. Level 1
consists of the most “observable” market inputs to arrive at fair value (e.g., liquid securities). Level 2 would
broadly include securities valued using observable inputs other than quoted prices used to value Level
1 securities, while Level 3 consists of the most “unobservable” inputs (e.g., highly illiquid securities). The
Standard emphasizes the need to elevate the three-level hierarchy as high as possible to maximize the use of
observable inputs. For example, if the fund has market prices from an exchange or dealer market, the fund
cannot use an internal model (e.g., discounted cash flow model) and ignore readily available market prices. The
more illiquid the security, the greater there is need to use multiple valuation techniques to arrive at fair value.


What Are Observable Inputs?

Observable market inputs should not be limited to information that is only available to the entity making the
fair value determination or to a small group of users. Observable market inputs should be readily available
and distributed to participants in that market. In addition, observable market inputs should include a level
of transparency that is reliable and verifiable. Observable market inputs are typically a by-product of having
sources that are knowledgeable and active in the particular market. Management will have to use its judgment
to evaluate whether market inputs are “observable.”

Transaction-based market inputs tend to be more reliable. The range between bid-and-asked prices can
indicate as to whether the market is active or inactive. A more active market will generally dictate narrow
ranges between the bid-and-ask quotes with more illiquid markets having larger spreads.


Fair Value Hierarchy

The three levels of the hierarchy and the material inputs are as follows:


       Level 1 Inputs - include unadjusted quoted prices for identical assets or liabilities in active markets
       (e.g., exchange-traded securities). An active market is defined as a market in which transactions for
       the asset or liability occur with sufficient frequency and volume to provide pricing information on an
       ongoing basis.
       Level 2 Inputs - include quoted prices for identical assets in markets that are not active (e.g., thinly
       traded securities), quoted prices for similar assets (e.g., restricted securities, private investments in
       public companies, etc.), or market inputs other than directly observable quoted price. These “other
       market inputs” are often used in conjunction with valuation models and include interest rates, yield
       curves, prepayment speeds, default rates and other market-corroborated inputs.
       Level 3 Inputs - include those inputs that are not currently observable (e.g., an option-pricing model
       using historical volatility, an entity’s own data or assumptions as a multiple of earnings or discounted
       cash flow projections, etc.)


Refer to Exhibit 1 for a matrix of the levels and examples of securities that typically fall within each level.


2
Significance of an Unobservable Input

The level designation is based on the lowest level input that is significant to the fair value measurement.
Unfortunately, the term “significant” is not defined by the Standard. In assessing the significance of a market
input, the fund should consider the sensitivity of the fair value to changes in the input used. Assessing the
significance of an input will require judgment considering factors specific to the financial instrument being
valued. The tone from the top should be one of conservatism in assigning level designations to securities
with unobservable inputs. By the design of the principles-based standard, determining the significance of a
market input is a matter of judgment and two funds may have different conclusions.


Effective Date of SFAS 157

The effective date to implement the Standard is for fiscal years beginning after November 15, 2007 and
interim periods within those fiscal years. The major implementation challenges will be for funds with a year
ending December 31, 2008. The first implementation impacting financial statements will be calendar-year-
end funds that liquidate during 2008. For offshore funds with a June 30 fiscal year-end, June 30, 2009 will
generally be the first fiscal year for implementation.


Implementation Challenges

In order to successfully implement the requirements of the Standard, the best place to start is to understand
the “end game.” Management needs to understand the content and format of the financial statement
disclosures up front. The disclosures will become a tool for fund investors to use in order to look at an
overview of the fund’s portfolio. In addition to providing a framework in determining how to arrive at fair value,
the Standard provides more transparency to investors about the types of securities the fund is invested in, as
well as the portion of the fund’s performance derived from Level 3 securities. (Refer to Exhibit 2 for sample
financial statement disclosures required under the Standard.)

For a project of this importance, management needs to establish an effective project ownership team.
We recommend assigning a champion to the process who will effectively liaise between the investment
management team and other internal accounting and technology staff. Once the project team is established,
we recommend that they reach out to the CPA firm and administrator to gain an understanding of how to
add value to the project. By including them throughout the process, the fund can avoid unwanted surprises
during the year-end financial reporting process.

Many have underestimated the scope, complexity and time required for this implementation. The best
practice is to perform a soft close as of an interim date (e.g., September 30), which would include completing
the disclosures required by the Standard.




                                                                                                                3
Valuation Policies and Procedures

Auditors will want to review the fund’s valuation policies and procedures. In general, these policies should
address the following:

	       •	Methodology	on	level	designation
	       •	Definition	of	an	active	market	
	       •	The	level	of	average	trading	volume	and	frequency	that	will	deem	a	position	as	thinly	traded	(i.e.,		    	
          inactive), which will generally require a Level 2 designation
	       •	Determination	of	the	principal	and/or	most	advantageous	market
	       •	Identifying	aftermarket	events	and	their	impact	on	fair	value
	       •	Quantitative	and	qualitative	documentation	on	the	valuation	techniques	used,	including	how	they	fit		 	
          into the fair value hierarchy
	       •	Evaluating	the	effect	of	security	restrictions
	       •	Identifying	risk	assumptions	reflected	in	unobservable	inputs
	       •	Identifying	the	reports	that	will	provide	the	required	data	to	prepare	the	year-end	financial	statement			
          disclosures, including reconciliations of those reports to the books and records of the fund
	       •	Back	testing	of	realized	transactions	(Editor’s note: A best practice is back testing all material
          Level 2 and Level 3 securities by comparing the realized fair value with the fair value reported
          in the most recent financial reporting period.)

Management will need to continually monitor the fund’s front- and back-office accounting systems that will
be used to track and produce data. Level designations can change as dictated by continually evolving market
conditions.

In our preliminary discussions with funds and administrators, the consensus is that the tagging of securities
should be done on a monthly basis. The accounting system should have the necessary data fields to tag
each security and enable the fund to generate the level designations by security.

In addition, if the fund is engaging an administrator for preparation of financial statements, the fund should
understand the processes and data used by the administrator to prepare the SFAS 157 disclosures. The
champion of the implementation should manage the coordination with the administrator well before year-end.


Use of Third Party Pricing Services and Broker-Dealer Quotations

Understanding the nature and content of the services provided by the third party pricing services regarding
valuation information is management’s responsibility. Management must understand the methods used



    4
and determine whether the pricing data is transactional or model-based. If model-based, management
must understand the significant inputs used and how they are impacted by changing market conditions. In
addition, management must understand how and when changes to the methods and models used by third
party pricing services will be communicated and how they will impact the fund’s level designations.

The level of due diligence review of third party pricing services and quotes received from broker-dealers will
depend on facts and circumstances such as:

	      •	Type	and	complexity	of	the	security
	      •	Liquidity	of	the	market	and	extent	of	actual	transactions
	      •	Nature	and	complexity	of	pricing	methodologies	and	assumptions
	      •	Historical	accuracy		

Best practices should include an ongoing monitoring process to verify the reliability of the pricing
methodologies, assumptions and sources used. Back testing of pricing service valuations and broker-dealer
quotations should be part of the ongoing monitoring procedures.


Considerations for Level Designations
Level 1
Active vs. Inactive

Typically,	securities	traded	on	the	NYSE,	AMEX,	other	major	exchanges	and	the	NASDAQ	national	market	
will be classified as Level 1. When a security is thinly traded and not representative of an active market
(or if trading is halted), it will most likely be moved into Level 2. Share volume, spread between bid-and-
asked prices and frequency of trades are factors in determining level designation. The fund’s valuation
policy should include a quantitative threshold to determine an active market, which typically will be based
on average trading volume. The accounting system should develop an exception report based on this
quantitative threshold in order to determine the movement of securities between Level 1 and Level 2. As a
result, the fund should obtain the trading volume (e.g., last 30 days) of each position held at month-end.


Aftermarket Events

In addition, the Standard requires consideration of aftermarket events (this would include normal trading
days and when an accounting period ends on a non-business day, such as a weekend or holiday). The fund’s
valuation policy should monitor the variances between the last closing price and the aftermarket events.
Variances over a threshold amount determined by management should be reviewed and adjusted when
material. Any adjustment to the price provided by an exchange would move that security into Level 2.




                                                                                                                 5
Level 2
Liquidity Discounts

Level 2 will include restricted stock, private investments in public companies (PIPEs) and convertible bonds.
The fair value of these securities is generally based upon the price of the actively traded public equity price
on an “as if” converted basis less discounts applied to take into consideration legal restrictions, liquidity
risk and other risk assumptions. In practice, we have seen discounts typically range from 5% to 30% (with
higher discounts on a case-by-case basis). In situations where the discount is significant or when convertible
securities are not in the money, these positions will typically move into Level 3.

In applying liquidity discounts, a fund must consider assumptions used to arrive at fair value from the
perspective of a market participant. (Editor’s note: Consideration of the quantity of the security held by
the fund should not factor into the fair value determination.)

Derivatives Valued Using Models

In order for derivatives that are valued using models (e.g., interest rate swaps) to qualify for Level 2, the model
must be:

	       •	Widely	accepted
	       •	Non-proprietary	
	       •	Use	data	that	is	observable

Certain inputs can be derived through extrapolation and still maintain Level 2 status (e.g., extrapolating a five-
year interest rate yield into a seven-year yield). If there are significant judgments or adjustments to the model
or data, the derivatives will fall under Level 3. For example, the extrapolation of short-term inputs for longer-
term inputs may require additional assumptions or judgments that are not observable, therefore moving the
position to Level 3.

Level 3
Private Equity

Private equity will generally be Level 3, given the lack of observable market inputs. Many funds that own
private equity have traditionally recorded the fair value as the initial cost and adjusted when there was a new
round of financing. One of the talking points we have used with clients over the years in regard to private
equity is that “cost is not fair value, but fair value can approximate the cost.” The valuation policy should
document the fair value of private equity investments through internal analysis, review of financial statements
from the portfolio company and comparable public securities, etc.




    6
When considering a new round of financing into the fair value inputs, the following factors should be
considered:

	      •	Attributes	and	characteristics	of	the	transaction
	      •	Complexity	of	the	capital	structure
	      •	Proximity	to	reporting	date
	      •	Any	changes	in	the	portfolio	company	in	the	intervening	period	between	transaction	date	and		                	
         reporting date
	      •	Again,	cost	can	be	considered	(but	not	on	its	own)	since	it	cannot	be	presumed	to	be	fair	value

A best practice would include the use of multiple valuation techniques to supplement and corroborate the fair
value of a recent round of private equity financing.

Accounting for Transaction Costs

The Standard does not impact the accounting for transaction costs. In a private equity transaction, as
required by the AICPA Investment Companies Accounting and Audit guide, transaction costs should be
capitalized in the initial cost of the asset or liability. In many instances, there will initially be an unrealized
loss for a security that has capitalized transaction costs. Under the Standard, the fair value does not include
costs that are required to complete a sale transaction, such as commissions or closing costs. In summary,
day one recognition of gains or losses on purchases of assets or liabilities, reflecting the difference between
the fair value and the transaction price, are permissible under the Standard, which amends certain prior
GAAP pronouncements.

Fund of Funds Investments in Private Investment Funds

An issue that has been much discussed relates to where fund of funds investments fall in the fair value
hierarchy. A common question has been whether the fund of funds can “look through” to the underlying
investee funds’ investments for financial statement presentation. When the unit of account is another private
investment fund (in other words, the security being valued is a limited partnership interest or shares in an
offshore corporation), the answer is “no.” These investments will generally be classified as Level 3, unless
there is an observable public or over-the-counter market of transactions for the underlying investments.
(Editor’s note: Some funds of funds may want additional disclosure concerning the level distribution
that the underlying funds report to them. This may be done in the fund of fund financial statements
if all financial statements of the underlying funds are received by time of issuance or in a separate
communication or report to investors.)

Another topic that has had some strong views is the valuation for a fund of funds investment in other private
investment funds. What is clear is that the net asset value (NAV) is generally the most appropriate starting



                                                                                                                  7
point when determining fair value measurements.
There has been much discussion as to when an adjustment might be appropriate to the NAV of an underlying
investment fund. Some of the factors that should be considered:

	       •	Redemption	restrictions	(lock-up	terms)
	       •	Early	withdrawal	fees
	       •	Withdrawals	have	been	suspended	(temporarily	or	if	the	underlying	fund	is	in	liquidation)	
	       •	Fund	is	closed	to	new	investors

(Editor’s note: There is not one right answer. What is important is the consideration of these factors in a
fund of funds valuation policy which will reflect an exit price and be fair to existing and future investors
of the fund of funds.)

Additionally, similar to evaluating the effect of the security restrictions (see Level 2), side letter agreements will
generally not transfer to the “hypothetical” buyer of the fund of fund investment and therefore side letters will
typically not factor into the fund of fund investment’s fair value analysis.


Other Considerations
Accounting for Transfers between Levels

We are recommending that, as a best practice, a schedule documenting a year-to-date “roll forward” of all
levels be prepared and reconciled at the end of each month. CPA firms will request an audit trail from the
roll forward of the Level 3 securities (a required financial statement disclosure) to the books and records of
the fund. Since the designation is done monthly, transfers between levels will be recorded at the end of each
month. As discussed earlier, positions can move between levels during an accounting period. The valuation
policy should document the procedures that are in place to analyze the movement of securities between levels.

Distressed or Forced Sales

There are many questions concerning the language in SFAS 157 relating to distressed or forced sales. In
late 2007, the Center for Audit Quality (its governing board comprises leaders from the public company
auditing firms, the American Institute of CPAs, and the investor and issuer communities) issued a white paper,
Measurements of Fair Value in Illiquid Markets. The white paper commented that there is a high hurdle in
determining whether a sale is distressed or forced. Accordingly, even when the market is not active, values
from observed trading should be considered as a valuation input. It is inappropriate to ignore current quoted
prices and deem those transactions as distressed just because the market has become illiquid (e.g., in periods
of market dislocation).




    8
Next Steps

The implementation of the Standard has many challenges. Please refer to Exhibit 3 for frequently asked
questions in applying the Standard. The Standard has increased the complexity, internal resources and time
required for year-end financial reporting.

Implementation should include:

	      •	Documenting	policies	and	procedures	and	incorporating	the	Standard’s	nuances
	      •	Addressing	system	requirements	for	data	aggregation
	      •	Assigning	levels	on	a		monthly	basis	from	December	31,	2007	forward
	      •	Performing	a	dry	run	as	of	an	interim	date	by	completing	all	of	the	required	financial	footnote			       	
         schedules and disclosures
	      •	Coordinating	with	third	party	service	providers	(administrators,	CPA	firms,	pricing	services	and	prime
         brokers)




                                                                                                              9
Exhibit 1
Matrix of Levels and Typical Level Designations


                 Level                                 Types of Inputs                             Typical Instruments
                                                                                                         (Note 1)

Level 1 - Valuations based on quoted        Unadjusted quoted prices from an                Exchange-traded	securities,	most	U.S.	
prices in active markets for identical      exchange or broker-dealer market that is        government securities, certain other
assets or liabilities                       deemed to 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) and
prices in markets that are not active       broker-dealer market that is deemed             listed derivatives that are not actively
or for which all significant inputs are     to be inactive, brokered markets for            traded, most OTC derivatives, restricted
observable, either directly or indirectly   restricted securities, registered debt and      stock, corporate and municipal bonds,
                                            observable market inputs, such as equity        certain corporate loans, certain high-yield
                                            prices, yield curves, implied volatility,       debt, certain residential and commercial
                                            interest rates, prepayment speeds, loss         mortgage loans, certain mortgage-
                                            severities, credit risks, and default rates     backed securities (MBS), asset-backed
                                            (including those inputs extrapolated from       securities (ABS), and collateralized debt
                                            other observable inputs). (Note 2)              obligation (CDO) securities, futures
                                                                                            and forward contracts, and physical
                                                                                            commodities.

Level 3 - Valuations based on inputs        Models utilizing significant inputs that are    Certain corporate loans, certain
that are not observable and significant     unobservable (e.g., historical volatilities);   mortgage loans, certain high-yield
to the overall fair value measurement       such as Black-Scholes, discounted cash          debt, distressed debt (i.e., securities of
                                            flows,	multiples	of	earnings	or	EBITDA	         issuers encountering financial difficulties,
                                            including risk assumptions consistent           including bankruptcy or insolvency),
                                            with what market participants would use         certain MBS, ABS and CDO securities,
                                            to arrive at fair value.                        investments in real estate funds and other
                                                                                            private investment companies, private
                                                                                            equity investments, and 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).

Note 1 - Level designation is based upon the lowest level input that is significant to the fair value of the measurement of
the security and actual designation may vary from the “typical” designations illustrated above, based on actual 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 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	not	traded	in	an	active	market	or	the	prices	from	the	exchange	that	are	adjusted	due	
to aftermarket events would be assigned a Level 2 designation.




10
Exhibit 2
Sample Financial Statement Footnote Disclosures

The illustrative financial statement footnote disclosures that follow have taken into consideration the
requirements outlined in SFAS 157. Level designation within the fair value hierarchy should be based
on the lowest level input that is significant to the fair value measurement of the security and may vary
from the designations illustrated in the disclosures below.

Significant Accounting Policy Footnotes

Valuation of Investments in Securities and Securities Sold Short at Fair Value-Definition and Hierarchy

The Fund adopted the provisions of SFAS No. 157, “Fair Value Measurements” (SFAS No. 157), effective
January 1, 2008. Under SFAS No. 157, fair value is defined as the price that would be received to sell an
asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants
at the measurement date.

In determining fair value, the Fund uses various valuation approaches. SFAS No. 157 establishes a fair value
hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes
the use of unobservable inputs by requiring that the most observable inputs be used when available.
Observable inputs are those that market participants would use in pricing the asset or liability based
on market data obtained from sources independent of the Fund. Unobservable inputs reflect the Fund’s
assumption about the inputs market participants would use in pricing the asset or liability developed based
on the best information available in the circumstances. The fair value hierarchy is categorized into three levels
based on the inputs as follows:

       Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or
       liabilities that the Fund has the ability to access. Valuation adjustments and block discounts are not
       applied to Level 1 securities. Since valuations are based on quoted prices that are readily and
       regularly available in an active market, valuation of these securities does not entail a significant degree
       of judgment.

       Level 2 - Valuations based on quoted prices in markets that are not active or for which all significant
       inputs are observable, either directly or indirectly.

       Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value
       measurement.




                                                                                                                   11
Sample Financial Statement Footnote Disclosures (continued)

The availability of valuation techniques and observable inputs can vary from security to security and is
affected by a wide variety of factors, including the type of security, whether the security is new and not
yet established in the marketplace, and other characteristics particular to the transaction. To the extent
that valuation is based on models or inputs that are less observable or unobservable in the market, the
determination of fair value requires more judgment. Those estimated values do not necessarily represent
the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be
reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be
materially higher or lower than the values that would have been used had a ready market for the securities
existed. Accordingly, the degree of judgment exercised by the Fund in determining fair value is greatest
for securities categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into
different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value
hierarchy within which the fair value measurement falls in its entirety is determined by the lowest level input
that is significant to the fair value measurement.

Fair value is a market-based measure considered from the perspective of a market participant rather than an
entity-specific measure. Therefore, even when market assumptions are not readily available, the Fund’s own
assumptions are set to reflect those that market participants would use in pricing the asset or liability at the
measurement date. The Fund uses prices and inputs that are current as of the measurement date, including
during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs
may be reduced for many securities. This condition could cause a security to be reclassified to a lower level
within the fair value hierarchy.

Valuation Techniques

The Fund values investments in securities and securities sold short that are freely tradable and are listed on a
national securities exchange or reported on the NASDAQ national market at their last sales price as of the last
business day of the year.

Many cash and over-the-counter (OTC) contracts have bid-and-ask prices that can be observed in the
marketplace. Bid prices reflect the highest price that the marketplace participants are willing to pay for an
asset. Ask prices represent the lowest price that the marketplace participants are willing to accept for an
asset. For securities whose inputs are based on bid-ask prices, the Fund’s valuation policies require that
fair value be within the bid-ask range. The Fund’s policy for securities traded in the OTC markets and listed
securities for which no sale was reported on that date are valued at their last reported “bid” price if held long,
and last reported “asked” price if sold short.




12
Sample Financial Statement Footnote Disclosures (continued)

Fair value for many cash and OTC derivative contracts is derived using pricing models. Pricing models take
into account the contract terms (including maturity), as well as multiple inputs, including where applicable,
time value, implied volatility, equity prices, interest rate yield curves, prepayment speeds, interest rates, loss
severities, credit risks, credit curves, default rates and currency rates.


OTC Derivative Contracts

OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign
currencies, the credit standing of reference entities, equity prices or commodity prices.

Depending on the underlying security and the terms of the transaction, the fair value of certain OTC
derivatives may be able to be modeled using a series of techniques, including closed-form analytic formulas,
such as the Black-Scholes option-pricing model, simulation models or a combination thereof. Certain pricing
models do not entail material subjectivity as the methodologies employed include pricing inputs that are
observed from actively quoted markets (as is the case of generic interest-rate swap and option contracts). In
the case of more established derivative contracts, the pricing models used by the Fund are widely accepted
by marketplace participants. OTC derivative contracts are generally categorized in Levels 2 and 3 of the fair
value hierarchy.

Government Bonds

The fair value of sovereign government bonds is generally based on quoted prices in active markets. When
quoted prices are not available, fair value is determined based on a valuation model that uses inputs that
include interest-rate yield curves, cross-currency-basis index spreads, and country credit spreads similar to
the bond in terms of issuer, maturity and seniority. Sovereign government bonds are generally categorized in
Levels 1 or 2 of the fair value hierarchy.

Municipal Bonds

The fair value of municipal bonds is estimated using recently executed transactions, market price quotations
and pricing models that factor in, where applicable, interest rates, bond- or credit-default swap spreads and
volatility. These bonds are generally categorized in Level 2 of the fair value hierarchy.




                                                                                                                 13
Sample Financial Statement Footnote Disclosures (continued)

Corporate Bonds

The fair value of corporate bonds is estimated using recently executed transactions, market price quotations
(where observable), bond spreads or credit default swap spreads. The spread data used are for the same
maturity as the bond. If the spread data does not reference the issuer, then data that references a comparable
issuer is used. When observable price quotations are not available, fair value is determined based on cash
flow models with yield curves, bond, or single-name credit default swap spreads and recovery rates based
on collateral values as key inputs. Corporate bonds are generally categorized in Level 2 of the fair value
hierarchy. In instances where significant inputs are unobservable, they are categorized in Level 3 of the
hierarchy.


Bank Debt

The fair value of bank debt is generally valued using recently executed transactions, market price quotations
(where observable) and market-observable credit default swap levels. When quotations are unobservable,
proprietary valuation models and default recovery-analysis methods are employed. Bank debt is classified in
Levels 2 or 3 of the fair value hierarchy.

Commercial Mortgage-Backed Securities (CMBS) and Asset-Backed Securities
(ABS)

CMBS	and	ABS	may	be	valued	based	on	external	price/spread	data.	When	position-specific	external	
price data are not observable, the valuation is based on prices of comparable securities. Included in
this category are certain interest-only securities, which, in the absence of market prices, are valued as a
function of observable whole-bond prices and cash flow values of principal-only bonds using current market
assumptions at the measurement date. CMBS and ABS are categorized in Level 2 of the fair value hierarchy
when external pricing data is observable and in Level 3 when external pricing data is unobservable.

Investments in Private Equity

The Fund’s investments in private equity consist of direct private equity investments. The transaction price,
excluding transaction costs, is typically the Fund’s best estimate of fair value at inception. When evidence
supports a change to the carrying value from the transaction price, adjustments are made to reflect expected
exit values. Ongoing reviews by Fund management are based on an assessment of each underlying
investment, incorporating valuations that consider the evaluation of financing and sale transactions with
third parties, expected cash flows and market-based information, including comparable transactions, and
performance multiples, among other factors. These nonpublic investments are included in Level 3 of the fair
value hierarchy.


14
Sample Financial Statement Footnote Disclosures (continued)

Investments in Special Purpose Vehicles

The Fund’s investments in Special Purpose Vehicles (SPVs) are either offshore private investment companies
or United States corporations that invest directly or indirectly through joint ventures or United States
limited liability companies in private equity or debt securities, real estate or intangible property. The Fund’s
investments in these SPVs are stated at fair value by evaluating the fair values of the net assets of the SPVs.
The net assets of each underlying SPV are valued-based on each underlying investment within the SPV
incorporating valuations that consider the evaluation of financing and sale transactions with third parties,
expected cash flows and market-based information, including comparable transactions, and performance
multiples, among other factors. Investments in SPVs are included in Level 3 of the fair value hierarchy.

Investments in Private Investment Companies

Investments in private investment companies are typically valued utilizing the net asset valuations provided
by	the	underlying	private	investment	companies	and/or	their	administrators.	Fund	management	considers	
subscription and redemption rights, including any restrictions on the disposition of the interest in its
determination of fair value. Investments in private investment companies are included in Level 3 of the fair
value hierarchy.

Physical Commodities

The Fund trades various physical commodities, including crude oil and related refined products, metals and
agricultural products. Fair value for physical commodities is determined using observable inputs, including
broker quotations and published indices. Physical commodities are categorized in Level 2 of the fair value
hierarchy.




                                                                                                              15
Sample Financial Statement Footnote Disclosures (continued)


Note X-Fair Value Measurements

The Fund’s assets and liabilities recorded at fair value have been categorized based upon a fair value
hierarchy	in	accordance	with	SFAS	No.	157.		See	Note	X	for	a	discussion	of	the	Fund’s	policies.	

The following table presents information about the Fund’s assets and liabilities measured at fair value as of
December 31, 2008 (in thousands):


                                    Quoted Prices in
                                                            Significant Other             Significant
                                   Active Markets for                                                              Balance as of
                                                            Observable Inputs            Unobservable
                                    Identical Assets                                                             December 31, 2008
                                                                (Level 2)               Inputs (Level 3)
                                        (Level 1)

 Assets (1)
 Investments in securities,                       $ 910                  $ 1,291                   $ 1,065                 $ 3,266
 at fair value

 Investments in special
 purpose vehicles,
 at fair value
                                                                                                           300                  300


 Investments in private
 investment companies,
 at fair value
                                                                                                           250                  250


 Derivative contracts,
 at fair value (2,3)                                                            300                        200                  500

                                              $     910                  $ 1,591                   $ 1,815                 $ 4,316
 Liabilities
 Securities sold short,                       $ 1,850                    $      300                $       180             $ 2,330
 at fair value

 Derivative contracts,
 at fair value (2,3)                                                            250                        100                  350

                                              $ 1,850                    $      550                 $      280             $ 2,680


Editors’ Notes:
(1) SFAS 157’s disclosure requires fair values by level for “each major asset and liability category.” It is permissible to
provide greater detail in the above table to conform to the categories disclosed in the condensed schedule of investments (e.g.,
corporate equities, options, U.S. government securities, corporate and other debt, etc.).
(2) Amounts represent the impact of counterparty netting across levels of the fair value hierarchy. Netting among positions
classified within the same level is included within that level.
(3) The FASB agreed that the presentation of derivatives on a gross basis would be more meaningful; as a result, the above
presentation is presented on a gross basis, however, the FASB does allow derivatives to be presented net.



16
Sample Financial Statement Footnote Disclosures (continued)


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 and liabilities measured at fair value for the year ended December 31, 2008
(in thousands):



                                                                                                                             Change in
                                                                                          Net              Level 3           Unrealized
                                  Level 3                                                                  Ending
                                                 Realized and      Purchases,          Transfers                           Gains (Losses)
                                Beginning
                                                  Unrealized        Sales and          In and/or          Balance         for Investments
                                 Balance
                                                Gains (Losses)     Settlements          (Out) of        December 31,        Still Held at
                              January 1, 2008
                                                                                        Level 3             2008           December 31,
                                                                                                                                2008

 Assets
 Investments in securities,             $ 290            $ 400            $ 250              $ 125            $ 1,065             $ 200
 at fair value

 Investments in special
 purpose vehicles, at fair
 value
                                                            20                280                                  300                  8


 Investments in private
 investment companies,
 at fair value
                                          150               50                 50                                  250                 40


 Derivative contracts,
 at fair value
                                          350             (175)                                    25              200                205


                                    $     790            $ 295              $ 580            $ 150            $ 1,815             $ 453
 Liabilities
 Securities sold short,                 $ 100        $     (10)          $     80           $      10           $ 180               $ (6)
 at fair value

 Derivative contracts,
 at fair value                       $     60              (20)                20                  40              100                (18)

                                        $ 160        $     (30)         $     100           $      50           $ 280             $ (24)


Realized and unrealized gains and losses are included in net gain (loss) on investments in the statement of operations. The change
in unrealized gains (losses) for the year ended December 31, 2008 for investments still held at December 31, 2008 of $242 and $187
are reflected in unrealized appreciation or depreciation of securities and net gain (loss) from derivative contracts, respectively, in the
statement of operations.



                                                                                                                                       17
Exhibit 3
Frequently Asked Questions

General Questions
1. What are the most significant differences between current practices under GAAP and SFAS 157-Fair Value
   Measurements?
2. If a fund changes its valuation methodology for a certain security, when is the adjustment to the fair value
   of the security recorded?
3. When is a valuation model acceptable under SFAS 157?
4. If there are multiple valuation techniques available, how does the fund determine the most appropriate
   valuation technique under SFAS 157?
5. What is the consequence for assigning incorrect levels?
6. Are the SFAS 157 disclosures reported on the condensed schedule of investments or in the footnotes to
   the financial statements?
7. For feeder funds, is the investment in the master fund a Level 3 investment?


Third Party Pricing/Broker-Dealer Quotations
8. Where does pricing from recognized third party pricing services and broker-dealers fall within the
   three-level hierarchy?
9. If a fund receives broker-dealer quotes from multiple broker-dealers, can an average of the
   broker-dealer quotes be used to arrive at fair value?
10. What level designation would the fund assign to a security where the fund can only get one quote
    with a large bid-ask spread from a broker-dealer that has provided a legal disclaimer on the
    quote?
11. When a fund receives multiple indicative broker-dealer, are the quotes considered
    observable or unobservable?
12. What would the level designation be for securities that rely on indicative broker-dealer quotes
    with legal disclaimers?


Fair Value Hierarchy—Level 1 Considerations
13. How does the fund determine the principal or most advantageous market?
14. A	security	is	purchased	on	Exchange	A	but	is	traded	on	Exchange	A	and	B.		Exchange	B	has	more	



18
						liquidity	and	is	more	active	than	Exchange	A.		Does	the	fund	price	the	security	using	Exchange	A	or	
      B prices?
15. How can a fund determine, in quantitative terms, the definition of an active market?
16. For exchange-traded equities, can the fund use the consolidated tape to price the securities?
17. Block Discounts—Can a fund take a haircut off the price of a position in a small-cap company?


Fair Value Hierarchy—Level 2 and Level 3 Considerations
18. In determining an “inactive” market for thinly traded securities, is there a quantitative
    measurement (such as number of days to liquidate based on trailing volume or daily volume) to
    assist in the evaluation?
19. Should a discount be taken on a restricted stock?
20. Are total return swaps where the underlying notional position is an actively traded equity (i.e,
    Level 1 security) considered Level 1 or Level 2?
21. Where do options fall within the fair value hierarchy?
22. What	level	are	private	investments	in	public	companies	(PIPEs)	and	the	warrants	typically					
                                                                                                 	         											 	
    attached to those transactions?
23. In an illiquid market (such as the asset-backed security market), can there be a disconnect
    between the intrinsic value (e.g., the value determined by applying data inputs to a valuation
    which may presume the position would be held to maturity) and what the current quoted
    observable prices are for the security in the market place? Can the intrinsic value be used in lieu
    of the quoted prices when the current market is not active and therefore has unusually large bid-
    ask spreads?
24. If there are no recent transactions for an asset-backed security and the fund uses matrix pricing
      comparing asset-backed securities that have similar attributes and vintages, or the fund uses the
						ABX	credit	derivative	index	to	price	the	security,	what	level	designation	would	these	approaches	
      result in?
25. Is a fund of funds investment in a private investment company always a Level 3 security?


Fair Value Hierarchy—Level 3 Considerations-
Private Securities
26. For an investment in private equity, how does a recent round of financing factor into the fair value
    inputs in arriving at fair value, as well as the level designation within the fair value hierarchy?
27. Should transaction costs on acquisition be capitalized in the cost of the security, or expensed
    as incurred?


                                                                                                                  19
28. For a private loan, does SFAS 157 require an adjustment to the “fair value” based on movements of
    interest rates in the marketplace (even though the underlying credit of the borrower has not deteriorated)?


Frequently Asked Questions

General Questions
1. What are the most significant differences between current practices under GAAP and SFAS 157-
   Fair Value Measurements?

The goal of SFAS 157 is to provide a framework that will increase consistency in developing fair value
measures as well as provide greater transparency to investors through increased disclosure in financial
statements. The basic valuation principles are broadly the same. A change in accounting may result in
situations where funds used an entry price to approximate fair value. SFAS 157 requires that an exit price
methodology is used. Day one gains or losses on the purchase of securities are now allowed (which amends
certain prior GAAP pronouncements ). In addition, some of the other differences from current practices that
SFAS 157 requires are:

	        •	Use	of	a	three-level	fair	value	hierarchy
	        •	No	blockage	discounts	allowed	for	Level	1	securities
	        •	Increased	financial	statement	disclosures
	        •	Requirement	to	determine	the	principal	market	or	most	advantageous	market
	        •	Use	of	a	market-based	measurement	instead	of	an	entity-specific	measurement
	        •	Adjustments	for	risk	of	using	certain	valuation	techniques	or	valuation	inputs
	        •	Adjustments	for	non-performance	risk	and	credit	rating	changes	in	valuing	liabilities

2. If a fund changes its valuation methodology for a certain security, when is the adjustment to the
   fair value of the security recorded?

Fair value measurements are accounting estimates and, except in certain instances addressed by SFAS 157
(e.g., elimination of blockage discounts), adjustments to the fair value of the security will be recorded in the
current accounting period ending on the valuation date of the security.




    20
Frequently Asked Questions (continued)

3. When is a valuation model acceptable under SFAS 157?

In most cases, the use of a valuation model is acceptable only when quoted prices in active markets are not
available. The inputs used in the model should include the assumptions that market participants would use
in pricing the asset in a current transaction even if the market participants’ assumptions are different from the
fund’s inputs. The fund can not ignore market data typically used by market participants. The best practice
is to back test models and calibrate the models’ assumptions to continually improve the valuation process
with the ultimate goal to arrive at an appropriate fair value.

4. If there are multiple valuation techniques available, how does the fund determine the most
   appropriate valuation technique under SFAS 157?

The valuation methods with the most observable inputs should be given priority over those that have
unobservable inputs. The overall theme of SFAS 157 is to elevate the three-level hierarchy as high as possible
and to use the most observable and reliable market inputs in fair value measurement. If one valuation
method proves to be a better representation of fair value than other methods, then that valuation method
should be used. However, multiple valuation methods can be combined to value a security. The weighting
of each valuation method will require judgment by the fund. Once the valuation methods are chosen, the
best practice is to use the methods chosen on a consistent and contemporaneous basis. If a change in
methods or a change in the combination of methods used will result in a better fair value measurement, the
change in approach is allowable. Any change in method is treated as a change in an accounting estimate
and the resulting impact on fair value should be recorded to income in the accounting period of the change.
In addition, when material, changes in valuation techniques will require disclosure in the footnotes to the
financial statements.

5. What is the consequence for assigning incorrect levels?

Assigning levels under SFAS 157 is part of the fund’s year-end financial reporting internal control system. If
the internal controls are not adequate to assign the correct levels, the deficiency may be deemed a significant
deficiency or material weakness which would require a comment in a SAS 112 letter.

6. Are the SFAS 157 disclosures reported on the condensed schedule of investments or in the
   footnotes to the financial statements?

SFAS 157 disclosures are not part of the condensed schedule of investments. The best practice is to include
the required disclosures of SFAS 157 within the footnotes to the financial statements.




                                                                                                              21
Frequently Asked Questions (continued)

7. For feeder funds, is the investment in the master fund a Level 3 investment?

Generally, SFAS 157 disclosures are not required for feeder funds whose sole investment is in a master fund.
Feeder fund disclosures should include a reference to the valuation and disclosures included in the attached
report of the master fund.


Third Party Pricing/Broker-Dealer Quotations
8. Where does pricing from recognized third party pricing services and broker-dealers fall within the
   three-level hierarchy?

Prices from recognized third party pricing services or broker-dealers can fall within Levels 1, 2 or 3. The fund
must gain an adequate level of transparency to understand the inputs used by the pricing services or broker-
dealers that support the prices provided.

9. If a fund receives broker-dealer quotes from multiple broker-dealers, can an average of the broker-
   dealer quotes be used to arrive at fair value?

The first step in the evaluation of broker-dealer quotes is to determine the principal market. If no principal
market exists, then the most advantageous market should be used. If the brokers that provided the quotes
are participants in the principal market, SFAS 157 allows for the use of pricing within the bid-ask price quotes
received and as a result, an average will be permissible.

10. What level designation would the fund assign to a security where the fund can only get one
    quote with a large bid-ask spread from a broker-dealer that has provided a legal disclaimer on
    the quote?

If the quote itself is not a firm commitment from the broker-dealer to transact at the price quoted or if the
broker-dealer is not willing to provide transparency, the input would generally result in a Level 3 designation.
Observable market inputs should be readily available and distributed to participants in that market. In
addition, observable market inputs should include a level of transparency that is reliable and verifiable. If the
fund is unable to obtain a level of transparency behind the pricing source, alternative valuation methods will
be required to support the fair value of the security.




22
Frequently Asked Questions (continued)

11. When a fund receives multiple indicative broker-dealer quotes, are the quotes considered
    observable or unobservable?

In order to evaluate whether broker-dealer quotes are observable, the fund must evaluate the availability of
those quotes to the marketplace as well as evaluate the consistency of the source. Observable market inputs
should not be limited to information that is only available to the entity making the fair value determination
(or to a small group of users). Observable market inputs should be readily available and distributed to
participants in that market. In addition, observable market inputs should include a level of transparency
that is reliable and verifiable. Management will have to use their judgment to evaluate whether inputs are
“observable.”

Transactional-based market inputs tend to be more reliable. The range between bid-and-asked prices can
be used to identify whether the market is active or inactive. A more active market will dictate more narrow
ranges between bid-and-ask quotes with illiquid markets having larger spreads.

12. What would the level designation be for securities that rely on indicative broker-dealer quotes
    with legal disclaimers?

An indicative broker-dealer quote is typically provided by a broker-dealer or market maker to a trading party
that is not firm and the broker-dealer is not obligated to transact at the quote provided. Therefore, the
fund must evaluate whether the quote is readily available and distributed to the participants in that market.
In addition, the fund must evaluate whether the quote is reliable and verifiable. If the fund cannot obtain
transparency to understand these issues as well as the inputs used to arrive at the quote, the quote would
not be an observable input and the related security would generally result in a level 3 designation.


Fair Value Hierarchy-Level 1 Considerations
13. How does the fund determine the principal or most advantageous market?

The principal market is the market in which the fund would sell the asset or transfer the liability with the
greatest volume and level of activity. If the fund cannot identify a principal market, the most advantageous
market should be used to arrive at fair value. The most advantageous market is the market that would assign
the highest fair value to an asset or the lowest fair value in transferring a liability. (Transaction costs should
be taken into consideration in determining the most advantageous market.) In making that determination,
the fund must calculate the net amount received from the sale of an asset or the amount paid to transfer a
liability. If the fund cannot gain access to the principal or the most advantageous market, it would not be
permissible to use that market to estimate fair value.




                                                                                                                23
Frequently Asked Questions (continued)

14. A security is purchased on Exchange A and is traded on both Exchange A and B. Exchange B has
   more liquidity and is more active than Exchange A. Does the fund price the security using
   Exchange A or B prices?

Under SFAS 157, the fund must first determine the principal market. The principal market is the one where
the fund has regularly transacted in the security. If the fund cannot identify a principal market, the most
advantageous market should be used to arrive at fair value. The most advantageous market is the market
which would assign the highest fair value to an asset or the lowest fair value in transferring a liability. If the
fund cannot gain access to the most advantageous market, it would not be permissible to use that market to
estimate fair value.

If the fund in this case transacts on both exchanges with neither being the principal market, the fund would
again	use	the	most	advantageous	market.		If	the	fund	only	transacts	on	Exchange	A,	the	fund	would	use	the	
price	from	Exchange	A.		If	the	fund	does	not	have	access	to	Exchange	B,	the	fund	would	use	the	price	from	
Exchange	A.

15. How can a fund determine, in quantitative terms, the definition of an active market?

An active market is defined as a market in which transactions for the asset or liability occur with sufficient
frequency and volume to provide pricing information on an ongoing basis. Currently, there has not been any
quantitative	guidance	issued	by	the	SEC,	FASB	or	other	industry	participant	on	the	definition	of	an	active	
market. SFAS 157 is principles-based and management will need to use judgment to determine what an
active market is. An active market will generally:

	        •	Provide	reliable	pricing
	        •	Provide	reasonably	narrow	observable	ranges	within	bid	ask	spreads
	        •	Be	supported	by	actual	market	transactions	that	are	typically	daily
	        •	Be	provided	by	sources	actively	involved	in	the	relevant	market	
	        •	Enable	a	participant	to	corroborate	pricing	on	a	historical	basis

16. For exchange-traded equities, can the fund use the consolidated tape to price the securities?

The “consolidated tape” is a high-speed, electronic system that constantly reports the latest price and volume
data on sales of exchange-listed stocks. The data reflected on the consolidated tape derives from various
market centers, including all securities exchanges, electronic communications networks and third-market
broker-dealers. Under SFAS 157, the fund would not use the consolidated tape but choose the price from the
exchange that is either the principal market or if no principal market exists, the most advantageous market.



    24
(Editor’s note: If a fund continues to use the “consolidated tape” for pricing, it should set up an
internal accounting system to document that any differences against the principal market or most
advantageous market are immaterial throughout the fiscal year.)

Frequently Asked Questions (continued)

17. Block Discounts—Can a fund take a haircut off the price of a position in a small cap company?

The first step here is to determine whether the security is actively traded. SFAS 157 prohibits the use of block
discounts for securities traded in an active market. Under previous authoritative GAAP, a block discount was
applied to the price of a large position when the market would not be able to absorb the entire block without
significantly impacting the market price of the security. If the fund determines that the position is not actively
traded, a liquidity discount can be taken if in the perspective of the market participant, the fair value exit price
would include this discount.


Fair Value Hierarchy—Level 2 and Level 3 Considerations
18. In determining an “inactive” market for thinly traded securities, is there a quantitative
    measurement (such as number of days to liquidate based on trailing volume or daily volume) to
    assist in the evaluation?

As defined by SFAS 157, transactions that occur with sufficient frequency and volume where pricing
information is available on an ongoing basis are considered to be “actively” traded. Currently, there are no
industry standard quantitative guidelines. We recommend that the fund downloads the trading volumes
along with their price feeds. We also recommend that the fund develop a system that would highlight when
a security’s average trading volume does not meet a certain quantitative threshold (to be determined by
management). This reporting system could develop an exception report for management to evaluate whether
securities with low trading volume are Level 1 or 2 securities.

19. Should a discount be taken on a restricted stock?

The fund must assess the reason for the restriction and whether the restriction would be a consideration by
market participants in pricing the security. If the starting point of valuation is the exchange-traded price of
an unrestricted stock, typically a discount would be taken to arrive at fair value since a market participant
would assess a higher risk for the restricted position and thus demand a higher than expected internal rate
of return. An anomaly of SFAS 157 occurs when a member of fund management is on the board of directors
of a holding and therefore the fund has certain restrictions on sales of the related security. In this situation
a discount would not be taken since the restriction would not be transferred to a buyer of the security. If the
restriction is on the security and such restriction would transfer to the holder (e.g., Rule 144 stock), a discount
should be taken.



                                                                                                                 25
Frequently Asked Questions (continued)

20. Are total return swaps where the underlying notional position is an actively traded security (i.e.,
    Level 1 security) considered Level 1 or Level 2?

The unit of measure is the total return swap contract and not the underlying stock. A total return swap
contract where the underlying notional position is actively traded would likely fall into Level 2.

21. Where do options fall within the fair value hierarchy?

For options traded on an exchange in an active market, the options would be assigned a Level 1 designation.
For options that are traded on an exchange (but not in an active market), the option would typically be
assigned a Level 2 designation. For options valued using a widely accepted and non-proprietary model
where the inputs, such as implied volatility, are observable, the options would also typically be assigned
a Level 2 designation. Options that are priced via a model using historical volatility, other non-observable
inputs, or include significant judgments and adjustments to arrive at fair value would typically be assigned a
Level 3 designation.

22. What level are private investments in public companies (PIPES) and the warrants typically
    attached to those transactions?

For	a	PIPE	investment	where	the	fair	value	is	based	on	the	price	of	the	actively	traded	public	equity,	the	PIPE	
would typically be Level 2. If the discount from the underlying public equity price is significant, the securities
will fall into Level 3. In addition, for convertible securities that are not “in the money” where the fair value is
based upon the underlying borrower’s credit worthiness and other unobservable inputs, they will fall into
Level 3.

Typically,	warrants	in	PIPE	transactions	will	fall	into	Level	3	since	the	input	of	historical	volatility	into	a	model	
is not an observable input. Warrants can occasionally fall into Level 2 if they are in the money and the
underlying public security is actively traded or an observable implied volatility can be obtained from market
data. The challenge is to determine the lowest level input that is significant to the fair value measurement.
For in the money warrants, the volatility may not be a significant input to its fair value and thus result in a Level
2 designation. It will be up to the judgment of management to evaluate the significance of the inputs.




26
Frequently Asked Questions (continued)

23. In an illiquid market (such as the asset-backed security market) there can be a disconnect
    between the intrinsic value (e.g., the value determined by applying data inputs to a valuation
    which may presume the position would be held to maturity) and what the current quoted
    observable prices are for the security in the marketplace. Can the intrinsic value be used in lieu
    of the quoted prices when the current market is not active and therefore has unusually large bid-
    ask spreads?

The use of unobservable inputs is appropriate only to the extent that observable inputs are not available.
SFAS 157 states that entity-level inputs (i.e., unobservable) can be used as long as there is not contrary data
indicating that market participants would use different assumptions. If such contrary data exists, the fund
must adjust its assumptions to incorporate that market information. The fund must also consider the risk
inherent in the valuation technique used and the risk inherent in the inputs to the valuation technique. A hold-
to-maturity mentality does not conform to SFAS 157. SFAS 157 requires the fair value measurement to reflect
an exit price in current market conditions, including the relative liquidity of the market.

24. If there are no recent transactions for an asset-backed security and the fund uses matrix pricing
    comparing asset-backed securities that have similar attributes and vintages, or the fund uses the
    ABX credit-derivative index to price the security, what would be the resulting level designation for
    these approaches?

Using matrix pricing of similar asset-backed securities that have recent observable transactions or using
the	ABX	credit	derivative	index	as	a	starting	point	are	Level	2	inputs.		Adjustments	to	Level	2	inputs	will	
vary depending on the factors specific to the security (e.g., comparability, vintage, volume). However, any
adjustment to the Level 2 inputs that is significant to the fair value measurement will drop the designation to
Level 3.

25. Is a fund of funds investment in a private investment company always a Level 3 security?

The unit of account for the fund of funds is the underlying investee fund itself (in other words, the security
being evaluated is the limited partnership interest or the offshore shares issued by the underlying investee
fund). Therefore, most fund of funds investments in private investment companies will typically be designated
as Level 3, unless there is an observable market of transactions for the limited partnership interest or offshore
shares.




                                                                                                              27
Frequently Asked Questions (continued)


Fair Value Hierarchy—Level 3 Considerations-
Private Securities
26. For an investment in private equity, how does a recent round of financing factor into the fair value
    inputs in arriving at fair value, as well as the level designation within the fair value hierarchy?

The fund should consider the timing and pricing of a recent round of financing and whether any material
events occurred subsequent to the transaction that would impact the fair value measurement on the
measurement date. Since capital structures of a private company can be complex, a full analysis of the
contractual terms must be part of the fair value process. Generally, private equity investments will be
classified as Level 3. SFAS 157 encourages multiple valuation techniques when dealing with Level 3
securities. When using multiple valuation techniques, the fund’s management may place a greater weighting
to the most recent round of financing over valuation methods such as discounted cash flow projections or a
multiple	of	revenues	or	EBITDA.

27. Should transaction costs on acquisition be capitalized in the cost of the security or expensed as
    incurred?

Under the AICPA Audit and Accounting Guide for Investment Companies, funds should capitalize the
transaction costs in the initial cost basis of the security. Funds would then measure the security at fair value
which may result in a potential initial unrealized loss on the investment.

28. For a private loan, does SFAS 157 require an adjustment to the “fair value” based on movements
    of interest rates in the marketplace (even though the underlying credit of the borrower has not
    deteriorated)?

Yes. If the private loan is a fixed rate or floating rate loan and interest rates have moved, a market participant
would factor in that movement into the fair value of the private loan. This poses challenges to investment
funds that originate loans, and their existing valuation policy is to generally carry loans at par unless there is
a default or impairment (which would require a write down). SFAS 157 will require that these funds look to
the market to see what the current yields are for similar loans and adjust the carrying value of the loans to fair
value.




28
About the Author

Chris Mears 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 Editor

Howard Altman, CPA, is a Co-Managing Principal and the Principal-in-Charge
of financial services 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.




                                                                                   29
About the Contributors
Vincent Calcagno, CPA, is a principal based in the Rothstein Kass San Francisco office and specializes
in audit, tax and consulting engagements for investment funds and broker-dealers. He also 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.

Stacey Schell, CPA, provides financial reporting, tax and accounting services to clients in the financial
services industry with emphasis on domestic and offshore investment partnerships, master feeder structures
and fund of funds that employ a variety of investment strategies.

Richard Sumida, CPA, is a senior manager on the Rothstein Kass quality control team. He is extensively
involved in the research and consultation of complex accounting and auditing issues relating to the alternative
investment industry, including various fund structures, hard-to-value investments, and emerging accounting
pronouncements.


About Rothstein Kass
Rothstein Kass provides audit, tax, accounting and consulting services to hedge funds, fund of funds, private
equity funds, broker-dealers and registered investment advisers. The firm is recognized nationally as a top
service provider to the industry through its Financial Services Group. The Financial Services Group consults
on a wide range of organizational, tax, operational and regulatory issues. The firm also advises on fund
structure both inside and outside the U.S., on compliance and financial reporting, as well as on tax issues
from a federal, state, local and international perspective. Rothstein Kass has offices in New York, New Jersey,
California, Colorado, Texas and the Cayman Islands.
www.rkco.com


Publications
Beyond Performance: How Hedge Funds Can Strengthen and Build Their Affluent Client Base
As competition in the hedge fund sector intensifies, it will be more important than ever before for hedge
fund professionals to complement strong investment results with a thorough recognition of the priorities and
expectations of their client base. Authors Russ Alan Prince and Hannah Shaw Grove share the research they
have conducted with wealthy individuals and families that invest regularly, and significantly, in hedge funds
and funds of funds. Their findings will help hedge fund firms understand the most effective ways to reach,
cultivate and retain high-net-worth investors.


30
4 Becker Farm Road
Roseland, NJ 07068
973.994.6666


Beverly Hills
Dallas
Denver
Grand Cayman
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www.rkco.com




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