Are investment funds shortchanged by the exemption from consolidation with more efforts and disclosures required by fair value accounting?

By Chee Wee Lock, Partner and Industry Leader of Professional & Business Services Vertical Industry Group, RSM Singapore - taken from RSM Reporting - Issue 26

Amendments to IFRS 10, Consolidated Financial Statements, IFRS 12, Disclosure of Interests in Other Entities and IAS 27, Separate Financial Statements on Investment Entities (IE) provide an exemption from consolidation for investment funds and similar entities. As such, an IE records its investments in subsidiaries at fair value through profit or loss, instead of consolidating them. The main reason for such preferential treatment is that the IE operates in a unique business model where fair value information is provided to its users and such fair value information is more useful for the stakeholders within the IE’s ecosystem. However, the assessment whether an entity qualified as an IE is not straightforward. Let us explore closely.

First, the assessment needs to consider all facts and circumstances such as the purpose and design of the entity. Before we can do such consideration, let us understand the definition of an IE. An IE is (1, 2) “an entity that:

  • obtains funds from one or more investors for the purpose of providing those investors with investment management services;
  • commits to its investors that its business purpose is to invest funds solely for returns from capital appreciation, investment income or both; and
  • measures and evaluates the performance of substantially all of its investments on a fair value basis.”

If it is apparent from its corporate documents or offering memorandum that the purpose of the entity is to solicit funds from its investor or investors and to invest them solely to gain from capital appreciation or investment income, then the entity can be an IE. Conversely, if an entity states to its investors that it is making an investment to develop, manufacture or promote products with its investees, it appears its business purpose is inconsistent with that of an IE.

After the IE meets all the essential elements of the definition of IE, it then needs to have one or more of the following typical characteristics (3): 

  • holds more than one investment;
  • has more than one investor;
  • has investors that are not the IE’s related parties; and
  • has ownership interests in the form of equity or similar interests.

Even when it does not have all the typical characteristics, management may still judge that the entity is nonetheless an IE, although a disclosure of such management judgement is required.

A further requirement is that an IE’s (4) subsidiary that provides investment-related services (such as advisory, investment management and administrative support) will be required to be consolidated by the IE (5). It may seem that the IE would benefit from cost and time savings when it is provided an exemption from consolidation. Also, it would appear that users of financial statements can now better assess the financial position, performance and cash flows of the IE, instead of using consolidated financial statements that also comprise of the investees’ figures. As such, more meaningful and useful information could now be obtained by investors of the IE since fair value is what they are interested in, together with income and capital appreciation. These investors are not interested in (and no longer bother with) the line-by-line consolidation of the investees’ assets and liabilities as they have no title to these assets, have no obligation to these liabilities and are not the least interested by how these assets and liabilities are utilised by the investees.

Within the theoretical context highlighted above, in our experience, we came across a fair value determination through a DCF (discounted cash flow) by a PE (Private Equity) fund (an IE) on an investment (also an IE) that, in turn, had the unquoted loan receivable with an embedded option from a related company. The embedded option permitted the receivable to be converted into shares in yet another related company that owned a plantation. The PE’s fair value determination thus had to include another expert’s valuation of the plantation for the estimation of the option value through the Black-Scholes model.

In the days before the amendments to IFRS 10, IFRS 12 and IAS 27, the instrument above would have been consolidated at the PE level with assets and liabilities of the IE (including the fair value of the convertible loan receivable). Therefore, the gross assets and gross liabilities of the combined entity are now simply presented as a net figure of the investee IE with a more conscious assessment of its fair value and greater disclosures of the rationale, techniques and parameters of the inputs of the valuation model or technique. Thus, it may be argued that the amendments require more effort and time for the preparation of these disclosures which, however, are now more useful and transparent.

However, according to some, all of the above ‘benefits’ for an IE could be offset by the issues faced in stating the investments at fair value. This is aggravated by the fact that the fund managers’ remuneration in the form of management fees and performance fees is tied to the fair value of the IE/investments. In the instance of the PE and venture capital (“VC”) industry, the competitiveness to attract capital from desirable limited partners (“LP”) by the general partners make the fair value even more important.
What then are the issues faced and costs incurred by an IE in recording their investments at fair value?

IFRS 13 defines fair value 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.”(6) Like ASC 820, IFRS 13 also sets out a three-level hierarchy that categorises the inputs to valuation techniques used to measure fair value. Highest priority is given to quoted (unadjusted) prices in active markets at Level 1 and lowest priority to unobservable inputs at Level 3. (7)

To record investments in financial assets using quoted market prices or Level 1 inputs may look straightforward, but critics have challenged that holders of Level 1 investments could also be overstating the fair value when the whole or a significant block of interests are to be sold at the quoted price. The usual trading capacity of the listed security may not be sufficient to allow such large interests to be transacted at the bid price. Such liquidity adjustment should be allowed but IFRS 13 currently does not allow such Level 1 adjustment. It is also debatable whether the valuation of Google, for example, looked more transparent the day after it went public when Level 1 inputs were used instead of Level 3 inputs the day before.(8)

The difficulty in determining the fair value increases when the IE uses Level 3 or unobservable inputs through valuation techniques or models used by the IE or its third party valuation specialists. Typically, such models include many assumptions and parameters. For instance, a discounted cash flow projection (DCF) often used as such a valuation model is vulnerable to manipulation where a slight change of revenue growth, earnings estimate or the discount rate could change the fair value by millions of dollars. However, this is partially addressed by IFRS 13’s disclosure requirement to provide narratives in the form of qualitative and quantitative sensitivity analyses on how changes in the unobservable or Level 3 inputs or parameters will have an impact on the fair value.

Using our earlier example of the fair value determination through a DCF by the PE fund (an IE) of an investment (also an IE) that, in turn, has the unquoted convertible loan receivable above, the PE’s fair value determination now includes yet another expert’s valuation of the plantation and the estimation of the option value which has other unobservable (and sometimes unverifiable) inputs such as expected ‘strike/exercise price’ (“at a certain discount to its market price”), volatility rate and risk-free rate.
With such valuation techniques as described above and their ambiguity, are we still able to say that the fair value derived from Level 3 inputs is a 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?

Yes, we can, because while this price is theoretical and requires substantial judgement, it is not based on the assumption that the business or assets have to be sold in the near future or eventually or that it is a forced sale price. As long as the IE or its agent can consistently articulate, through adequate disclosures in the financial statements (including sensitivity analyses), how the fair value from a valuation model that uses Level 3 inputs is derived and explains the rationale, we think the IE or its agent would have satisfied the spirit of fair value accounting and that of IFRS 13.

As for all other entities, it would be beneficial also to the IE to review the robustness of its model and to fine-tune it such that the resultant fair value is regularly compared with the macroeconomic data and general market trends, and to compare with recent transactions including the last round of financing (LRF) transactions.

We also witnessed how fund management clients in the PE/VC industry have benefited from the above valuation process which, in a way, forced the fund managers to document and think through the assumptions and parameters to ensure the fair value was appropriately determined. Some fund managers would even include the valuation process review as part of their periodic monitoring and reporting to enhance the investors’ confidence more effectively than through extensive policies and procedures. If done well, the exercise is just an extension of their daily monitoring, which is aligned to the funds’ strategic decision-making and includes exit strategies.

In conclusion, it may appear that the IE is shortchanged initially in the sense that the savings from the exemption from consolidation are offset by the cost and resources incurred for the equally daunting tasks and process of fair value determination.
However, if you look more in-depth, the users are better off, as they can now allocate capital to better-performing investments (and IE), be it through Level 1, Level 2 or Level 3 inputs. The valuation models or techniques are also now better documented and more robustly fine-tuned, and all these have brought about more informed participation of all stakeholders in critical decision-making. A final note of caution is that this fair value concept must be better enhanced with greater involvement of investment entities’ stakeholders of, namely, the IE, the investors/LP (limited partnerships), auditors, regulators and valuation experts through more frequent interactions and in-depth participation coupled with enhancement to the model, disclosures and documentation, so that it continues to create value for users through more useful and transparent financial information.

(1) IFRS 10, B85A
(2) IFRS 10, Paragraph 27
(3) IFRS 10, paragraph 28
(4) IFRS 12, paragraph 9A
(5) IFRS 10, paragraph 32
(6) IFRS 13, paragraph 9
(7) IFRS 13, paragraph 72
(8) Hoffelder, Kathy, “Fair-Value Rule Seeks Clearer M&A Deals,” (5 April 2013)

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