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Accounting changes affecting private equity funds

Accounting, valuation and back-office updates for private equity funds

INSIGHT ARTICLE  | 

Following is an overview of accounting changes and related issues that private equity funds will need to address in 2017. For a more detailed discussion, view our webcast, Accounting and tax updates for private equity funds.

Accounting updates

ASU 2015-07: Fair value hierarchy disclosures for investments measured at net asset value (NAV)

While issued on May 5, 2015, amendments to Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2015-07, Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) (a consensus of the FASB Emerging Issues Task Force), deserve consideration.

Per ASU 2015-07:

  • There is no longer a requirement to categorize within the fair value hierarchy investments that are measured at NAV, though funds still must reconcile total investment values to the balance sheet or provide sufficient information to make such reconciliation possible.
  • Reporting entities should continue to disclose certain information about investments for which fair value is measured at NAV. 

ASU 2015-07 is effective for public business entities for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years.

ASU 2016-18: Restricted cash

ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (a consensus of the FASB Emerging Issues Task Force), seeks to establish a consistent treatment of restricted cash, for example, in situations where a fund serves as an escrow agent in the sale of a company or where there is a seller hold back. ASU 2016-18:

  • Requires the statement of cash flows to explain the change in the total cash, cash equivalents and restricted cash or restricted cash equivalents during the period.
  • Restricted cash and restricted cash equivalents should be included with cash and cash equivalents in the reconciliation of the beginning-of-period and end-of-period amounts shown on the statement of cash flows.
  • Disclosure about the nature of the restrictions is required.

ASU 2016-18 is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019.

Amendments to Topic 820

In December 2016, the FASB issued ASU 2016-19, Technical Corrections and Improvements, which included technical corrections and improvements to Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements, dealing with valuations. The corrections included distinctions between valuation approaches (the market, income and cost approaches) and the techniques used to execute those approaches, as well as valuation-related disclosures.

Accounting standards and updates that do not affect private equity funds

ASU 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, and ASU 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, generally do not apply to private equity funds.

Accounting matters that will affect portfolio companies

ASU 2016-02, Leases (Topic 842), will require most leases to be reflected on the balance sheet. The associated right-of-use assets and liabilities could significantly affect financial ratios, which could affect portfolio companies’ access to credit.

ASC 606, Revenue from Contracts with Customers, will go into effect for public entities for years beginning after Dec. 15, 2017 and the interim periods within those years. Implementation of ASC 606 by all other entities (e.g., private companies) must occur no later than in annual reporting periods beginning after Dec. 15, 2018 and interim periods within annual periods beginning after Dec. 15, 2019. Private equity funds should ensure that portfolio companies are ready to deal with these new revenue recognition rules.

Valuations and private equity funds

Effective valuations are critical to any private equity fund. Following valuation best practices will not only improve valuation results, but will also make your audits more efficient and better position your fund to address regulator’s concerns. Consider the following:

  • Valuation policy—does your valuation policy provide robust guidance and explain how your approach is properly tailored to your investments? Does your policy align with generally accepted accounting principles? Do you review your policy regularly? 
  • Valuation committee—having a dedicated valuation committee can provide an external, objective voice separate from the parties involved in your deals.
  • Valuation approach—your approach should be consistent, should fit your investments and should rely on the right data. Be sure to explain and document changes in technique.
  • Valuation database—maintaining a valuation database will allow you to track valuation performance over time as you compare sales prices to valuations. This also can help attract investors and provide evidence for your auditors and regulators.
  • Reliability of inputs—what are you doing to ensure your portfolio company’s financial data is reliable?
  • Using a valuation specialist—funds are increasingly relying on outside valuation specialists. Outside specialists can provide a deeper understanding of valuation standards and approaches, provide objectivity and free up capacity.
  • Valuation narrative—a valuation is more than just calculations. A detailed valuation narrative walks through the thought processes that drive your decisions. It should outline company performance, decisions on valuation approaches and techniques, the inputs you used, waterfall issues and any additional support used.

Venture capital funds and others considering investments in early-stage companies face unique valuation challenges. Such companies often offer little observable data outside of the price of a recent investment. That doesn’t mean, though, that you should just carry the investment at cost until the next round. Consider the company’s progress against various milestones, such as revenue growth, cash burn rate or market share. How have changes in the economy or other market conditions affected company value? Answer this question honestly—would you make the same investment at the same terms today? 

Back-office best practices

All private equity funds rely on an effective back office. Among the most vital back-office functions is capital account maintenance, especially concerning equity allocations and distributions. Consider these tips:

  • Make sure you understand the equity provisions in your partnership agreement and ensure that the agreement actually reflects the intent of the fund and its partners. If there is a disconnect, amend the agreement.
  • Be clear on the differences between income allocations and distributions of cash.
  • Understand the differences between an American and European waterfall.
  • Be sure to carefully track the sources and uses of cash.

Private equity funds also are well-advised to pay strict attention to internal documentation. Do you have an accounting manual and checklists that document standard processes? Standardized forms and templates also can help ensure consistency and can ensure continuity of practices during turnover or while a fund grows. The Institutional Limited Partners Association (ILPA), a trade association for institutional limited partners in the private equity asset class, provides a variety of templates and can be a valuable resource for funds seeking to strengthen their back offices.

Small Business Investment Company (SBIC) updates

In late 2015, the SBIC Advisers Relief Act allowed funds to exclude SBIC funds from the calculation of funds under management. Some funds were able to deregister with the SEC as a result. The Act also increased the family of funds limit for two of more SBIC funds under common control to $350 million.

2016 saw the following proposed changes to rules affecting SBICs:

  • Relaxation of rules around investing in passive businesses
  • Technote on management fees that would address issues under the new model limited partnership agreement
  • Increases in SBIC licensing and examination fees
  • New schedules 5 (reconciliation of partner capital) and 6 (financing) in examinations

Our webcast, Accounting and tax updates for private equity funds, offers more detail on these and other issues.

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