Memories of mark-to-market
It could be a new name of a sauce made by President’s Choice, but the raft of blow-out U.S. bank earnings this week justifiably turns the mind to “Memories of mark-to-market”. How long ago was it that our accounting Lords decided that M-T-M was the way to go? Not very long at all.
Did they listen to industry professionals when they professed that Fair Market Value accounting treatment was misguided (see prior representative posts “Accountants are failing investors with ‘fair value’ accounting” Aug 6-07 and “D’Alessandro: fair market value accounting is ‘perverse’” Sept 30-08)? Nope.
Yet with the quick return to massive profits at Goldman Sachs (GS:NYSE) and JP Morgan (JPM:NYSE), just seven months after staring down the rifle barrel of an economic depression, one might feel a little morose about the irony of that little understood Law of Unintended Consequences. Sure, the U.S. Congress was bang-on when it jaw-boned the Accounting Standards Board to amend the M-T-M treatment of illiquid bank SIVs, conduits and otherwise icky mortgage assets. But to not tie that to anything…?
Having achieved what we all needed last March (by avoiding a Depression), Congress set up many of the staff at the large U.S. banks (and i-banks hiding within a commercial bank’s chainmail) for what could be their most financially rewarding year ever. If they were mad about large bonuses in the face of a declining financial market, just think how cross our elected officials will be to find out that by waving their magic wand over the accounting industry, they’ve only restocked the coffers of the folks in the red suspenders.
MRM
NAV IS NOT FAIR VALUE
The break on mark-to-market really needs to be extended to LPs in VC and private equity funds that are in the first few years (lets say 3yrs) of a funds investment period. Get rid of this whole “j-curve” nonsense. Allow LPs to hold their investment at book (i.e. paid-in capital). Obviously investors should take marks if underlying portfolio companies have suffered serious impairment or need to be written down, but most of this whole “j-curve” phenomenon is just fees & expenses, and what are those fees & expenses? They are an investment in a team, in asset management infrastructure, in systems, and deal origination costs (read – trips to conferences and the like). I would argue that these investments have some future value and then should not be simply subtracted from the value of portfolio companies, cash and other assets and liabilities to arrive at NAV (net asset value). We are talking about big numbers here and, I bet, many of our livelihoods. This is an investment that LPs have made and expect to earn a return on. Of even more concern, is how the “j-curve” is currently exacerbating an already moribund fundraising environment for private equity & venture capital funds. I won’t get into the details of why venture capital funds are good, but the mom and apple pie of it is, they create a lot of jobs (CVCA did a study on this). I also don’t think this argument is without valuation precedent. How many unprofitable (or even profitable) public companies trade well above an intrinsic asset value because they have spent money on the things I mentioned above (a team, systems, product development and market research). Furthermore, most fund structures provide for LPs to get priority on a return of capital including fees & expenses (that contract provision must have some value).
This is not the only example of NAV not reflecting fair market value. Anecdotally, The current price for a secondary interest in a fund (i.e. buying an LP position from an original investor in a fund) is currently trading at a 50% discount to NAV. So should we be writing all our holdings down by 50%. In this case, the argument can be made that we are in a distressed market, but the point still remains that NAV is not market value.
(for disclosure: this is a devils advocate perspective from an institutional LP whose personal compensation is not negatively impacted by the “j-curve” effect)