NEW YORK--(BUSINESS WIRE)--Jointly developed FASB and IASB accounting changes that could alter how private equity (PE) firms accrue carried interest would have no impact on Fitch's ratings of alternative managers as the agency's analysis already relies heavily on non-GAAP financial disclosures.
Carried interest is the incentive income PE firms earn when fund returns surpass their stated hurdle rates.
For PE firms, the possible new standards would impact revenue accruals by requiring that carried interest only be recognized as revenue after there was no risk that the carry could be returned to the fund. In most cases, that could be long after significant cash earnings have been received from the fund.
While the proposed standards would remove revenue accruals from GAAP financial statements, Fitch expects alternative managers to continue disclosing the carry accrual in the notes to their financial statements. Some alternative managers already use the proposed revenue recognition standard to account for carried interest and provide sufficient disclosures in their financial filings to make comparisons with managers that recognize the carry accrual on their income statements.
Presently, carried interest is accrued over the life of a fund based on what would be earned by the firm if the fund was liquidated at the then current fair values of a fund's holdings.
The new method would eliminate PE earnings volatility stemming from quarterly changes in the fair values of underlying portfolio companies, although volatility would remain due to the episodic nature of funds approaching their full wind down. Most funds require the execution of multiple IPOs (where the full exit can take several years) and/or strategic transactions to completely realize value, and significant amounts of carry can build over time. Under the proposed rule, this carry would not show up in the revenue line of a PE segment until all meaningful investments have been harvested. A benefit of the approach is that it would eliminate any accrual inconsistencies across PE firms in reporting carried interest under present GAAP standards.
Fitch focuses heavily on an alternative asset manager's ability to generate fees, which, when based on committed capital, can be very predictable over time. However, a firm's ability to generate carry income is not ignored, as it speaks to a manager's ability to deliver strong fund performance and raise additional capital, which will generate future fee earnings.
The potential for clawback risk, or the need to return excess carry income to limited partners, is a key consideration in Fitch's liquidity analysis of the alternative managers. This risk will not abate with a change in revenue recognition standards, as managers will continue to have discretion related to the timing of cash carry distributions to employees.
Our analysis measures of fee-only earnings (FEBTIDA), already excludes carry-related revenue and performance fees from assessments of the IM's core earnings trends.
Current accrual approaches for carry are similar to those used by financial firms for accounting for the investment gains and losses on financial assets. That means that in any given quarter, the carried interest impact on revenue could be positive or negative. Increases in fair values in rising markets can drive significant increases in PE segment revenues, and in down markets, decreases can occur.
The revised approaches to revenue recognition finalized by the accounting boards in May are taking effect across virtually all business sectors and will increase the disclosure requirements for many corporations.
There has been no final determination on when or even if the new the standards would take effect for private equity firms, but should changes occur, market speculation is that the final phase in would only arrive around 2017.
Additional information is available on www.fitchratings.com.
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