Capital Markets

Fair Value Rule Triggers $800 Million Loss

American Capital explains the fair value hit to investors in its latest regulatory filing.
Stephen TaubMay 7, 2008

The new accounting rule on fair value measurement has caused a private equity firm to plunge into the red. American Capital Strategies reported a loss of $813 million for the first quarter of this year — compared with earnings of $134 million last year — as a result of implementing FAS 157, Fair Value Measurements, it reported in a regulatory filing.

The loss was tied to $997 million of unrealized depreciation, according to the company, which has $19 billion in capital resources under management and is traded on the New York Stock Exchange. “This depreciation was driven by declining trading prices, the continued widening of investment spreads and our adoption of [FAS] 157,” said Malon Wilkus, chairman, president and CEO.

FAS 157, which went into effect for fiscal years that began November 15, 2007, requires companies to use a hierarchical framework to measure financial assets and liabilities. Securities considered hardest to value because they have unobservable inputs are dubbed Level 3 items by the rule, meaning that they are thinly-traded and measured using estimates based on the value the company believes a hypothetical third party would pay for them.

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Last week, Robert Herz, chairman of the Financial Accounting Standards Board, said that the new rule was correct in how it pushed companies to disclose fair value measurement information — despite complaints from corporations about the mandate being too onerous. Herz said he also thought it would be useful if companies included a bit more supplemental information in this area, including valuation ranges and the length of time they expect to hold on to a financial assets. American Capital appears to agree with the FASB chairman.

In its earnings announcement released this week, Wilkus emphasized that the company expects the assets — that have experienced about $656 million of depreciation in this or a prior quarter — to appreciate as they are held to settlement or maturity. The filing explained that the company invests primarily in illiquid Level 3 assets, with the intention to hold the assets to settlement or maturity. “This is in contrast to the premise under GAAP that assets generally should be valued on the basis of their current market value and, if no market exists, on a hypothetical market value,” the company stated.

This in turn would reverse much of the current depreciation. “The underlying credit quality of these assets remains in line with our forecasts made at the time the investments were underwritten, which include a recession,” he added. “We believe that with the adoption of [FAS] 157, investors will need to focus on both reported GAAP fair values as well as values that we anticipate realizing on settlement or maturity of our investments, or Realizable Value. Our history bears this out.”

He also noted that under the company’s previous valuation policies, the proceeds American Capital realized on $10 billion of investments exceeded the prior quarter valuations on average by less than 1 percent. “In the future, we intend to report the anticipated realizable values on settlement or maturity of our investments as well as GAAP values so investors can consider both,” he stated.

The $997 million in total net depreciation included $327 million of net depreciation related to American Capital’s private finance investments (excluding European Capital and American Capital LLC.) That includes $180 million of depreciation related to the adoption of FAS 157, with the balance tied to a decline of cash flows and the trading multiples of comparable public companies of certain of its portfolio companies.

Reiterating its point, American Capital also told investors that historically, it has not sold most investment assets into a market. For instance, it typically settles its private finance investments at the time of a change of control transaction, such as through a sale or recapitalization of the portfolio company.

“Credit quality remains good in light of the economic environment,” said American Capital CFO John Erickson. “Most of the depreciation this quarter was not as a result of weakening credit.” He explained that non-accruing loans at fair value remained within a reasonable level of 1.5 percent of total loans at fair value. He added: “While we believe the economy is in the early stages of a recession, our investment strategy during the past several years of buying non-cyclical companies appears to be paying off as those investments are generally performing very well.”