Why is there a difference between GAAP and Actual Performance?
The Investment Company Act of 1940 (‘40 Act) was created to regulate the organization of investment companies and to set standards for the investment industry. The ‘40 Act is focused primarily on the regulatory framework for retail investment products and includes provisions regarding filings, service charges and financial disclosures. It defines the responsibilities and requirements of publicly traded investment product offerings, including open-end mutual funds, closed-end mutual funds, and unit investment trusts. The ’40 Act also impacts the operations of hedge funds, private equity funds and interval funds.
Level 1, Level 2 and Level 3 Assets
’40 Act registered funds are required to prepare their financial statements using Generally Accepted Accounting Principles (GAAP) and must comply with GAAP accounting rules when calculating performance returns at the end of its fiscal year. Additionally, ‘40 Act funds must use market values to value portfolio securities for which market quotations are readily available, otherwise known as Level 1 assets. Level 2 assets must be valued using market data obtained from external, independent sources which could include quoted prices for similar assets in active markets, prices for identical or similar assets in inactive markets, or models which have observable inputs, such as interest rates, default rates, and yield curves.
Level 3 assets are considered to be the most illiquid and hardest to value. They are not traded frequently and fair value for these assets cannot be determined by using readily observable inputs or measures, such as market prices or models. Examples would include private operating companies, illiquid commercial mortgages, private equity and debt investments. Many of the ’40 Act funds covered by FactRight hold a significant level of level 3 assets. Fair value of Level 3 assets is determined in good faith by the fund’s board of directors, a process otherwise colloquially known as a mark to management or guesstimation.
Certain ’40 Act funds hold Level 3 assets that themselves provide updated valuations at year-end once their annual audit process is complete. In this case, a timing issue may arise that can compromise performance transparency. As an example, say the Kitchen Sink Interval Fund (Kitchen Sink) holds an investment in Sam’s GoTo Lending Fund, (Sam’s), a private debt fund. Per regulation, Kitchen Sink must provide valuations of its assets as of December 31 to its auditor and meet its fiscal year-end filing deadline with the SEC, which may include GAAP based performance figures.
Sam’s, a private fund, provides its investors audited financials with updated valuations on an annual basis. In our example, Sam’s audit is completed under no regulatory requirement timeframe, and sent to its investors on the day after Kitchen Sink provided its year-end filing to the SEC. Sam’s auditors determined one of Sam’s two debt investments, a 18%-interest 12-month loan to the Quick and Dirty Car Wash, was not collectable and valued the loan at zero at year-end, thus reducing the value of Sam’s by half.
After receiving Sam’s updated valuation, Kitchen Sink adjusts its net asset value (NAV) and publishes updated performance in its marketing material with reduced performance figures for the previous year that do not match the GAAP figures previously disclosed in their regulatory filing, causing confusion and concern to its investors who are wondering why their actual performance does not match that which was disclosed to the SEC.
The point is that funds like Kitchen Sink may need to adjust certain valuations once the underlying investment holdings complete their own audited financial statements and/or close their own books. It is not always possible for these funds to obtain this information until the related financial statements and/or valuations are produced, which may be subsequent to Kitchen Sink’s filing deadline. As a result, and in accordance with GAAP rules, these funds adjust their statement of assets and liabilities subsequent to filing its fiscal year-end shareholder report with the SEC. Thus, GAAP return numbers presented to the SEC at year-end may not reflect the actual returns earned by investors. Actual investor returns are calculated using a fund’s relevant NAV per share. During a certain timeframe, performance figures published by a fund based on NAV may be a better indicator of actual investor returns that GAAP performance figures.
The good news it that it all comes out in the wash, eventually. The timing difference between GAAP and actual performance typically only occurs with the year-end figures due to annual audits and is usually caught up by the first quarter of the next year. But it’s important to appreciate the time lag and take the year-end figures, audited as they are, with a grain of salt in the interim.