On May 3, 2017, Ernst & Young made available the bullet points for a presentation on the “accounting, financial reporting, and regulatory considerations” affecting investment vehicles in this space.
Mark to market or historic cost
In general, the presentation says, the accounting treatment depends on where on a spectrum of such vehicles the accountant finds himself. A timberland investment company is mark-to-market with no consolidation of non-investment companies. The fund level debt is typically carried at a contractual amount or with amortized cost. Cash distributions from investments are recorded as earnings or as the return of capital.
On the other hand, real estate investment trusts (REITs), whether public or private, use historical cost accounting under GAAP, with depreciation of assets and a consolidation of controlling interest. They also employ purchase price accounting for acquisitions and impairment analysis for updates of the balance sheet.
There is also a broad “other” category. These “other” timberland vehicles are often sponsored by a general partner or managing member, have a very specific investment goal, and take on high net worth individual investors well as institutions. There is a “great diversity” in their accounting methods.
How does one know whether a particular timberland-related concern is an investment company, fitting on the starting point of the above spectrum? Typical characteristics are as follows: it has more than one investment and more than one investor. There may be a parent company, but the TIC has investors that are not investors of that parent. It has ownership interests (whether equity or partnership), and it manages most of its investments on a fair value basis.
Ernst & Young makes the point that when such an entity reports, it calculates ratios for each class of investor (excluding the manager). These ratios include net investment income as well as the expense ratio. These should be calculated “prior to the effects of any incentive allocation.”
If the incentives are structured as fees, they should be included in the calculation of the expense ratio.
In certain situations, the internal rate of return (IRR), rather than total return, is what must be disclosed. This is so if the entity has a limited life, does not continuously raise capital, limits opportunities for investors to withdraw before termination of the entity, and if the acquisition of market traded securities and derivatives by the entity is not routine.
On the matter of the “fair value” of assets, timberland assets may well fall within “level 3,” the tricky sort of valuation in which “inputs to the valuation methodology are unobservable and significant….” If so, then reporting should disclose methodology. As an example, Ernst & Young offers a sample document that discloses, “This value is based on exchange prices in a hypothetical orderly transaction at the measurement date between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability….”
Under the heading of “regulatory activities,” the Ernst & Young document reviews recent enforcement actions of the Securities Exchange Commission. There was a conflict of interest action in regard to investment ownership, in which an advisor “recommended the purchase of investments in three private funds without accurately disclosing that the owner of the funds had agreed to acquire the advisor after it raised $20 million for the funds.” Another conflict of interest matter drawing SEC wrath involved outside business activities, in which the advisor to a pooled investment vehicle “failed to disclose that he expected promotors of a company in which he recommended investments to help find the advisor clients in return for the investment.”
The implicit advice to timberland company managers is clear: try not to act in a conflicted way or, if you do find yourself conflicted, don’t cover it up.
Other recent enforcement actions have involved excessive and inappropriate fees and expenses. For example, a private equity fund advisor caused its funds to invest in a pooled investment charged “operating partner oversight fees” that were not expressly authorized by the governing documents nor disclosed to the fund’s limited partners in a timely manner.
Again: if you, dear reader, end up managing a timberlands fund, please don’t act like that!