Private Debt Investments Under IFRS 9 - All Roads Lead to Fair Value

This article explores the implications of IFRS 9 for general partners and investors in alternative investment funds.

General partners and investors in alternative investment funds have begun to take notice of the new framework for the classification and measurement of financial assets introduced by IFRS 9, which replaces IAS 39 as of January 1, 2018. CFOs, particularly those of credit funds, are expected to make important choices over the coming months with respect to the measurement and reporting of private debt investments. The situation is being closely monitored by institutional investors, for which these choices will have a profound impact.

Under IFRS 9, CFOs will need to decide for all financial assets whether they should be measured at either Fair Value (through P&L or other comprehensive income) or amortized cost.

Previously, under IAS 39, financial assets had been classified into several disjointed categories, which were arguably misaligned with the requirements of financial statement users. This classification system was subject to criticism due to its complexity.

The purpose of IFRS 9 has therefore been to simplify and improve the accounting for investments. Importantly, the new standard makes a clear distinction between accounting for investments at Fair Value and amortized cost. These changes are expected to be widely welcomed by institutional investors in alternative investment funds, which almost universally require NAV statements to be prepared based on Fair Value.

Fair Value is typically required by institutional investors for their own financial reporting purposes. Pension funds and funds of funds often use Fair Value as a common basis to make asset allocation and investment manager selection decisions. Fair Value is also used in the performance evaluation process and can therefore inform incentive compensation decisions.

In the absence of consistent and transparent information concerning the Fair Value of underlying investments, institutional investors may face challenges in exercising their fiduciary responsibilities, including the need to measure and control risk.

These drivers have led institutional investors in alternative investment funds to become increasingly insistent on Fair Value measurement and these investors have become more sophisticated in communicating this to general partners in recent years.

In certain circumstances, IFRS 9 allows banks and other financial institutions to hold loan books at amortized cost. This is not a path, however, that will be acceptable to institutional investors in the alternative investment funds sector. To measure and report fund investments at amortized cost is now seen by many as a disservice, given the overwhelming need of these investors for Fair Value.

If satisfying investor requirements were not enough to convince CFOs to apply Fair Value measurement, following the ‘cash flow characteristics’ and ‘business model’ tests under IFRS 9 will inevitably lead sophisticated general partners to conclude that Fair Value is the only viable option for private debt investments.

A private debt investment may only be accounted for at amortized cost if, firstly, the investment gives rise on specified dates to cash flows that are solely payments of principal and interest and, secondly, the investment is held within a business whose sole objective is to hold financial assets to maturity to collect contractual cash flows.

Applying these tests, the use of amortized cost would preclude many of the unique strategies and terms used by alternative investment funds to enable them to target excess returns. The preference for most general partners for strategies with sufficient flexibility to enable them to generate returns for investors should naturally lead most alternative investment funds towards Fair Value measurement.

While there may be a temptation for some alternative investment funds to see amortized cost as an “easy option” for private debt investments, this would be counterintuitive to fund business models, as any perceived failure to report Fair Value can be discouraging for institutional investors. There can be no more hiding under the new standard, since IFRS 9 makes clear that historical cost and amortized cost are not proxies for Fair Value.

In the rare circumstances that a fund chooses to measure private debt investments at amortized cost, they will now be required to perform more onerous impairment testing under IFRS 9, which must include a forward‑looking assessment of expected credit losses. This will be similar to the analysis performed by banks and other financial institutions.

Alternative investment funds should carefully consider the needs of investors when applying IFRS 9 for the first time. Investors and audit firms are becoming more aware of the issues and the choices that CFOs have in this regard.

Given the introduction of IFRS 9 and the ongoing needs of investors, it is becoming increasingly clear that when it comes to measuring and reporting private debt investments, all roads lead to Fair Value. 

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