Measuring investments in a limited partnership

Continuing a discussion that began in a 2016 experts’ newsletter on measuring private investments, this new article examines investments in a limited partnership (under a general partner–GP). In recent years, this type of investment has become more widely held in pension plan portfolios as a way to obtain higher returns than what is offered by traditional fixed-income securities. In a limited partnership, several limited partners (LPs), including pension plans, each invest in a share of a fund. The partnership’s managers invest the funds for the long term. The LPs commit to providing an amount of commited capital, and the return generated by these activities is shared by the partnership and each of the LPs.

Due diligence questionnaire, contract and valuation procedure 

Before making this kind of investment, one should obtain a due diligence questionnaire completed by the GP. The questionnaire covers all the operational and governance issues affecting valuation of the investments. A recommendation should be made to the team in charge that they need to obtain a contract between the GP and the LP, agreeing on a reasonable period of time within which the GP will provide the valuations. The section in the contract dealing with how the investments are measured should specify the existence of an independent valuation committee that meets on a regular basis. The valuation methodology used should be clearly set out in writing to allow the investor and the auditor to conduct audits. The methodology includes a quantitative and quantifiable part. Another part, which is qualitative, is based on judgment and along with the quantitative analysis, may produce significantly different valuations, depending on the severity of the impact. For example, the impacts of unforeseen situations, such as the global pandemic, on estimates of value are based on assumptions that can generate scenarios ranging from the most pessimistic to the most upbeat, depending on the manager’s view of the future. When the time comes to validate the valuation, questions should be raised about the assumptions that were used. Given that the investments cannot be valued daily, it is important to ensure that a rigorous process is in place, and that it is followed regularly. Other aspects that should be clearly explained by the GP in a document include the various types of expenses and the percentages applied, depending on the amounts of the capital commitments. 

Reconciling the valuation with the financial statements

The GP sends the fund’s capital account statement to the investors, showing the total value for all the LPs. The statement may also show each LP’s interest in the fund. When the GP’s annual audited financial statements show the total combined amount of all the investments in the partnership, each LP investor must verify, as much as possible, the expense and revenue amounts and, above all, the value of the investor’s interest in the partnership. The investor’s share of the fund’s fair value at the end of the period can be verified using the subscribed capital (commitment) as a percentage of the partnership’s total capital. 

The following example shows one way to reconcile the value of an interest in a fund for which the total commited capital has not yet been called:

• LP’s commited capital in the partnership: $15,000,000
• Total capital provided by all the LPs: $3,000,000,000
• The LP’s interest: 0.5% 

The LPs’ total equity as shown in the GP’s financial statements: $1,451,000,000   
Market value of the LP’s investment:  0.005*$1,451,000,000 = $7,255,000

Institutional investors (including pension plans) that hold such investments must therefore have a solid understanding of the content of the various statements of accounts available to them. This will help them recognize the fair value components in their own financial statements.

At the outset of the investment, there may be cash outflows to cover expenses, and the value of the investment may be nil. Thereafter, capital calls will generate positive value. The value of the investment declines as the years go by, up until the final distributions. 

GP’s expenses incurred managing the investments and how they should be recognized

The GP may calculate various types of expenses, representing its stake in the partnership’s appreciation. Such expenses may vary depending on which accounting standards the GP uses (IFRS, LUX GAAP, US GAAP or ASPE). They can also be audited, in order to ensure that they reflect the percentages set forth in the contract.

In practice, how the various components of fair value are recognized may vary for the expenses. Some GPs capitalize their expenses, while others expense them. Both approaches may be justified, either because the capitalized expenses have an impact on fair value or because the expenses are reconciled with the revenues they generate.  

Hierarchy of investments by level of fair value measurement (3 levels)

The GP’s fund may include assets belonging to various fair value measurement levels according to a hierarchy: Level 1 (valuation based on active markets), Level 2 (valuation based on observable data) and/or Level 3 (valuation based in large part on unobservable inputs). In this case, when the GP allocates its investment to Level 3 and/or to Levels 1 and 2, by simplicity and conservatism, the LP generally recognizes its interest in the fund at Level 3 of the hierarchy, on a single line of the financial statements.  

Communications and reconciliation during the fiscal year

The investor must check the interim quarterly reports. If a material difference is found in the reconciliation of the fair value of its interest, it will need to discuss the issue with the other LPs if possible and the GP in order to justify such a difference or reduce it, if necessary. 

It is important to make the verifications in the initial months of the investment in order to detect any potential discrepancies from what is set out in the contract. This will facilitate the reconciliation of cash flows over the period of the investment.   

Conclusion

What can be done to avoid material differences between the valuations of investments appearing in the financial statements of institutional investors and the valuations that will later be found in the annual audited reports of the funds, once the LP has produced its financial statements? If the various reports issued throughout the year are monitored and the valuation process has been tested using the commited capital ratio, as illustrated above, only the valuation for the last quarter of the fiscal year will need to be estimated. It is recommended that, several weeks before the end of the year, the LP contact the GP to obtain its forecast of realized and unrealized gains/losses for the last quarter of the year. A forecast report may be requested to be used in support of the values entered in the LP’s financial statements. In this way, the investor/LP can avoid material differences with the actual amounts, once they are known. The investor’s financial statements must present a fair value that can be verified using the support documents provided by the GP. 

All these verifications require time, good knowledge of the investments and regular communications between the teams taking part in the various stages of the process used to measure investments in limited partnerships. Pension plans with sufficient assets to make allocations to this type of investment may have specialized teams in place to manage and account for such investments, facilitating the process of monitoring them. However, in many pension plans the accounts for these investments are monitored by one or two people who have many other tasks. Training and networking are effective ways to arrive at a certain standardization in how such investments are presented. In addition, given the substantial amounts allocated to these investments, one should hope that GPs make a greater effort to provide their figures on a timely basis.

The Quebec CPA Order’s working group on pension plans