Not fair

The head of Castle Harlan is adding to the criticism that fair-value accounting is contributing to the economic crisis

The fair-value accounting rule, or FAS 157, which came into effect in the US this year, has taken a hit from a leading private equity executive who says it is exacerbating the current market difficulties. John Castle, chairman and chief executive officer of New Yorkbased Castle Harlan, says fair value “promotes instability in the markets rather than transparency and consistency”.

FAS 157 requires assets to be valued at market prices, with some banks and policymakers blaming the rule for billions in losses this year by large financial institutions. Earlier this year Oaktree Capital Management chairman Howard Marks blamed the spreading financial crisis in part on mark-to-market accounting. He said that because regulators have mandated such accounting standards after scandals such as Enron, banks' portfolios have grown increasingly unstable.

During a recent conference of mid-market private equity firms in New York, Castle added that requiring banks and other financial institutions to mark-to-market their assets each quarter would cause an immediate hit to income from unrealised losses. The result, he said, would be an undermining of the perceived strength of the institution.

“What is the market that these assets must be marked to?” he said. “In many cases it isn't really a market at all. The idea that all of our nation's assets should be priced based on the level at which a few bearish hedge funds can jam transactions through the market in the last few moments of the trading day is ridiculous.”

Castle said that traditional accounting practices allowed institutions to hold investments at cost and apply reserves only if there was a diminution of credit quality, which tended to stabilise reported earnings in unstable times. By contrast, he added, the new fair value rules tend to destabilise the financial system and cause more short-term swings as banks overstate reported earnings in flush times and exaggerate reported losses in down cycles.

Castle recommended that the current rule be replaced by more traditional accounting standards. As part of the recent $700 billion government bailout package, the SEC is required to produce a study by 2 January 2009 that will focus on the effect of fair value on a financial institution's balance sheet, its impact on bank failures in 2008, the feasibility of modifying such standards and potential alternatives to FAS 157.

As part of the study the SEC has been hearing from a number of institutional investors, accountants, analysts and standard setters. In November a panel of accountants and analysts from institutions like JPMorgan and Allstate Corp. said FAS 157 should not be replaced, and that banks should reveal more information about how they value their hard-to-price assets, Reuters reported.

Carlyle sues over China deal
The Carlyle Group has reportedly filed suit in Hong Kong against former business partner Neil Shen, alleging that Shen backdated an $11 million investment agreement with Chinese medical research company Green Villa Holdings to four days before the company signed a $10 million investment contract with Carlyle. The backdated agreement put in place conditions which would potentially enable venture capital firm Sequoia Capital to increase its 25 percent stake in the company to 38 percent, for a total investment of $28 million. Shen is now managing partner of the Chinese branch of Sequoia. The move allegedly led Green Villa's majority owner, Ren Jun, to write to Carlyle and pull out of his contract with the firm. Carlyle is seeking $206 million in damages, a sum that represents the estimated profit the deal would have made for the firm based on an exit in 2011. Shen had previously secured investments from Carlyle for his online flight agency International. Sequoia makes investments in China, India, Israel and the US, and has made deals with companies including Cisco Systems and Apple.

CDC criticised over salary
UK government-backed fund of funds CDC Group has been criticised by Edward Leigh, chairman of government spending watchdog the Public Accounts Committee, over the £970,000 (€1.1 million; $1.4 million) salary paid to CDC chief executive Richard Laing. Following a National Audit Office report on CDC's operations, Laing called the size of the remuneration “ridiculous”. CDC is owned by the UK government and was created with the goal of decreasing global poverty by making commercially-driven investments in the world's poorest countries. Since 1995, it has been self-funded. The report described CDC's standards of corporate governance as being “consistent with good practice” in the private sector, but said “there have been lapses in oversight and governance of executive remuneration since 2004”. The framework for executive remuneration is now being reviewed. Emerging marketsfocused private equity firms Aureos and Actis are both CDC spin-outs. The group recently announced new investment targets that will lead to more funding to lowincome countries, particularly in Sub-Saharan Africa and South Asia, while it also appointed Richard Gillingwater as its new chairman.