Beyond the Balance Sheet

by Marty Duren

Paul Mason, PhD, associate professor of accounting at the Hankamer School of Business, hadn’t planned to enter academia. The licensed CPA was, however, looking to change from public accounting to a different career field.

“I considered a counseling degree,” he said, “or going to work with a client in the oil and gas industry.”

Mason was already doing internal training at his accounting firm, when he contacted Rebecca Files, now his department chair at the Business School. Her advice – as well as counsel from his wife – convinced him that an academic career was worth pursuing. Mason teaches classes on federal taxation, energy accounting and law, and private equity investing. Academica was the right move for a curious learner.

“I realized only later that I enjoyed the research aspect, which has served me well during my academic career,” he said.

Mason’s curiosity and financial background led him and co-authors Peter D. Easton and Stephanie A. Larocque of the University of Notre Dame, and Steven Utke of the University of Connecticut, to write, “Private Equity Fund Reporting Quality, External Monitors, and Third-Party Service Providers,” which was published in The Accounting Review.

Mason’s interest in private equity (PE) is timely, as the market for private investment funding is growing. With that growth comes the need for tighter regulation. Protection of investors’ capital is dependent on a proper regulatory environment. Regulations with teeth depend on transparency like that brought about by the Dodd-Frank Act. Dodd-Frank, passed into law in 2010, requires more public disclosures, as well as audits for large private funds. It was passed in the aftermath of the global financial collapse of 2008-2009.

Augmented reporting from PE firms is necessary because of the ways in which PE differs from traditional investment banks like JPMorgan Chase & Co. and Goldman Sachs.

“First, PE is much less regulated than the banking industry,” Mason said. “Second, PE funds raise capital from high-net-worth individuals, pensions, endowments and the like, to be deployed in building a portfolio of businesses with the intent of creating value through influencing the management of these companies.”

Investment banks, on the other hand, generally facilitate capital raising or corporate acquisitions for a fee but do not take ownership of and operate the company.

Mason and his co-authors studied a key disclosure for potential investors in private funds: a fund’s net asset value (NAV). Making it tricky for investors is that NAVs are important, but difficult to determine.

“NAVs are important because they can influence investors’ decisions to invest in subsequent funds,” Mason said. “We know from existing research that NAVs are inaccurate and biased. We examined whether monitoring by investors and auditors – known to influence public firms’ reporting quality – play a similar role in PE firms, and whether they cause NAVs to be more accurate or unbiased.”

They found investors’ characteristics are not related to the quality of NAV reporting. This differs from the public markets, which suggests PE is unique in the relationship between investors and funds. However, they also document auditors and the use of other third-party service providers are associated with reporting quality.

Although regulators will see the findings more applicable and investors will find them helpful, they aren’t the only ones likely interested in this study.

“PE funds themselves may be interested,” Mason said, “especially in selecting specific auditors or third-party service providers, such as valuation specialists, marketers and administrators.”

The evidence presented in Mason and his co-author’s study is of growing importance to regulators and investors, now that PE has passed public markets as the primary means of raising capital and regulators turn a more focused eye to the private markets.