Investment entities – the disappointing dozen

Some of Canada’s provincial regulators recently released CSA Multilateral Staff Notice 51-349 Report on the Review of Investment Entities and Guide for Disclosure Improvements, which “summarizes key findings from an Ontario Securities Commission (OSC) staff review of the continuous disclosure of reporting issuers that meet the definition of an investment entity under IFRS 10 Consolidated Financial Statements.”

The exercise focuses on entities which meet that definition even though they aren’t “investment funds” as Canadian regulations define the concept – and so aren’t subject to the specific reporting regime set out in NI81-106. As the notice points out for example, an “investment fund” typically doesn’t “seek to obtain control of or become involved in the management of companies in which it invests.” However, an entity that does frequently obtain such controlling interests and so isn’t an “investment fund” might still be an IFRS 10-type “investment entity,” if among other things it can demonstrate that its business purpose is to invest funds solely for returns from capital appreciation or investment income or both, rather than to profit from other possible benefits of having control. As you’ll recall, IFRS 10 directs that such an investment entity doesn’t consolidate its subsidiaries, and doesn’t apply IFRS 3 when it obtains control of another entity, measuring these investments instead at fair value through profit or loss.

The review only encompassed twelve such entities, but apparently that’s sufficient to “represent over 90 per cent of the collective market capitalization of the investment entities subsector in Ontario.” The notice summarizes the findings as being “disappointing.”  It highlights the following points:

  • “the importance of fair value measurements and entity specific fair value disclosures in both the financial statements and the MD&A to help investors understand the performance of the investment entity and judgements made by management;
  • with so much dependency on fair value, consider if external expertise is needed to determine fair value of private investments;
  • in addition to fair value disclosures, there may be instances where additional investee specific financial information and operational disclosure is necessary to inform an investment decision;
  • the unique financial reporting of investment entities does not preclude compliance with other securities requirements such as executive compensation disclosure, business acquisition disclosure and entity specific technical requirements; and
  • this is an emerging area where market participants may need to look through the structure and look to other securities requirements for guidance. This notice provides examples of these instances and when investment entities should consider consultation with Staff to determine how specific securities requirements may apply to them.”

Many of us have likely come across situations where it’s unclear whether or not a particular entity meets the IFRS 10 definition, often because of the apparent extent of its day to day involvement with its investees. The notice cites this and other difficulties, and observes: “OSC Staff would also raise questions if an investment entity’s portfolio was primarily based on one investment for a period of more than one year and it was unclear whether there was an investment plan in place that could result in the acquisition of several investments in the near term to diversify the investment entity’s risk and maximize its returns.” It also emphasizes the importance of disclosing significant judgments under IAS 1 and IFRS 12 where relevant: IFRS 12 specifically requires such disclosure when an issuer treats an investee as an investment entity in the absence of one or more of the “typical characteristics” set out in IFRS 10.28 (this would apply if the investee holds only one investment or has only one investor, among other situations).

Investment funds subject to NI 81-106 are required to provide a statement of investment portfolio as part of their financial statements, disclosing the investee name, cost and fair value for each investment held. This isn’t required of non-81-106 investment entities, but even so: “OSC Staff were encouraged that the majority of investment entities in the review provided this disclosure in their financial statements, or in certain instances, in their MD&A.” The notice expresses the view that this allows “an investor to understand the key characteristics of the portfolio composition including the associated risks and the drivers of any change in fair value.” On the other hand, in itself the statement of investment portfolio is largely just a list of names, so it may be equally as or more important to disclose information about the investment policies and oversight that govern the portfolio, and about the risks attaching to the investees. The notice indicates that some investment entities didn’t provide sufficient information in these broader areas.

Not surprisingly, the notice also makes various observations about the quality of disclosures about how fair values were determined, and provides an appendix of “fair value measurement disclosure considerations.” For example, regarding the use of significant unobservable inputs in “level 3” valuations, it prompts preparers to consider: “Is disclosure detailed enough to understand the use of discount rates, valuation multiples, expected volatility, discounts for lack of marketability and how they are derived?” Even if the answer there is “yes”, I’m never quite sure what an investor is meant to do with the information, other than assume for their own downside protection that the resulting valuation might be completely wrong. But then, an investor can make that assumption even if the disclosure isn’t detailed enough to understand the purported valuation technique…

The opinions expressed are solely those of the author

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