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ASC 820

Fair Value Measurements and Disclosures: Best Practices for Implementation and Compliance for the Alternative Investment Industry 2010 Update

Disclaimer: These materials provided by Rothstein, Kass & Company, P.C., and its affiliates ("Rothstein Kass"), are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s) and are not intended to be a substitute for reading the legislation or accounting standards themselves, or for professional judgment as to adequacy of disclosures and fairness of presentation. The materials do not encompass all possible disclosures required by accounting principles generally accepted in the United States of America. The form and content of each reporting entity's financial statements are the responsibility of the entity's management. The materials are being provided with the understanding that the information contained therein should not be construed as legal, accounting, tax or other professional advice or services. The contents are intended for general informational purposes only and it should not be used as a substitute for consultation with professional accounting, tax, legal and other advisors. The materials and the information contained therein are provided as is, and Rothstein Kass makes no express or implied representations or warranties regarding these materials or the information contained therein. Without limiting the foregoing, Rothstein Kass does not warrant that the materials or information contained therein will be errorfree or will meet any particular criteria or performance or quality. In no event shall Rothstein Kass, its officers, principals and employees be liable to you or anyone else for any decision made or action taken in reliance on the information provided in these materials. The information and content provided in these materials is owned by Rothstein Kass and should only be used for your personal or internal use and should not be copied, redistributed or otherwise provided to third parties. In order to comply with U.S. Treasury Regulations governing tax practice (known as "Circular 230"), you are hereby advised that any tax advice provided herein was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding U.S. federal, state or local tax penalties, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

December 2010

Dear Clients and Friends:

Rothstein Kass is pleased to present this updated implementation and compliance guide relating to Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures ("ASC 820"). As a leading international professional services firm providing audit, tax and consulting services to an array of sophisticated and discerning clients, Rothstein Kass is proud of our association with the alternative investment community. Our collaborative culture has enabled our firm to grow alongside the industry through extensive and frequent interactions with our clients, their administrators and service providers. We believe that this guide represents a practical approach to implementing and complying with the requirements of ASC 820, including sample financial statement footnotes and a Frequently Asked Questions section. Well before the onset of the global credit crisis, the FASB had taken steps to reconcile disparate conceptions of "fair value" as it appears in many different authoritative references through the GAAP hierarchy. A good portion of these efforts centered on the development of consistent valuation standards for illiquid or "level three" holdings. In the months immediately following the market meltdown, these issues were briefly pushed to the forefront as some hedge funds were forced to unwind profitable positions to meet a raft of redemption requests from investors facing their own liquidity concerns. For many funds, the sudden need for increased liquidity served as a harsh reminder of the importance of aligning fund objectives and strategies with those of its investors to promote stability. At the same time, misconceptions regarding the nature and practices of the alternative investment community made the industry a likely target of ambitious regulatory reform intended to prevent future market upheaval. Thorough analysis has since shown that hedge funds did not pose systemic risk, while effective advocacy has helped to promote understanding among legislators and regulators. As a result, the final financial reform bill reflects an informed and reasoned approach to industry regulation. Implemented in concert with enhanced fair value guidelines, these efforts should help to provide the greater level of transparency that the market demands. Transparency will be even more critical as asset flows from institutional investors allow a greater portion of Americans to gain access to the alternative investment industry through retirement accounts. Amid intense competition, the percentage of illiquid assets and the methodology for valuing these holdings will be important considerations for investors. Needless to say, the FASB has tremendous relevance to the financial services industry. ASC 820, for example, offers a framework for comparability and consistency that will help to establish institutional-quality best practices across our industry. While our intention is to clarify the fundamental aspects of ASC 820, it is still clear that fair value remains an art, not a science. We are confident that you will find this paper informative and helpful. Please reach out to me, Christopher Mears or any of the Principals in our Financial Services Group if we can be of assistance.

Howard Altman Co-CEO and Co-Managing Principal Rothstein Kass

ASC 820 - Fair Value Measurements and Disclosures: Best Practices for Implementation and Compliance for the Alternative Investment Industry - 2010 Update

Overview

On July 1, 2009, the Financial Accounting Standards Board ("FASB") launched a single source of authoritative non-governmental guidance called the FASB Accounting Standards Codification ("ASC" or the "Codification"). The Codification does not change United States Generally Accepted Accounting Principles ("U.S. GAAP"), but rather it is a new structure which takes accounting pronouncements and organizes them by accounting topics. ASC Topic 820, Fair Value Measurements and Disclosures ("ASC 820") (formerly FASB Statement No. 157 Fair Value Measurements, "SFAS 157") is now the sole source for guidance on how entities should measure and disclose fair value in their financial statements. Since the issuance of our previous white paper entitled "SFAS 157 Fair Value Measurements: Notwithstanding the updates and clarifications made by the FASB to the guidance for fair value measurements and disclosures, one thing has not changed, the definition of fair value. Fair value is defined in ASC 820 as the "price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Implementation Challenges for the Alternative Investment Industry" dated September 2008, the FASB has made several updates to the fair value guidance contained in U.S. GAAP. The following updated white paper contains the most up-to-date information from current guidance contained in the Codification that effects the alternative investment industry (e.g., hedge funds, private equity funds and fund of funds), herein referred to as "fund(s)." It takes on an "exit price" approach. In the past, many measures of fair value under U.S. GAAP were based upon the entry price or management's "good faith" measurement. Under current U.S. GAAP, the entry price cannot be presumed to be representative of the fair value at initial recognition. Transactions between related parties or under duress ("forced sales") are examples that may preclude an entry price from approximating the fair value. In addition, there may be instances in which the initial transaction occurs in a market different than the market that a fund would have access to in exiting the investment. For example, a broker may transact in an inter-dealer market where that market is not available to the fund. In addition, entry prices include transaction costs that may not be recoverable in an exit price. These principles open the door to potentially recognizing "day one" gains and losses on transactions.

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Fair value continues to be measured using all assumptions utilized by marketplace participants, including risk assumptions considered by those participants. The measurement of fair value assumes an orderly, hypothetical transaction in the principal market for the asset or liability. However, if the volume and level of market activity for an asset or liability has significantly decreased, and transactions in a particular market are not orderly, ASC 820 provides additional guidance on factors to consider in estimating fair value. Moreover, if no principal market exists, and there are multiple markets, then the most advantageous market is used. (Editor's note: The use of the most advantageous market when multiple markets exist goes against the grain of "conservatism" but this is clearly what the FASB intended.)

observable inputs other than quoted prices used to value Level 1 securities, while Level 3 consists of the most "unobservable" inputs (e.g., highly illiquid securities). ASC 820 emphasizes that valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs. For example, if a fund utilizes observable inputs in an orderly market to determine fair value, such as market prices from an exchange or dealer market, the fund is precluded from using an internal valuation model (e.g., discounted cash flow model) and cannot ignore readily available market prices. However, the more illiquid the investment, the greater the need exists to use multiple valuation techniques to arrive at fair value.

to use its judgment to evaluate whether market inputs are "observable." Transaction-based market inputs tend to be more reliable. The range between bid-and-ask prices can indicate as to whether the market is active or inactive. A more active market will generally dictate narrow ranges between the bid-and-ask quotes with more illiquid markets having larger spreads.

Determining Fair Value when a Market is "Inactive" and Transactions are "Not Orderly"

As a result of the recent financial crisis, the FASB issued additional fair value measurement guidance in April of 2009 for estimating fair value when the volume and level of activity for an asset or liability has significantly decreased and when a transaction is deemed "not orderly." This guidance reinforces the notion that fair value is based on orderly transactions under current marketplace assumptions. Funds are not compelled to rely on quotations which reflect distressed transactions. However, it is also inappropriate to apply a "hold-to-maturity" approach to fair value or to use assumptions based on "normalized" market conditions. When current prices are not indicative of orderly market transactions, funds should utilize alternate valuation techniques to estimate fair value under current market conditions.

What Are Observable Inputs?

Observable inputs are inputs based

For illiquid securities where a market may not exist, a fund must develop a fair value approach based upon a hypothetical market which incorporates assumptions potential market participants would use in purchasing the security. One of the most significant elements of ASC 820 is the use of a three-level fair value hierarchy. Level 1 consists of the most "observable" market inputs to arrive at fair value (e.g., liquid investments). Level 2 would broadly include assets and liabilities valued using

on market data obtained from sources independent of the entity and should not be limited to information that is only available to the entity making the fair value determination or to a small group of users. Observable market inputs should be readily available to participants in that market. In addition, observable market inputs should include a level of transparency that is reliable and verifiable. Observable market inputs are typically a by-product of having sources that are knowledgeable and active in the particular market. Management will have

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When determining fair value, funds should consider whether factors exist that indicate a significant decrease in the volume and level of activity for an asset or liability by comparing those levels to normal levels of market activity. Those factors include, but are not limited to whether: · There are few recent transactions. · Price quotations are not based on current information. · Price quotations vary substantially either over time or among market makers (for example, some brokered markets). · Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability. · There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting fund's estimate of expected cash flows, considering all available market data about credit and other nonperformance risk for the asset or liability. · There is a wide bid-ask spread or significant increase in the bid-ask spread. · There is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities. · Little information is released publicly (for example, a principalto-principal market).

Significant judgment may be required to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability based on the weight of the evidence. When the market has become less active or is no longer active, there is an increased likelihood of distressed or forced transactions underlying market transactions. Therefore, quoted prices become less reliable indicators of fair value. In circumstances where there has been a significant decrease in the volume and level of activity for an asset or a liability in relation to normal market activity, additional steps should be taken to determine whether other valuation techniques and inputs are needed to meet the objective of a fair value measurement. It is not appropriate to presume that all transactions in an inactive market are not orderly (that is, distressed or forced). If the reporting fund concludes that there has been a significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity, the fund should then consider whether circumstances exist that indicate that transactions associated with the quoted prices are not orderly. Such circumstances include, but are not limited to whether: · There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and

customary for transactions involving such assets or liabilities under current market conditions. · There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. · The seller is in or near bankruptcy or receivership (that is, distressed) or the seller was required to sell to meet regulatory or legal requirements (that is, forced). · The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability. The challenge for most funds is having sufficient market intelligence available to evaluate whether a transaction is orderly or if it is a distressed or forced sale. In situations where funds do not have enough information to conclude one way or the other on whether it is an orderly transaction, the fund should consider the transaction price as an input in estimating fair value. However, it should not be the sole basis to arrive at fair value. All information that is available without undue cost and effort should be considered. The best practice is to employ multiple valuation techniques. A fund should place less weight on transactions which the fund does not have sufficient information to conclude whether transactions are orderly when compared with other transactions that are known to be

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orderly. The use of broker quotes and pricing services are common valuation techniques employed by funds. The fund must attempt to obtain transparency from the sources of these fair value estimates and make a determination of whether the broker quotes are based upon current information that reflects orderly transactions or a valuation technique that reflects market participant assumptions. (Editor's note: The larger the variance between the fair value estimate determined by management and the broker quote that is considered not to be orderly, the higher the expectation to have additional support from multiple valuation methods.)

inputs other than the directly observable quoted price. These "other market inputs" are often used in conjunction with valuation models and include interest rates, yield curves, prepayment speeds, default rates and other marketcorroborated inputs. Level 3 Inputs - include those inputs that are not currently observable (e.g., an option-pricing model using historical volatility, a fund's own data or assumptions such as a multiple of earnings or discounted cash flow projections, etc.). Refer to Exhibit 1 for a matrix of the levels and examples of securities that typically fall within each level.

For exchange-traded instruments such as securities sold short and exchangetraded derivatives, common practice has been to use market quotations to determine the fair value of an identical liability when the instrument is traded as an asset. However, in many cases, the availability of relevant observable inputs to determine the fair value of a liability can be limited or unavailable. Certain liabilities are unable to be traded in the open marketplace due to contractual or other legal restrictions which prevents their transfer. Furthermore, the unit of account for an instrument traded as an asset can result in a difference in value from the unit of account when traded as a liability. As a result, questions have arisen on how to determine the fair value of a liability in a hypothetical transaction when the liability is restricted from being transferred, or when sufficient observable market data is not available.

Fair Value Hierarchy

The three levels of the fair value hierarchy and the material valuation inputs are as follows:

Application of Fair Value Measurements to Liabilities

The fair value measurement premise for

Level 1 Inputs - include unadjusted quoted prices for identical assets or liabilities in active markets (e.g., exchangetraded securities). An active market is defined as a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Level 2 Inputs - include quoted prices for identical assets in markets that are not active (e.g., thinly traded securities), quoted prices for similar assets (e.g., restricted securities, private investments in public companies, etc.), or market

liabilities assumes both of the following: a. The liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled).

In August of 2009, the FASB issued additional guidance to address the uncertainties and to enhance the consistency in applying the fair value measurement principles to liabilities. If a quoted price in an active market

b. The nonperformance risk relating to that liability is the same before and after its transfer. The notion of determining the exit price of a liability based on the price that would be received to transfer the liability has raised many implementation questions.

for the identical liability is available, the quoted price should be used and would represent a Level 1 measurement. In circumstances in which a quoted price in an active market for the identical liability is not available, a reporting fund shall measure fair value using one or more of the following techniques:

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a. A valuation technique that uses: 1. The quoted price of the identical liability when traded as an asset. 2. Quoted prices for similar liabilities or similar liabilities when traded as assets. b. Another valuation technique that is consistent with the principles of ASC 820. Examples of valuation techniques consistent with the principles of ASC 820 include an income approach, such as a present value technique, or a market approach, such as a technique that is based on the amount at the measurement date that a fund would pay to transfer the identical liability or would receive to enter into the identical liability. When measuring the fair value of a liability using the quoted price of the instrument when traded as an asset, a fund shall not adjust the quoted price of the asset for the effect of any restrictions preventing the transfer of the liability. It is assumed that the impact of any restrictions relating to the transfer of a liability is built into the value of the liability at inception. However, the quoted price of the liability when traded as an asset shall be adjusted for factors specific to the asset that are not applicable to the fair value measurement of the liability. Any adjustment to the quoted price when traded as an asset would preclude Level 1 classification. Some circumstances in which a fund

should consider whether the quoted price of the asset should be adjusted include the following: a. The quoted price for the asset relates to a similar (but not identical) liability traded as an asset. b. The unit of account for the traded asset is different from that of the liability (e.g., the quoted price for the asset includes the effect of a thirdparty credit enhancement). When measuring the fair value of a liability using a valuation technique consistent with the principles of ASC 820, funds should consider whether market inputs are derived from orderly transactions, as well as whether internal valuations may be more representative of fair value. Funds should consider the effect of their own nonperformance risk when determining the fair value of liabilities. This can result in a seemingly counterintuitive valuation result, as a decline in a fund's creditworthiness would result in a lower fair value measurement for a liability (e.g., a higher discount rate applied to expected cash flows), therefore resulting in the recognition of an unrealized gain. However, the fair value of the instrument should be considered from the perspective of a market participant creditor; that is, the credit impairment of the debtor would result in a reduction in value to the creditor. Funds should consider the impact of their nonperformance risk, including the

existence of master netting arrangements, when determining the fair value of financial liabilities transacted with counterparties. (Editor's note: Liabilities such as reverse repurchase agreements and debt facilities are fixed and determinable obligations of a fund and should be presented at face value unless the fair value option is elected under ASC 825, Financial Instruments.)

Significance of an Unobservable Input

The level designation in the fair value hierarchy is based on the lowest level input that is significant to the fair value measurement. However, the term "significant" is not defined by ASC 820. In assessing the significance of a market input, a fund should consider the sensitivity of the financial instrument's fair value to changes in the input used. Assessing the significance of an input will require judgment considering factors specific to the financial instrument being valued. The tone from the top should be one of conservatism in assigning level designations to securities with unobservable inputs. By the design of the principles-based standard, determining the significance of a market input is a matter of judgment. Consequently, two unrelated funds assigning level designations to the same investment using similar unobservable inputs may reach different conclusions.

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Best Practices for Fair Value Measurements and Disclosures

Many have underestimated the scope, complexity and time required to implement and remain current with the fair value measurement and disclosure requirements contained in U.S. GAAP. Whether there is a need to implement the fair value guidance in ASC 820 for the first time (a new fund), or comply with updates to existing fair value measurement and disclosure guidance, management needs to establish an effective protocol in determining fair value. We recommend management create a financial reporting team. When implementing the guidance of ASC 820, the financial reporting team should first understand (1) how to measure fair value based on a fund's portfolio, and (2) the content and format of the required financial statement disclosures. Also, we recommend management assign a "Champion" to the implementation process who will effectively liaise between the investment management team, valuation committee, and other internal accounting and technology staff. Furthermore, once the financial reporting team is established, we recommend that they reach out to their auditor and fund administrator to gain an understanding of how those outside parties could add value to the process. By including certain outside third parties throughout the fair value measurement and disclosure process, a fund can avoid unwanted surprises during the

year-end financial reporting process. As a best practice, a fund should perform a soft close as of an interim date (e.g., September 30), which would include the preparation of all footnote disclosures required by ASC 820. It is important to note that if a fund engages an administrator for the preparation of its financial statements, management should understand the processes and data used by the administrator to prepare the required fair value disclosures. The "Champion" of the implementation process should manage the coordination with the administrator well before the year-end close. In addition to providing a framework in determining how to arrive at fair value, ASC 820 also provides greater transparency to investors regarding (a) the types of investments a fund is invested in, (b) the methods used to value those investments, (c) the risk exposures underlying those investments, (d) movements between fair value hierarchy levels, and (e) the portion of a fund's performance derived from Level 3 securities. Ultimately, the required fair value disclosures will become a tool that fund investors can use to evaluate a fund's portfolio. Complying with the guidance in ASC 820 has many challenges. The fair value measurement and disclosure guidance in ASC 820 has increased the complexity, internal resources and time required for year-end financial reporting.

Compliance with the fair value measurement and disclosure guidance should include: · Documenting policies and procedures to comply with ASC 820, including monitoring active vs. inactive markets, aftermarket events and reliability of market data. · Addressing system requirements for data aggregation. · Evaluating the level designations within the fair value hierarchy on a monthly basis. · Performing a soft close as of an interim date including the preparation of all of the required financial footnote schedules and disclosures prior to the year-end close. · Coordination with third party service providers (administrators, CPA firms, pricing services and prime brokers). Refer to Exhibit 3 for frequently asked questions in applying ASC 820.

Valuation Policies and Procedures

Management will need to have a process in place to allow it to gather the necessary information to comply with the fair value measurement and disclosure standards. To that end, management should continually monitor a fund's front- and back-office accounting systems used to track and produce valuation data. This will allow a fund to make informed decisions on valuation techniques and

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the assignment of level designations for the investments within a fund's portfolio ("tagging of investments"). In our discussions with fund managers and administrators, the tagging of investments is performed either on a monthly, quarterly, or annual basis. The best practice is to tag securities at a minimum on a quarterly basis. If resources permit, we recommend tagging securities on a monthly basis. Level designations can change as dictated by continually evolving market conditions. A fund's accounting system should have the necessary data fields to allow it to tag each security and enable the fund to generate reports showing the level designations by security. Management and auditors alike will need to review a fund's valuation policies and procedures on a periodic basis. In general, these policies should address the following: · Methodology on level designation. · Definition of an active market. · The level of average trading volume and frequency that will deem an investment as thinly traded (i.e., inactive), which may require a Level 2 or Level 3 designation. · Determination of the principal and/or most advantageous market. · Identifying aftermarket events and their impact on fair value. · Quantitative and qualitative documentation on the valuation

inputs and techniques used, including how the fair value measurement of assets and liabilities fit into the fair value hierarchy. · Evaluating the effect of investment restrictions. · Identifying risk assumptions reflected in unobservable inputs. · Identifying the reports that will provide the required data to prepare the yearend financial statement disclosures, including reconciliations of those reports to the books and records of the fund. · Back testing of realized transactions. (Editor's note: As part of a fund's review of its valuation policies and procedures, a best practice is to "back test" all material Level 2 and Level 3 investments by comparing the investment's transaction price in the subsequent period [realized proceeds from the sale of an asset or disbursements made to settle a liability] against the fair values of those investments reported in the most recent financial reporting period.)

component of nonperformance risk, however, other risks such as regulatory and other operational considerations may influence overall nonperformance risk as well. As part of the valuation process, funds should consider the impact of any nonperformance risks with respect to their counterparties to securities and derivative transactions. Generally, additional consideration of nonperformance risk will not be necessary for exchange-traded securities since quoted prices will include the effects of market participant assumptions on credit risks. In addition, exchange-traded derivatives, such as futures contracts and certain option contracts, are generally subject to market protections, such as daily margin postings and guarantees from the exchange clearinghouse, which mitigates the impact of nonperformance risk outside of those reflected within the quoted prices. Therefore, the fair value processes for exchange-traded derivatives are generally not expected to involve significant nonperformance risk adjustments. We expect that the consideration of counterparty risks will be more significant for valuations of illiquid securities and derivatives transacted over-the-counter with financial institutions. When funds rely on valuation inputs other than quoted prices for the valuation of illiquid securities, funds

Consideration of Counterparty Risks Within Fair Value Measurements

The impact of nonperformance risks is viewed by market participants as an essential component of a fair value measurement. Nonperformance risk represents the risks that a party to a transaction will not perform under its obligation. Generally, an entity's credit risk represents the most significant

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should consider the use of observable credit data that would be relevant from a market participant standpoint. The effect of significant nonperformance risks on the valuation of illiquid securities can influence the determination of inputs such as projected cash flows and valuation discounts to reflect market participant assumptions. For over-the-counter derivatives, the evaluation of a fund's counterparty credit risk exposures should include the consideration of master netting arrangements (e.g., standardized International Swaps and Derivatives Association agreements), collateral balances, contract settlement provisions, and the attributes of the different derivative contract types. To the extent an enforceable master netting arrangement exists, a fund may need to incorporate valuation adjustments at the portfolio level to consider the effects of nonperformance risks on the valuation of derivatives held with a particular counterparty. However, funds should carefully review any master netting arrangements to determine whether the arrangements permit the netting to apply between different product types. For derivatives in a net asset position held with a financial institution counterparty, the credit risk of the counterparty should be considered as part of the assumptions of what a market participant would pay for the asset positions. For derivatives in a net liability position, a fund should consider its own credit risk as part of

the valuation of its liability positions. Funds should monitor the credit risks of the financial institutions they transact with at each reporting period. Publicly available information such as published credit ratings, credit spreads, credit default swap rates, and SEC filings may be utilized. Funds should consider the responsiveness of available credit risk information to changes in market conditions as part of their monitoring process, as certain data, such as default rates, may not provide timely information relating to a counterparty's current status of nonperformance risk.

The level of due diligence review of third party pricing services and quotes received from broker-dealers will depend on facts and circumstances such as: · Type and complexity of the investment. · Liquidity of the market and access to actual transactions and other observable inputs. · Nature and complexity of pricing methodologies and assumptions. · Historical accuracy. · Background and expertise of service providers in valuing the financial product. Best practices should include an

Use of Third Party Pricing Services and BrokerDealer Quotations

Understanding the nature and content of the services provided by the third party pricing services regarding valuation information is management's responsibility. Management must understand the methods used by third party service providers and determine whether the pricing data is transactional or model-based. If pricing data is modelbased, management must understand the significant inputs used and how they are impacted by changing market conditions. In addition, management must understand how and when changes to the methods and models used by third party pricing services will be communicated and how they will impact a fund's level designations.

ongoing monitoring process to verify the reliability of the pricing methodologies, assumptions and sources used. Back testing of pricing service valuations and broker-dealer quotations should be part of the ongoing monitoring procedures.

Accounting for Transaction Costs

U.S. GAAP requires the capitalization of transaction costs in the initial cost of the asset or liability (i.e., the entry price). In contrast, the fair value of the asset or the liability represents the price that would be received for the asset or paid to transfer the liability (i.e., the exit price). Since the fair value of an investment does not include costs that are required to complete a sale transaction, such as commissions or closing costs in many instances, there will initially be an unrealized loss for a security that has capitalized transaction costs. Therefore,

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day one recognition of gains and losses on purchases of assets or liabilities, reflecting the difference between the fair value and the transaction price, are permissible under U.S. GAAP.

bid-ask spread. As a best practice, a fund's accounting system should generate an exception report based on this quantitative threshold in order to determine whether investments should be transferred out of Level 1. To perform this exercise, a fund should obtain the trading history (e.g., last 30 days) of each investment held at month-end.

investments is generally based upon the price of the actively traded public equity price on an "as-if" converted basis less discounts applied to take legal restrictions into consideration, liquidity risk, price volatility, and other risk assumptions. In practice, we have seen discounts typically range from 5% to 30% (with higher discounts on a case-by-case basis). In situations where the discount is significant or when convertible securities are not in the money, these positions will typically move into Level 3. In applying liquidity discounts, a fund must consider assumptions used to arrive at fair value from the perspective of a market participant. (Editor's note: Consideration of the quantity of the investment held by a fund, or a fund's intention to hold an investment, is not relevant in estimating fair value at the measurement date.)

Considerations for Level Designations

Level 1

Typically, securities traded on an active market, such as the NYSE, AMEX, or other major exchanges will be classified as Level 1, provided that (a) the market is the principal (or most advantageous) market and (b) the fund has the ability to access the principal (or most advantageous) market. However, when a security is thinly traded and its reported "fair value" is not representative of an active market (or if trading is halted), the security may need to be transferred into Level 2 or Level 3. As discussed previously in the section entitled Determining Fair Value when a Market is "Inactive" and Transactions are "Not Orderly", a fund should consider certain factors to determine if there has been a significant decrease in the volume or level of activity and if a transaction is deemed not orderly.

Aftermarket Events

In addition, ASC 820 requires consideration of aftermarket events (this would include normal trading days and when an accounting period ends on a nonbusiness day, such as a weekend or holiday). A fund's valuation policy should monitor the variances between the last closing price at the measurement date and the aftermarket events. Variances over a threshold amount determined by management should be reviewed and the fair value of the investment should be adjusted when variances are deemed material. Any adjustment to the price provided by an exchange would move that security into Level 2.

Derivatives Valued Using Models

In order for derivatives that are valued

Level 2 Liquidity Discounts

Level 2 inputs are inputs other than

using models (e.g., interest rate swaps) to qualify for a Level 2 designation, the model used to measure fair value must:

A fund's valuation policy should include a quantitative threshold to determine what constitutes an active market, which typically will be based on average trading volume, frequency of observable transactions, and evaluation of the

quoted market prices included within Level 1 that are observable. Level 2 securities will include restricted stock, private investments in public equity (PIPEs) and certain convertible bonds. The fair value of these types of

· Be widely accepted. · Be non-proprietary. · Use data that is observable. Certain inputs derived through extrapolation may be corroborated by

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observable market data and still maintain Level 2 status (e.g., extrapolating a fiveyear interest rate yield into a seven-year yield). However, if there are significant judgments or adjustments made to either the model or data, the derivatives may be considered Level 3. For example, the extrapolation of short-term inputs for longer-term inputs may require additional assumptions or judgments that are not observable, therefore moving the investment to Level 3.

When considering a new round of financing into the fair value inputs, the following factors should be considered:

Investments in Private Investment Companies

Since the issuance of SFAS 157,

· Attributes and characteristics of the transaction. · Complexity of the capital structure. · Proximity to reporting date. · Any changes in the portfolio company in the intervening period between transaction date and reporting date. · Again, cost can be considered (but not on its own) since it cannot be presumed to be fair value. As a best practice, a fund's financial

questions regarding the use of Net Asset Value ("NAV") in determining the fair value of alternative investments have been raised by auditors, constituents, and financial statement preparers. Diversity in practice existed when fund management and administrators used various techniques to adjust NAV in determining the fair value of its interests in certain alternate investments, such as hedge funds, private equity funds, real estate funds, offshore fund vehicles, and funds of funds. The widespread diversity in practice resulted in arbitrary adjustments to NAV. In response to stakeholders concerns, the FASB issued an update to ASC 820 that provides additional guidance for reporting entities that have investments in certain entities that calculate NAV to determine fair value. The updated guidance in ASC 820 applies to investments if the investment meets both of the following criteria at the measurement date: · There is no readily determinable fair value for the investment (i.e., if active market quotations are available for the investment, then the quoted prices should be used). · The investment has all of the attributes of an investment company as specified in the Codification, or if it lacks one or more of the specified attributes and it

Level 3 Private Operating Companies

Investments in private operating companies, also known as private equity investments, will generally be categorized in the fair value hierarchy as a Level 3 investment, given the lack of observable market inputs. Many funds that invest in private equity companies have traditionally recorded the fair value of those investments at their initial cost, and subsequently made adjustments when there was a new round of financing. One of the talking points we have used with clients over the years in regard to private equity investments is that "cost is not fair value, but fair value can approximate the cost." A fund's valuation policy should document the fair value of private equity investments through its use of internal analysis, review of portfolio company financial statements, and comparison of the fair value of public securities to the fair value of its investment in the private equity.

reporting team should document the fair value measurement of its private equity investments by performing an ongoing review of the approaches used to determine fair value. A fund should incorporate multiple valuation techniques to determine fair value of its investments in private operating companies such as a discounted cash flow analysis as well as a market based approach that includes information of comparable public companies. A market based analysis should also include comparisons of public company performance multiples as part of its supporting documentation of fair value. Furthermore, a fund should include the use of multiple valuation techniques to supplement and corroborate the fair value of a recent round of private equity financing.

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is industry practice to issue financial statements using guidance that is consistent with measurement principles of investment companies. ASC 820 provides that a fund may now use NAV as a practical expedient when determining the fair value of its interests in alternative investments unless it is probable the investments will be sold at a price other than NAV. Furthermore, a reporting entity is permitted to estimate the fair value of certain alternative investments using NAV without further adjustment if NAV is calculated consistent with the guidance in ASC Topic 946, Financial Services - Investment Companies, ("ASC 946") (formerly the AICPA Audit and Accounting Guide, Investment Companies) as of the reporting entity's measurement date. (Editor's note: While funds will benefit because of the reduced time and effort required to use the practical expedient, management must still take responsibility for the fair value measurement of alternative investments.) A common question that is often raised is whether a reporting fund is permitted to "look through" to the underlying investee funds' investments to either determine fair value or for financial statement presentation. In cases where a fund invests in an investee fund that invests in other underlying investments, the reporting fund is not required to

"look through" to the investee fund's investments as long as a reporting fund evaluates the effectiveness of each of its investee funds' processes over internal controls and valuation practices of the investee and is able to conclude that the reported NAV is calculated in a manner consistent with ASC 946. However, before concluding that the reported NAV is calculated in accordance with the measurement principles of ASC 946, the reporting fund should consider the following: · Evidence gathered during the initial due diligence and ongoing monitoring procedures of the investee fund. · The investee fund's fair value estimation processes and control environment, as well as its policies and procedures for estimating fair value of underlying investments, and any changes to those processes, the control environment, or policies or procedures. · The use of independent third party valuation experts. · The portion of the underlying securities held by the investee fund that are actively traded (i.e., Level 1 securities). · Comparison of historical realizations to last reported fair value (i.e., back testing of securities). · Whether NAV has been appropriately adjusted for items such as carried interest and clawbacks. · The professional reputation and standing of the investee fund's service providers such as its auditor and administrator.

· Qualifications, if any, of the auditor's report or whether there is a history of significant adjustments to the NAV reported by the investee fund manager as a result of its annual audit or otherwise. · Evaluate the basis of accounting of the investee fund (i.e., U.S. GAAP, International Financial Reporting Standards ("IFRS"), income tax basis, cash basis, etc.). Moreover, when determining whether the investment will be categorized as Level 2 or Level 3 within the fair value hierarchy, a reporting fund must consider the length of time remaining until the investment becomes redeemable. As long as the reporting fund has the contractual and practical ability to redeem at the NAV in the near term at the measurement date, then an investment may be classified as Level 2, even if a redemption notice was not submitted. "Near term" is a matter of professional judgment, and historically has been defined by the FASB as a period of time not to exceed one year from the measurement date. However, a redemption period of 90 days or less would likely be considered near term since any potential discount relative to the time value of money to the next redemption date would not likely be considered a significant unobservable input. It is important to note that a redemption period of 90 days or less should not automatically be deemed near term. Other facts and circumstances, such as the likelihood

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or actual imposition of gates, and the liquidity of the investee fund's portfolio, should also be considered by the reporting fund in determining the appropriate level within the hierarchy. In situations when there are material adjustments to NAV to arrive at fair value the result will typically be a Level 3 designation. For funds that are either precluded from or elect not to use NAV as a practical expedient to estimate fair value, such as when a sale of an investment is probable at an amount different from NAV, or an adjustment to the reported NAV cannot be estimated, the specific attributes of the investment that independent market participants would take into account in valuing the investment must be considered. The features, risks and other restrictions related to each investment should be evaluated in the aggregate since those attributes may be considered by a market participant with access to the market for the investment when determining a price for the investment. The ability of a fund to provide liquidity to its investors through subscriptions and redemptions are key considerations in evaluating whether an adjustment to NAV would be required. For example, if the fund is an open-ended fund which permits investors to periodically transact in and out of the investment, market participants may accept NAV as fair value since it is likely they would also

transact at the same reported NAV. The use of redemption gates and side pockets are common techniques used to manage the liquidity of a fund in an orderly manner. The mere existence of contractual provisions permitting the use of gates and side pockets might not normally have an effect on fair value unless those provisions are actually exercised. These considerations are likely to be evaluated by the reporting fund as part of its initial due diligence procedures when making an investment in a particular fund. These features are generally considered and accepted by market participants, and may not result in any adjustment to NAV. However, reporting funds should still consider these features in conjunction with other inputs available to value the investment. In summary, if market participants would be expected to place a discount or premium on the reported NAV because of risks, features or other factors relating to the investment, then the fair value measurement of the investment would need to be adjusted for that risk or opportunity. However, if market participants might accept the same risks, features or other factors relating to the investment and might transact at the reported NAV without premium or discount, those facts may suggest that no adjustment is needed to estimate fair value.

U.S. GAAP also requires reporting entities provide additional disclosures for its investments in certain investees that calculate NAV regardless of whether the reporting entitiy uses NAV as a practical expedient. The disclosures are intended so users of financial statements can understand the nature and risks of the investments. The following disclosures must be made by each major category of investment for interim and annual reporting periods: · Fair value and a description of the significant strategies of investee(s). · For investments that cannot be redeemed, the estimated time that it will take the investee(s) to liquidate the underlying assets. · Unfunded commitments to investee(s). · Redemption or liquidity terms such as notice periods and redemption times (e.g., 60-day notice period with monthly liquidity). · Temporary restrictions on redemptions from otherwise redeemable investee(s), including how long the restriction has been in effect and an estimate of the time the restriction will lapse or the statement of the fact when the fund is unable to make an estimate. Examples of restrictions would be lockups, gates and suspended redemptions. · Any other significant restrictions on the ability to sell or redeem an investment. · The fair value of any portion of an investment that it is probable that it will be sold at an amount other than

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the reported NAV, and any remaining steps required to complete the sale or redemption. · Any plans or intentions to sell a group of unspecified investments that continue to qualify for the practical expedient and the remaining steps required to complete the sale. Additional disclosures should be made to explain the overall risks and exposures to economic concentrations of the investee funds by geographic regions, industries and types of securities. In determining the appropriate major categories of investments in private investment companies, a reporting fund should consider the activity or business sector, vintage, geographic concentration, credit quality and other economic characteristics of the investee funds.

determining when transfers between levels are recognized. Examples of policies for when to recognize transfers between Levels 1 and 2 in the fair value hierarchy could include the following: · The actual date of the event or change in circumstances that caused the transfer. · The beginning of the reporting period. · The end of the reporting period. Refer to Exhibit 2 for examples of sample financial statement footnote disclosures. (Editor's Note: As a best practice, we recommend that fund managers prepare a quarterly rollforward schedule showing year-to-date transfers within all levels within the fair value hierarchy. We also recommend that fund managers prepare a reconciliation from the above mentioned rollforward schedule to the books and records of the fund since auditors will usually request this information during their annual audit. In order to prepare a complete and accurate quarterly rollforward schedule, fund managers must determine the level designation for each investment at the end of each quarter.) As discussed earlier, investments may be transferred between Levels during an accounting period. For example, certain events may give rise to a transfer between Levels in the fair value hierarchy such as the lifting of certain restrictions on common stock, an active market

subsequently deemed to be inactive and disorderly, and a private operating company that completes an initial public offering. Although not a "brightline," industry practice has accepted 10% of NAV as a starting point to determine transfers that are "significant." Furthermore, when documenting a fund's valuation policy, fund managers should document the procedures that are in place to analyze the movement of investments between Levels.

Disclosures for Each "Class" of Assets and Liabilities

Beginning in 2010, ASC 820 requires a reporting entity to provide fair value measurement disclosures for each "class" of assets and liabilities. Previously, reporting entities were required to disclose fair value measurement information for its investments by "major categories." Many reporting entities had interpreted "major categories" to be the same categories that appear in the statement of financial condition. While ASC 820 does not specifically outline the criteria of a class, it does provide guidance as to what the components of the class should entail based on the nature and risk of the assets and liabilities. For equity and debt securities, a fund should determine the appropriate classes for those disclosures on the basis of the nature and risks of the assets and liabilities and their classification in the fair value hierarchy

Accounting for Transfers Between Levels

Beginning in 2010, ASC 820 requires a reporting entity to disclose the amounts of significant transfers between Level 1 and Level 2 and also requires the reporting entity to disclose the reason for the transfer between Levels in the fair value hierarchy. Significant transfers into Levels 1 and 2 are required to be disclosed separately from transfers out of each level. As it relates to funds, significance is typically measured against the fund's net asset value. In addition, management should disclose and consistently follow its policy for

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(Levels 1, 2, and 3). Furthermore, ASC 820 also requires that classes for equity and debt securities be determined using major security types. When preparing the fair value measurement disclosure for each class of assets and liabilities, we recommend that funds use as a starting point the same security types for classes that are used in the condensed schedule of investments (the "SOI"). However, a fund manager may consider separating a particular security type into greater detail based on factors such as business sector, vintage, geographic concentration, credit quality, and economic characteristics. For all other assets and liabilities, judgment is needed to determine the appropriate classes of assets and liabilities for which disclosures about fair value measurements should be provided. Depending on the nature and extent of the fund's holdings, a greater detail and number of classes may be more pertinent for investments classified as Level 3 due to the greater degree of uncertainty and subjectivity involved in determining Level 3 fair value measurements. In many cases, the industry in which the issuer of a security operates will be a meaningful class designation to provide disaggregation in fair value disclosures. However, other meaningful class designations can include market capitalization, geographic concentrations, asset class tranches,

investment strategies, commodity type, derivative underlyings, and credit rating categories, based on the risk concentrations that a fund determines to be significant and relevant to its investment strategies. In determining the appropriate level of disaggregation, a fund should also consider disclosures in other U.S. GAAP literature, such as ASC Topic 815, Derivatives and Hedging. The methodology used to determine classes under U.S. GAAP may vary across entities, but should result in increased transparency to the users of the financial statements. (Editors Note: We believe certain amendments to ASC 820 pertaining to the appropriate level of disaggregation did not contemplate the disclosures already required for investment companies in the SOI. When preparing the required disaggregation disclosures under U.S. GAAP, fund managers should evaluate whether the combination of the SOI disclosure requirements and the ASC 820 disaggregation disclosure requirements will provide sufficient transparency of the fair value hierarchy classifications to users of the financial statements. Moreover, funds that disclose their investments by major security type on the SOI should pay special attention to certain investments that "cross-over" into various levels within the fair value hierarchy. When investments shown on the SOI contains material amounts of Level 2 and Level 3 positions, a fund manager should consider bifurcating the amount of the

investment into significant concentrations [i.e. industry, geographic area, or vintage] in the three level hierarchy footnote disclosure table. As a practical matter, the SOI and the footnote disclosure showing assets and liabilities by class should be prepared simultaneously.) However, depending upon the amount of a fund's Level 3 activity during a period, the SOI may not provide enough meaningful disaggregation detail for use in the Level 3 rollforward since the SOI represents a snapshot of a fund's investments and is not an activity-based disclosure. Therefore, a fund may need to consider the magnitude of rollforward activity for a given class to determine whether it merits more granular detail in the Level 3 rollforward. Refer to Exhibit 2 for examples of sample financial statement footnote disclosures.

Disclosures About Inputs and Valuation Techniques

ASC 820 clarifies the disclosure requirements relating to inputs and valuation techniques used to measure fair value. For fair value measurements using significant other observable inputs (Level 2) and significant unobservable inputs (Level 3), a fund is required to disclose a description of the valuation technique(s) and inputs used in determining the fair values of each class of assets and liabilities. In addition, a fund shall disclose

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changes in valuation techniques and the reasons for making the change. Disclosures of valuation inputs should consider quantitative information about the inputs (e.g., prepayment rates, default rates, interest rates, discount rates, and volatilities), the nature and detailed characteristics of the item being measured, and how third-party information such as broker quotes, pricing services, net asset values and relevant market data was considered in measuring fair value. As a best practice, funds should review their disclosures for Level 2 and Level 3 investments to ensure that a robust description of the valuation inputs and methodologies used are included in the financial statements. In many instances, a qualitative description of valuation inputs may be sufficient to describe the valuation inputs used. However, funds should also consider disclosures of quantitative information on valuation inputs based on assumed market participant parameters when the magnitude of subjectivity intrinsic to the investment valuations warrant a greater degree of transparency in the disclosures. When multiple valuation methodologies are used within an investment class, we recommend disclosing the aggregate fair values by valuation methodology utilized. Refer to Exhibit 2 for examples of sample financial statement footnote disclosures.

Other Considerations

Activity in Level 3 Fair Value Measurement

Beginning in 2011, U.S. GAAP will change the presentation requirements currently effective under ASC 820 relating to the Level 3 rollforward table. Under the current literature, a reporting entity is required to disclose a reconciliation of the beginning and ending balances for significant unobservable inputs (Level 3 investments) by indicating the gains and losses for the period, purchases, sales, issuances, settlements and transfers in and/or out of Level 3 on a net basis. The new guidance will require purchases, sales, issuances, settlements and transfers in and/or out of Level 3 to be presented on a gross basis. Total gains or losses for the period (realized and unrealized) will still be permitted to be presented on a net basis. Effectively, significant changes in Level 3 investments during the period will each be disclosed separately. Furthermore, the new guidance requires the reporting entity to disclose the reasons for transfers in and/or out of Level 3 investments. Similar to the policy requirements for transfers between Levels 1 and 2, management should disclose and consistently follow its policy for determining when transfers between levels are recognized. Refer to Exhibit 2 for examples of sample financial statement footnote disclosures.

(Editor's Note: The FASB decided to delay the effective date of disclosing the Level 3 rollforward on a gross basis until 2011 to give entities that required significant changes to their information systems adequate time to comply with the new standard. We recommend funds begin to evaluate the impact of this new disclosure requirement.)

Fair Value Disclosure Requirements for Derivative Assets and Liabilities

Beginning in 2010, ASC 820 requires a fund to provide fair value measurement disclosures for derivative assets and liabilities on a gross basis. Previously, funds were permitted to present the fair value disclosures for derivative assets and liabilities on a net basis. However, the activity of derivative assets and liabilities included in the Level 3 rollforward continue to be permitted to be presented on either a gross or net basis. Refer to Exhibit 2 for examples of sample financial statement footnote disclosures.

Effective Dates of New Fair Value Measurement and Disclosure Guidance

As discussed in our previous white paper on fair value measurements, SFAS 157 was issued in September 2006 and was

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effective for financial statements with fiscal years beginning after November 15, 2007 and interim periods within those fiscal years (the first quarter of 2008 for a calendar year-end fund). The fair value measurement and disclosure guidance contained in SFAS 157, together with any fair value measurement and disclosure guidance issued subsequent to the issuance of SFAS 157, was included in ASC 820 upon the launch of the Codification in July 2009. It should be noted that post Codification, the FASB will no longer issue FASB Statements, FASB Staff Positions ("FSPs"), FASB Interpretations ("FINs"), or Emerging Issue Task Force ("EITF") Abstracts. New authoritative U.S. GAAP is now communicated via a new document called an Accounting Standards Update ("ASU"). When amendments to the Codification contained in an ASU become effective, the Codification guidance is updated. The following fair value measurement and disclosure ASU's were issued by the FASB subsequent to the launch of the Codification: · ASU 2010-06, Improving Disclosures About Fair Value Measurement (issued January 2010; effective for interim and annual reporting periods beginning after December 15, 2009, except for disclosures of gross activity in the Level 3 rollforward which will be effective for fiscal years beginning after December 15, 2010). · ASU 2009-12, Investments in Certain Entities That Calculate Net Asset

per Share, or Its Equivalent (issued September 2009; effective for interim and annual reporting periods beginning after December 15, 2009). · ASU 2009-05, Measuring Liabilities at Fair Value (issued August 2009; effective for the first reporting period, including interim periods, beginning after issuance).

other premiums and discounts in a fair value measurement. · Disclosure of a measurement uncertainty analysis for Level 3 fair value measurements. · Disclosure of any transfers between Level 1 and Level 2 of the fair value hierarchy as well as any transfers in and out of Level 3. A final standard is expected to be issued in early 2011. As of press time, there are many practice implementation issues relating to certain proposed provisions of which the resolution of various constituent concerns is not yet determinable. Rothstein Kass is monitoring the progress of this topic and will provide additional guidance when the final standard is issued.

FASB/IASB Convergence Proposed Guidance on Fair Value Measurement and Disclosure

On June 29, 2010, both the FASB and the International Accounting Standards Board (the "IASB") (collectively "the Boards") released separate exposure drafts on proposed fair value measurements and disclosures standards with the objective to align U.S. GAAP and IFRS. In the FASB exposure draft, the FASB has proposed certain amendments to ASC 820 that would change fair value measurement principles and disclosures. These proposed amendments may result in additional changes in the way funds prepare their financial statements. Proposed Changes The more notable of those proposed amendments to U.S. GAAP include the following: · Highest and best use valuation premise. · Measuring the fair value of financial instruments that are managed within a portfolio. · Application of blockage factors and

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Exhibit 1 Matrix of Levels and Typical Level Designations

Level

Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities.

Types of Inputs

Unadjusted quoted prices from an exchange or broker-dealer market that is deemed to be active.

Types of Investments (Note 1)

Exchange-traded securities, most U.S. government securities, certain other sovereign government securities, listed derivatives, futures contracts and overthe-counter ("OTC") securities traded in an active market. Exchange-traded securities (Note 3) and listed derivatives that are not actively traded, most OTC derivatives, restricted stock, corporate and municipal bonds, certain corporate loans, certain high-yield debt, certain residential and commercial mortgage loans, certain mortgage-backed securities ("MBS"), asset-backed securities ("ABS"), and collateralized debt obligation ("CDO") securities, investments in certain private investment companies, futures and forward contracts, physical commodities, and certain deferred fee arrangements. Certain corporate loans, certain mortgage loans, certain high-yield debt, distressed debt (i.e., securities of issuers encountering financial difficulties, including bankruptcy or insolvency), certain MBS, ABS and CDO securities, investments in real estate funds and certain private investment companies, private equity investments, complex OTC derivatives (including certain foreign currency options, long-dated commodity options and swaps, certain mortgagerelated credit default swaps, derivative interests in mortgage-related CDOs, and basket credit default swaps), and certain deferred fee arrangements.

Level 2 - Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

Adjusted prices from an exchange or broker-dealer market that is deemed to be inactive, brokered markets for restricted securities, registered debt and observable market inputs, such as equity prices, yield curves, implied volatility, interest rates, prepayment speeds, loss severities, credit risks, and default rates (including those inputs extrapolated from other observable inputs). (Note 2)

Level 3 - Valuations based on inputs that are not observable and significant to the overall fair value measurement.

Models utilizing significant inputs that are unobservable (e.g., historical volatilities), such as Black-Scholes, discounted cash flows, multiples of earnings or EBITDA including risk assumptions consistent with what market participants would use to arrive at fair value.

Note 1 - Level designations within the fair value hierarchy are based on the lowest level input that is significant to an investment's fair value measurement. Actual level designations of an investment may vary from the examples illustrated above based on individual facts and circumstances. Note 2 - For Level 2 designations, any models used must be widely accepted, non-proprietary and the data used must be observable. Any significant judgments or adjustments to the model or data will likely result in a Level 3 designation. In addition, quotes from brokered markets must represent a firm commitment to transact or are developed from other observable market data. Note 3 - Exchange-traded securities that are traded in an inactive and disorderly market or the prices from the exchange are adjusted due to aftermarket events would generally be assigned a Level 2 designation.

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Exhibit 2 Sample Financial Statement Footnote Disclosures

The illustrative financial statement footnote disclosures that follow have taken into consideration the requirements outlined in ASC 820. Level designation within the fair value hierarchy should be based on the lowest level input that is significant to the fair value measurement of the security and may vary from the designations illustrated in the disclosures below.

developed based on the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows: Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Fund has the ability to access. Valuation adjustments are not applied to Level 1 investments. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these investments does not entail a significant degree of judgment. Level 2 - Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

represent the amounts that may be ultimately realized due to the occurrence of future circumstances that cannot be reasonably determined. Because of the inherent uncertainty of valuation, those estimated values may be materially higher or lower than the values that would have been used had a ready market for the investments existed. Accordingly, the degree of judgment exercised by the Fund in determining fair value is greatest for investments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement falls in its entirety is determined based on the lowest level input that is significant to the fair value measurement. Fair value is a market-based measure

Significant Accounting Policy Footnotes

Fair Value - Definition and Hierarchy Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the "exit price") in an orderly transaction between market participants at the measurement date. In determining fair value, the Fund uses various valuation approaches. A fair value hierarchy for inputs is used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs are to be used when available. Observable inputs are those that market participants would use in pricing the asset or liability based on market data obtained from sources independent of the Fund. Unobservable inputs reflect the Fund's assumptions about the inputs market participants would use in pricing the asset or liability

The availability of valuation techniques and observable inputs can vary from investment to investment and are affected by a wide variety of factors, including the type of investment, whether the investment is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Those estimated values do not necessarily

considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Fund's own assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date. The Fund uses prices and inputs that are current as of the measurement date, including periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may

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be reduced for many investments. This condition could cause an investment to be reclassified to a lower level within the fair value hierarchy.

To the extent these securities are actively traded and valuation adjustments are not applied, they are categorized in Level 1 of the fair value hierarchy. Securities traded on inactive markets or valued by reference to similar instruments are generally categorized in Level 2 of the fair value hierarchy.

inputs, including, where applicable, time value, implied volatility, equity and commodity prices, interest rate yield curves, prepayment speeds, interest rates, loss severities, credit risks, credit curves, default rates and currency rates. Certain pricing models do not entail material subjectivity as the methodologies employed include pricing inputs that are observed from actively quoted markets. In the case of more established derivative contracts, the pricing models used by the Fund are widely accepted by marketplace participants. OTC derivatives contracts (such as forward and swap contracts) which may be valued using models, depending on whether significant inputs are observable or unobservable, are categorized in Levels 2 or 3 of the fair value hierarchy.

Fair Value - Valuation Techniques and Inputs

Investments in Securities and Securities Sold Short The Fund values investments in securities and securities sold short that are freely tradable and are listed on a national securities exchange or reported on the NASDAQ national market at their last reported sales price as of the valuation date. Many OTC contracts have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that the marketplace participants are willing to pay for an asset. Ask prices represent the lowest price that the marketplace participants are willing to accept for an asset. For securities whose inputs are based on bid-ask prices, the Fund's valuation policies do not require that fair value always be a predetermined point in the bid-ask range. The Fund's policy for securities traded in the OTC markets and listed securities for which no sale was reported on that date are generally valued at their last reported bid price if held long, and last reported ask price if sold short.

Derivative Contracts The Fund records its derivative activities at fair value. Gains and losses from derivative contracts are included in net gain (loss) from derivative contracts in the statement of operations. Derivative contracts include forward, futures, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, and equity prices or commodity prices. Derivative contracts, such as options and futures, which are listed on a national securities exchange or reported on the NASDAQ national market, are generally categorized in Level 1 of the fair value hierarchy. Depending on the underlying security and the terms of the transaction, the fair value of certain derivatives may be able to be modeled using a series of techniques, including closed-form analytic formula (such as the Black-Scholes option-pricing model), simulation models, or a combination thereof. Pricing models take into account the contract terms (including maturity) as well as multiple

Investments in credit default swaps are valued using pricing models widely accepted by marketplace participants. The pricing models take into account the contract terms (including maturity), time value, credit curves, recovery rates, and current credit spreads obtained from swap counterparties and other market participants. At December 31, 20XX, investments in credit default swaps had maturities within a range of X and XX years, and were valued using recovery rates with a range of XX% and XX%, and current credit spreads within a range of XXX and X,XXX basis points.

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Government Bonds The fair value of sovereign government bonds is generally based on quoted prices in active markets. When quoted prices are not available, fair value is determined based on a valuation model that uses inputs that include interest rate yield curves, cross-currency basis index spreads, and sovereign credit spreads similar to the bond in terms of issuer, maturity and seniority. Sovereign government bonds are generally categorized in Levels 1 or 2 of the fair value hierarchy. Municipal Bonds The fair value of municipal bonds is estimated using recently executed transactions, market price quotations and pricing models that factor in, where applicable, interest rates, bond or credit default swap spreads and volatility. Municipal bonds are generally categorized in Level 2 of the fair value hierarchy.

spreads, and recovery rates based on collateral values as key inputs. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy. In instances where significant inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy. Bank Debt The fair value of bank debt is generally valued using recently executed transactions, market price quotations (where observable) and market observable credit default swap levels. When quotations are unobservable, proprietary valuation models and default recovery analysis methods are employed, utilizing default rates within a range of X.X% to X.X%, recovery rates within a range of X.X% to X.X%, and loss rates within a range of X.X% to X.X%. Bank debt is categorized in Levels 2 or 3 of the fair value hierarchy. Commercial Mortgage-Backed

absence of market prices, are valued as a function of observable whole bond prices and cash flow values of principalonly bonds using current market assumptions at the measurement date. CMBS and ABS are categorized in Level 2 of the fair value hierarchy when external pricing data is observable and in Level 3 when external pricing data is unobservable. At December 31, 20XX, the Fund had investments in ABS with a fair value of approximately $XX,XXX,000 which are included in Level 3 of the fair value hierarchy. These securities represent mezzanine and equity tranches in various securitization trusts. The underlying loans for these securities include small business loans and credit card receivables that were originated between 200X and 201X. The underlying small business loans and credit card receivables have respective weightedaverage coupon rates of X.X% and X.X% and weighted-average maturities of X and XX years. To estimate their fair value, the Fund uses a cash flow model. The significant inputs used for the cash flow model include the following inputs:

Mezzanine (Tranches) Yields to Maturity Default Rates Loss Severities Prepayment Rates X.X% - X.X% X.X% - X.X% X.X% - X.X% X.X% - X.X% Equity (Tranches) X.X% - X.X% X.X% - X.X% X.X% - X.X% X.X% - X.X%

Corporate Bonds The fair value of corporate bonds is estimated using recently executed transactions, market price quotations (where observable), bond spreads, or credit default swap spreads. The spread data used is for the same maturity as the bond. If the spread data does not reference the issuer then data that references a comparable issuer is used. When observable price quotations are not available, fair value is determined based on cash flow models using yield curves, bond or single name credit default swap

Securities (CMBS) and Asset-Backed Securities (ABS) CMBS and ABS may be valued based on external price/spread data. When position-specific external price data is not observable, the valuation is either based on prices of comparable securities or cash flow models that consider inputs including default rates, conditional prepayment rates, loss severity, expected yield to maturity, and other inputs specific to each security. Included in this category are certain interest-only securities, which in the

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Investments in Private Operating Companies The Fund's investments in private operating companies consist of direct private common and preferred stock (together or individually "equity") investments. The transaction price, excluding transaction costs, is typically the Fund's best estimate of fair value at inception. When evidence supports a change to the carrying value from the transaction price, adjustments are made to reflect expected exit values in the investment's principal market under current market conditions. Ongoing reviews by the Fund's management are based on an assessment of trends in the performance of each underlying investment from the inception date through the most recent valuation date. These assessments typically incorporate valuation methodologies that consider the evaluation of arm's length financing and sale transactions with third parties, an income approach reflecting a discounted cash flow analysis, and a market approach that includes a comparative analysis of acquisition multiples and pricing multiples generated by market participants. In certain instances the Fund may use multiple valuation methodologies for a particular investment and estimate its fair value based on a weighted average or a selected outcome within a range of multiple valuation results. These investments in private operating companies are generally included in Level 3 of the fair value hierarchy.

Investments valued using an income approach utilized discount rates within a range of XX% to XX%. Additional inputs relied upon in this approach include annual projected cash flows for each investment through their respective investment horizons. These cash flow assumptions may be probability-weighted to reflect the risks associated with achieving expected performance levels across various business scenarios. Under the income approach, the privately-held nature of an investment may be reflected in the magnitude of the selected range of discount rates or through application of separate liquidity discounts within a range of XX% to XX%. Investments valued using a market approach utilized valuation multiples within a range of X.X and X.X times the annual earnings before interest, taxes, depreciation and amortization ("EBITDA"), or another performance metric such as revenues or net earnings. The selected valuation multiples were estimated through a comparative analysis of the performance and characteristics or each investment within a range of comparable companies or transactions in the observable marketplace. In addition, the Fund generally applies liquidity discounts within a range of XX% to XX%, and control premiums within a range of XX% to XX%, dependant upon the characteristics of the individual investment and its respective marketplace.

At December 31, 20XX, the approximate fair values of the Fund's investments in private operating companies, by valuation methodology, are as follows:

Third Party Transactions Income Approach Market Approach Blended Approach

$ $ $ $

X,XXX,000 X,XXX,000 X,XXX,000 X,XXX,000

Investments in Restricted Securities of Public Companies Investments in restricted securities of public companies cannot be offered for sale to the public until the Fund complies with certain statutory requirements. The valuation of the securities by management takes into consideration the type and duration of the restriction, but in no event does the valuation exceed the listed price on a national securities exchange or the NASDAQ national market. Investments in restricted securities of public companies are generally included in Level 2 of the fair value hierarchy. At December 31, 20XX, investments in restricted securities of public companies of approximately $XX,XXX,000 were valued using liquidity discounts within a range of XX% to XX%.

Rothstein Kass 21

Investments in Private Investment Companies Investments in private investment companies are valued, as a practical expedient, utilizing the net asset valuations provided by the underlying private investment companies, without adjustment, when the net asset valuations of the investments are calculated (or adjusted by the Fund if necessary) in a manner consistent with U.S. GAAP for investment companies. The Fund applies the practical expedient to its investments in private investment companies on an investment-byinvestment basis, and consistently with the Fund's entire position in a particular investment, unless it is probable that the Fund will sell a portion of an investment at an amount different from the net asset valuation. If it is probable that the Fund will sell an investment at an amount different from the net asset valuation or in other situations where the practical expedient is not available, the Fund considers other factors in addition to the net asset valuation, such as features of the investment, including subscription and redemption rights, expected discounted cash flows, transactions in the secondary market, bids received from potential buyers, and overall market conditions in its determination of fair value. Investments in private investment companies are included in Level 2 or 3 of the fair value hierarchy. In determining the level, the Fund considers the

length of time until the investment is redeemable, including notice and lock-up periods or any other restriction on the disposition of the investment. The Fund also considers the nature of the portfolios of the underlying private investment companies and their ability to liquidate their underlying investments. If the Fund has the ability to redeem its investment at the reported net asset valuation as of the measurement date, the investment is generally included in Level 2 of the fair value hierarchy. If the Fund does not know when it will have the ability to redeem the investment or it does not have the ability to redeem its investment in the near term, the investment is included in Level 3 of the fair value hierarchy. Note X -- Fair Value Measurements The Fund's assets and liabilities recorded at fair value have been categorized based upon a fair value hierarchy as described in the Fund's significant accounting policies in Note 1. The following tables present information about the Fund's assets and liabilities measured at fair value as of December 31, 2010 (in thousands):

22 Rothstein Kass

Assets (at fair value) Investments in securities Common stocks United States Banking Manufacturing Consumer discretionary Health care Real estate United Kingdom Manufacturing Telecommunications Preferred stocks Exchange traded funds Private preferred stocks Corporate bonds Government bonds Municipal bonds Asset-backed securities Senior debt Mezzanine debt Total investments in securities Investments in private investment companies Value Growth North America Asia Merger arbitrage North America Europe Private equity Total investments in private investment companies Derivative contracts Interest rate swaps Call warrants Total return swaps Call options Put options Total derivative contracts Securities purchased under agreements to resell Cash equivalents $ $

Level 1

Level 2

Level 3

Total

117,089 94,447 87,491 81,038 44,961 38,571 33,642 96,000 19,567

$ 2,191

$

$

117,089 94,447 89,682 81,038 44,961 38,571

462 600 18,541 59,481 2,584

34,104 96,600 19,567 18,541 62,065 22,391 31,534 19,159 9,518 49,802 20,432 9,518 780,540 72,424 53,909 1,191 23,339 1,191 23,339 1,460 38,223 38,223 190,546 60,439 1,879 1,396 47,072 31,507 23,807 2,159 62,753

22,391 31,534 1,273 635,197 95,541 72,424 53,909

1,460 127,793 60,439 45,193 30,111 23,807 2,159 25,966 3,567 664,730 $ 371,527 $ 115,830 $ 135,743 12,450 3,275

164,984 12,450 3,567 1,152,087

Rothstein Kass 23

Liabilities (at fair value)

Level 1

Level 2

Level 3

Total

Securities sold short Common stocks Preferred stocks Total securities sold short Derivative contracts Credit default swaps Total return swaps Interest rate swaps Contracts for differences Forward contracts Futures contracts Call options Put options Total derivative contracts $ 21,879 9,960 5,691 37,530 582,305 $ 116,067 121,723 $ 1,838 1,838 $ 23,839 24,660 23,112 22,384 22,072 1,838 25,677 24,660 23,112 22,384 22,072 21,879 9,960 5,691 155,435 705,866 $ 510,581 34,194 544,775 $ 4,653 1,003 5,656 $ $ 515,234 35,197 550,431

(Editors Note: When considering disaggregating assets and liabilities by "class," we recommend using line items contained in the condensed schedule of investments ("SOI") as a starting point. If one of the line items in the SOI contain significant amounts in more than one hierarchy level, further disaggregation would be required. The example above assumes significant amounts of common stock in Level 1 and 2 and asset-backed securities in Level 2 and 3.)

24 Rothstein Kass

Significant transfers into and out of each level of the fair value hierarchy for assets measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:

Assets (at fair value)

Transfers into Level 1

Transfers (out) of Level 1

Transfers into Level 2

Transfers (out) of Level 2

Transfers into Level 3

Transfers (out) of Level 3

Investments in securities Common stocks Preferred stocks Exchange traded funds Private preferred stocks Corporate bonds Government bonds Municipal bonds Asset-backed securities Total investments in securities Investments in private investment companies Derivative contracts Interest rate swaps Call warrants Total return swaps Call options Put options Total derivative contracts Securities purchased under agreement to resell $ 49,457 $ (8,412) $ 84,849 $ (55,434) $ 5,977 $ (76,437) 6,616 (1,467) 1,467 (6,616) 6,616 (1,467) 1,467 (6,616) 49,457 (8,412) 10,338 67,895 (53,967) 4,510 (1,926) (67,895) 1,926 (4,510) 4,510 (1,926) $ 39,019 10,438 $ (8,412) $ 8,412 $ (39,019) (10,438) $ $

Rothstein Kass 25

Significant transfers into and out of each level of the fair value hierarchy for liabilities measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:

Liabilities (at fair value)

Transfers into Level 1

Transfers (out) of Level 1

Transfers into Level 2

Transfers (out) of Level 2

Transfers into Level 3

Transfers (out) of Level 3

Securities sold short Common stocks Preferred stocks Total securities sold short Derivative contracts Credit default swaps Total return swaps Interest rate swaps Contracts for differences Forward contracts Futures contracts Call options Put options Total derivative contracts $ $ $ $ (562) (562) $ 562 562 $ (562) 562 $ $ $ $ $ $

All transfers are recognized by the Fund at the end of each reporting period. Transfers between Levels 1 and 2 generally relate to whether a market becomes active or inactive. Transfers between Levels 2 and 3 generally related to whether, for various reasons, significant inputs become observable or unobservable. See Note 1 for additional information related to the fair value hierarchy and valuation techniques.

26 Rothstein Kass

The following table presents additional information about Level 3 assets and liabilities measured at fair value. Both observable and unobservable inputs may be used to determine the fair value of positions that the Fund has classified within the Level 3 category. As a result, the unrealized gains and losses for assets and liabilities within the Level 3 category may include changes in fair value that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs. Changes in Level 3 assets measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:

Level 3 Change in Unrealized Gains (Losses) for Investments still held at December 31, 2010 (b) $

Assets (at fair value)

Beginning Balance January 1, 2010

Realized & Unrealized Gains (Losses)

(a)

Purchases, Sales and Settlements

Net Transfers into and/or (out) of Level 3

Ending Balance December 31, 2010

Investments in securities Common stocks Preferred stocks Exchange traded funds Private preferred stocks Corporate bonds Government bonds Municipal bonds Asset-backed securities Total investments in securities Investments in private investment companies Derivative contracts Interest rate swaps Call warrants Total return swaps Call options Put options Total derivative contracts Securities purchased under agreement to resell $ 135,115 $ (12,688) $ 63,863 $ (70,460) $ 115,830 $ 10,564 8,124 (37,115) 37,415 (5,149) 3,275 (2,396) 2,934 5,190 4,094 (41,209) 37,415 (5,149) 1,879 1,396 (562) (1,834) 17,319 17,319 109,672 34,910 33,451 (9,024) (23,552) (3,552) 30,000 2,584 (67,895) 28,677 49,802 62,753 12,481 11,569 1,391 (1,459) 20,000 2,584 18,541 2,584 (1,459) 547 $ $ $ $ $

Rothstein Kass 27

Changes in Level 3 liabilities measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:

Level 3 Change in Unrealized Gains (Losses) for Investments still held at December 31, 2010

Liabilities (at fair value)

Beginning Balance January 1, 2010

Realized & Unrealized Gains (Losses)

(a)

Purchases, Sales and Settlements

Net Transfers into and/or (out) of Level 3

Ending Balance December 31, 2010

(b)

Securities sold short Common stocks Preferred stocks Total securities sold short Derivative contracts Credit default swaps Total return swaps Interest rate swaps Contracts for differences Forward contracts Futures contracts Call options Put options Total derivative contracts $ 8,719 8,719 $ (7,443) (7,443) $ $ 562 562 $ 1,838 1,838 $ (418) (418) 8,719 (7,443) 562 1,838 (418) $ $ $ $ $ $

(a) Realized and unrealized gains and losses are all included in net gain (loss) on investments in the statement of operations. (b) The change in unrealized gains (losses) for the year ended December 31, 2010 for investments still held at December 31, 2010 are reflected in the net change in unrealized appreciation or depreciation on securities, net change in unrealized appreciation or depreciation on private investment companies, and net gain (loss) from derivative contracts in the statement of operations.

28 Rothstein Kass

The following footnote disclosure is a sample of a "gross" presentation of the Level 3 rollforward. This footnote disclosure is required for periods beginning after December 15, 2010 (calendar year-end 2011 funds); however, early adoption is encouraged. Changes in Level 3 assets measured at fair value for the year ended December 31, 2010 (in thousands) were as follows:

Level 3

Change in Unrealized Gains (Losses) for Investments still held at December 31, 2010

Assets (at fair value)

Beginning Balance January 1, 2010

Realized & Unrealized Gains (Losses)

Purchases

Sales

Settlements

Transfers into Level 3

Transfers (out) of Level 3

Ending Balance December 31, 2010

Investments in securities Common stocks Preferred stocks Exchange traded funds Private preferred stocks Corporate bonds Government bonds Municipal bonds Asset-backed securities Total investments in securities Investments in private investment companies Derivative contracts Interest rate swaps Call warrants Total return swaps Call options Put options Total derivative contracts Securities purchased under agreement to resell $ 135,115 $ (12,688) $ 56,451 $ (30,003) $ 37,415 $ 5,977 $ (76,437) $ 115,830 $ 10,564 8,124 (37,115) 37,415 1,467 (6,616) 3,275 (2,396) 2,934 5,190 4,094 (41,209) 37,415 1,467 (6,616) 1,879 1,396 (562) (1,834) 17,319 17,319 109,672 34,910 33,451 (9,024) 2,451 22,451 34,000 (26,003) (26,003) (4,000) 4,510 (1,926) (67,895) 28,677 49,802 62,753 12,481 11,569 1,391 $ $ $ $ $ $ $ $ $

(1,459)

20,000 4,510 (1,926)

18,541 2,584

(1,459) 547

Rothstein Kass 29

Exhibit 3 Frequently Asked Questions

General Questions

1. Are there any differences between the fair value measurement and disclosures guidance under previous U.S. GAAP in SFAS 157 and the codified guidance under current U.S. GAAP in ASC 820? 2. If a fund changes its valuation methodology for a certain investment, when is the adjustment to the fair value of the investment recorded? 3. When is the use of a valuation model to determine fair value acceptable under ASC 820? 4. If there are multiple valuation techniques available, how does a fund determine the most appropriate valuation technique under ASC 820? 5. What are the recognition guidelines for transfers between levels in the fair value hierarchy? 6. What is the consequence when a fund assigns incorrect levels to its investments according to the fair value hierarchy? 7. Are the fair value disclosure requirements in ASC 820 reported on the condensed schedule of investments or in the footnotes to the financial statements?

8. Are the fair value disclosure requirements in ASC 820 required for feeder funds whose sole investment is in a master fund?

large bid-ask spread from a brokerdealer that has provided a legal disclaimer on the quote? 16. When a fund receives multiple

9. Should a fund record its debt facility at fair value and disclose the debt per the requirements of ASC 820? 10. How does nonperformance risk impact the fair value measurement of derivatives? 11. What factors should funds consider when applying the fair value premise to liability instruments? 12. Are repurchase agreements and reverse repurchase agreements required to be disclosed in the fair value hierarchy level tabular disclosure?

indicative broker-dealer quotes, are the quotes considered to be observable or unobservable? 17. What would the level designation be for securities that rely on indicative broker-dealer quotes with legal disclaimers?

Fair Value HierarchyLevel 1 Considerations

18. How does a fund determine the principal or most advantageous market? 19. A fund purchases a security on Exchange A. The security is traded on both Exchange A and B. Exchange B has more liquidity and is more active than Exchange A. Does the fund determine the fair value of the security using Exchange A or B prices? 20. How can a fund determine, in

Third Party Pricing/BrokerDealer Quotations

13. Where does pricing from recognized third party pricing services and broker-dealers fall within the threelevel hierarchy? 14. If a fund receives broker-dealer quotes from multiple broker-dealers, can an average of the broker-dealer quotes be used to arrive at fair value? 15. What level designation would a fund assign to an investment where the fund can only get one quote with a

quantitative terms, the definition of an active market? 21. For exchange-traded equities, can a fund use the consolidated tape to price the securities?

30 Rothstein Kass

22. Block Discounts -- Can a fund take a "haircut" off the price of a position in a small cap company? 23. Is a fund required to disaggregate Level 1 investments in the footnotes to the financial statements by industry or geographic concentrations if Level 1 investments are already disclosed on the SOI?

29. In an illiquid market (such as the asset-backed security market) there can be a disconnect between the intrinsic value (e.g., the value determined by applying data inputs to a valuation which may presume the position would be held to maturity) and what the current quoted observable prices are for the security in the marketplace. Can the intrinsic value be used in lieu of the quoted prices when the current market is not active and therefore has unusually large bidask spreads? 30. If there are no recent transactions for an asset-backed security and a

measurement and the use of NAV as a practical expedient? 34. What fair value hierarchy level designation would a fund assign to an investment in a private investment company when the private investment company has a portion of its investment held in a side-pocket? 35. How does a fund conclude that NAV, as most recently reported by the investee fund manager, has been calculated according to the measurement principles of ASC 946? 36. What should a fund consider as part of the requirement to disclose information about the inputs and valuation techniques for Level 2 and 3 measurements?

Fair Value Hierarchy--Level 2 and Level 3 Considerations

24. Should a discount be taken when determining the fair value of a restricted stock? 25. Is it appropriate for a fund to adopt a policy of applying a standard discount rate to its investments (i.e., restricted stock or private investments in public equity (PIPEs)) when measuring fair value? 26. Are total return swaps where the underlying notional position is an actively traded security (i.e., Level 1 security) considered Level 1 or Level 2?

fund uses matrix pricing comparing asset-backed securities that have similar attributes and vintages, or a fund uses the ABX creditderivative index to price the security, what would be the resulting level designation for these approaches? 31. What level designation should a fund assign to a deferred fee liability which is reinvested into the fund? 32. When is it appropriate to designate

Fair Value Hierarchy--Level 3 Considerations-Investments in Private Operating Companies

37. For an investment in private operating companies, how does a recent round of financing factor into the fair value inputs in arriving at fair value, as well as the level designation within the fair value hierarchy? 38. Should transaction costs associated with the acquisition of an investment be capitalized into the cost of the investment or expensed as incurred?

27. Where do options fall within the fair value hierarchy? 28. What is the level designation in the fair value hierarchy for (PIPEs) including the warrants typically attached to those transactions?

a fund of funds investment in a private investment company as a Level 2 investment in the fair value hierarchy? 33. How does the probable sale of an investment for an amount other than NAV affect the investment's fair value

Rothstein Kass 31

39. For a private loan receivable, does ASC 820 require an adjustment to the "fair value" based on movements of interest rates for similar loans in the marketplace (even though the underlying credit of the borrower has not deteriorated)? 40. Can a fund rely on other disclosures within the financial statements in lieu of applying the disaggregation requirements to the disclosure of the Level 3 rollforward? 41. What is the expected impact of the proposed disclosure requirement of a measurement uncertainty analysis for Level 3 investments?

the sole source for guidance on how entities should measure and disclose fair value in their financial statements. ASC 820 includes (1) the original guidance contained in SFAS 157, as amended, and (2) new fair value measurement and disclosure pronouncements issued subsequent to the release of SFAS 157. The goal of SFAS 157 was to provide a framework to increase consistency in developing fair value measures as well as provide greater transparency to investors through increased disclosure in financial statements. ASC 820 retains that framework and requires the following for financial statement preparers: · Use of a three-level fair value hierarchy. · No blockage discounts allowed for Level 1 investments. · Increased financial statement disclosures. · Requirement to determine the principal market or most advantageous market. · Use of market-based assumptions instead of entity-specific assumptions. · Adjustments for risk of using certain valuation techniques or valuation inputs. · Adjustments for nonperformance risk and credit rating changes in valuing liabilities.

instances (e.g., elimination of blockage discounts), adjustments to the fair value of the investment as a result of a change in the valuation methodology will be recorded in the current accounting period ending on the valuation date of the investment. 3. When is the use of a valuation model to determine fair value acceptable under ASC 820? In most cases, the use of a valuation model to determine fair value is acceptable only when quoted prices representing orderly transactions in active markets are not available. The inputs used in the valuation model should include the assumptions that market participants would use in pricing the asset in a current transaction even if the market participants' assumptions are different from the fund's inputs. A fund cannot ignore market data typically used by market participants. The best practice is to back test models and calibrate the models' assumptions to continually improve the valuation process with the ultimate goal to arrive at an appropriate fair value. 4. If there are multiple valuation

Frequently Asked Questions

General Questions

1. Are there any differences between the fair value measurement and disclosures guidance under previous U.S. GAAP in SFAS 157 and the codified guidance under current U.S. GAAP in ASC 820? No. The Codification does not change U.S. GAAP; it creates a new structure which takes accounting pronouncements and organizes them by accounting topics. ASC 820, Fair Value Measurements and Disclosures (formerly FASB Statement No. 157 Fair Value Measurements) is now

2. If a fund changes its valuation methodology for a certain investment, when is the adjustment to the fair value of the investment recorded? Fair value measurements are considered accounting estimates. Except in certain

techniques available, how does a fund determine the most appropriate valuation technique under ASC 820? The valuation methods with the most observable inputs should be

32 Rothstein Kass

given priority over those that have unobservable inputs. The overall theme of ASC 820 is to elevate the fair value measurement in its entirety within the three-level hierarchy as high as possible and to use the most observable and reliable market inputs in a fair value measurement. However, funds should place less reliance on observable inputs which are indicative of disorderly transactions. If one valuation method proves to be a better representation of market participant assumptions than other methods, that valuation method should be used. However, multiple valuation methods can be combined to value an investment. The weighting of each valuation method will require judgment by the fund. Once the valuation methods are chosen, the best practice is to use the methods chosen on a consistent and contemporaneous basis. If a change in methods or a change in the combination of methods used will result in a better fair value measurement, the change in approach is allowable. Any change in method is treated as a change in an accounting estimate and the resulting impact on fair value should be recorded to income in the accounting period of the change. In addition, when material, changes in valuation techniques will require disclosure in the footnotes to the financial statements. 5. What are the recognition guidelines for transfers between levels in the fair value hierarchy?

Accounting guidance effective for 2010 will require funds to disclose significant transfers between Levels 1 and 2. All transfers in and out of Level 3 are required to be disclosed in the Level 3 rollforward. Significance of Level 1 and 2 transfers should be determined based on a meaningful benchmark, such as a fund's net assets. Funds may elect a policy for determining the timing of recognizing the transfer, but they must apply the policy consistently. 6. What is the consequence when a fund assigns incorrect levels to its investments according to the fair value hierarchy? Assigning levels according to the fair value hierarchy under ASC 820 is an important part of a fund's year-end financial reporting internal control system. If a fund's internal controls are not adequate to assign the correct levels to its investments, fair value footnote disclosures may be materially misstated. The resulting deficiency may be deemed a significant deficiency or material weakness which would require a comment in a SAS 115 letter. 7. Are the fair value disclosure requirements in ASC 820 reported on the condensed schedule of investments or in the footnotes to the financial statements? The fair value disclosure requirements in ASC 820 are not part of the condensed

schedule of investments and should be included in the footnotes to the financial statements. Some funds are evaluating the required disclosures of ASC 820 in conjunction with the required disclosures of the condensed schedule of investments. There is consideration of including the level designations in the condensed schedule of investments. To date, we have not seen this approach in practice. 8. Are the fair value disclosure requirements in ASC 820 required for feeder funds whose sole investment is in a master fund? Generally, the fair value disclosure requirements in ASC 820 are not required for feeder funds whose sole investment is in a master fund. Feeder fund footnote disclosures should include a reference to the valuation and disclosures included in the attached report of the master fund. 9. Should a fund record its debt facility at fair value and disclose the debt per the requirements of ASC 820? Under US GAAP, a debt facility should be presented at the amounts payable to the counterparty and not at fair value; unless the fair value option is elected under ASC 825, Financial Instruments. If a fund does not elect the fair value option for the debt facility, the debt is not required to be disclosed under the

Rothstein Kass 33

requirements of ASC 820. However, if a fund does elect the fair value option, the liability to the counterparty will be measured at fair value using the guidance in ASC 820 (i.e., maximize the use of observable inputs and minimize the use of unobservable inputs). Considering that the debt facility may not be trading in the market place, there may be little or no observable market data on the fair value of the debt facility. In this case, a fund will have to develop its own internal model, most likely using an expected present value technique to arrive at its estimate of fair value. This would typically result in a Level 3 designation. 10. How does nonperformance risk impact the fair value measurement of derivatives? Funds transacting in multiple overthe-counter derivative positions may need to incorporate portfolio-level adjustments to consider the effects of certain risks on the valuation of derivatives. The evaluation of a fund's credit risk exposures should include the consideration of master netting arrangements, collateral balances, contract settlement provisions, and the attributes of different derivative contract types. To the extent the master netting arrangement for a fund's over-thecounter derivatives portfolio allows for offsetting between different contract types, the fund may be able to determine the overall credit risk exposure based on

the net asset or liability balance with the derivative counterparty. However, funds should carefully review any master netting arrangements to determine whether the arrangements permit the netting to apply between different product types. Depending on the provisions of enforceable master netting arrangements, the nonperformance risk adjustments may be determined at the counterparty level or by contract type. Since certain disclosures are derived from an instrument-byinstrument level of detail, a reasonable allocation methodology may be needed to push down any top-side valuation adjustments for nonperformance risks at the portfolio-level to the fund's individual derivative positions. If the effect of the valuation adjustment is significant, it may render the adjusted valuation as a Level 3 measurement.

11. What factors should funds consider when applying the fair value premise to liability instruments? When a quoted price in an active market for the identical liability is available, the quoted price should be used. If the quoted price in an active market for the identical liability is not available, a fund shall measure fair value using one or more of the following techniques: a. A valuation technique that uses: 1. The quoted price of the identical liability when traded as an asset. 2. Quoted prices for similar liabilities or similar liabilities when traded as assets. b. Another valuation technique that is consistent with the principles of ASC 820. When measuring the fair value of a

Exchange-traded derivatives, such as futures contracts and certain options, are generally subject to market protections, such as daily margin postings and guarantees from the exchange clearinghouse which mitigates the impact of nonperformance risk outside of that reflected in the quoted price. Therefore, the fair value processes for exchange-traded derivatives generally are not expected to involve any significant nonperformance risk adjustments.

liability using the quoted price of the instrument when traded as an asset, funds should consider whether any adjustments would be needed to reflect intrinsic differences when the instrument is traded as an asset versus when the instrument is traded as a liability. When measuring the fair value of a liability using a valuation technique consistent with the principles of ASC 820, funds should consider whether market inputs are derived from orderly transactions, as well as whether internal valuations may be more representative of fair value.

34 Rothstein Kass

Funds should consider the impact of their nonperformance risk, including the existence of master netting arrangements, when determining the fair value of financial liabilities transacted with counterparties.

14. If a fund receives broker-dealer quotes from multiple brokerdealers, can an average of the broker-dealer quotes be used to arrive at fair value?

level of transparency behind the pricing source, alternative valuation methods will be required to support the fair value of the security. 16. When a fund receives multiple

The first step in the evaluation of multiple 12. Are repurchase agreements and reverse repurchase agreements required to be disclosed in the fair value hierarchy level tabular disclosure? Repurchase agreements are considered investments stated at fair value and should be included in the fair value hierarchy level tabular disclosure. Reverse repurchase agreements typically represent a fixed and determinable obligation of a fund and should be presented at face value. Therefore, reverse repurchase agreements are not included in the fair value hierarchy level tabular disclosure. 15. What level designation would a fund assign to an investment where the fund can only get one quote with a large bid-ask spread from a broker-dealer that has provided a legal disclaimer on the quote? 13. Where does pricing from recognized third party pricing services and broker-dealers fall within the three-level hierarchy? Prices from recognized third party pricing services or broker-dealers can fall within Levels 1, 2 or 3. A fund must gain an adequate level of transparency to understand the inputs used by the pricing services or broker-dealers that support the prices provided. If the quote itself is not a firm commitment from the broker-dealer to transact at the price quoted or if the broker-dealer is not willing to provide transparency, the input would generally result in a Level 3 designation. Observable market inputs should be readily available and distributed to participants in that market. In addition, observable market inputs should include a level of transparency that is reliable and verifiable. If a fund is unable to obtain a broker-dealer quotes is to determine the principal market in which the fund would sell the asset or transfer the liability with the greatest volume and level of activity. If no principal market exists, then the most advantageous market should be used. If the brokers providing the quotes are participants in the principal or the most advantageous market, ASC 820 allows for funds to use a mid-point within the bidask price quotes received by the brokers as a practical expedient.

indicative broker-dealer quotes, are the quotes considered to be observable or unobservable? In order to evaluate whether brokerdealer quotes are observable, a fund must evaluate the availability of those quotes to the marketplace as well as evaluate the consistency of the source. Observable market inputs should not be limited to information that is only available to the entity making the fair value determination (or to a small group of users). Observable market inputs should be readily available and distributed to participants in that market. In addition, observable market inputs should include a level of transparency that is reliable and verifiable. Management will have to use their judgment to evaluate whether inputs are "observable." Transactional-based market inputs tend to be more reliable. The range between bid-and-ask prices can be used to identify whether the market is active or inactive. A more active market will dictate more narrow ranges between bid-and-ask quotes with illiquid markets having larger spreads.

Third Party Pricing/BrokerDealer Quotations

Rothstein Kass 35

A best practice is to utilize a back testing program to validate the indicative brokerdealer quotes. To the extent there are an adequate number of transactions and the variances between the broker-dealer quotes and actual market transactions are reasonable, back testing may help verify the reliability of the market input. 17. What would the level designation be for securities that rely on indicative broker-dealer quotes with legal disclaimers? An indicative broker-dealer quote is typically provided by a broker-dealer or market maker to a trading party that is not firm and the broker-dealer is not obligated to transact at the quote provided. Therefore, a fund must evaluate whether the quote is readily available and distributed to the participants in that market. In addition, a fund must evaluate whether the quote is reliable and verifiable. If a fund cannot obtain transparency to understand these issues as well as the inputs used to arrive at the quote, the quote would not be an observable input and the related security would generally result in a Level 3 designation.

The principal market is the market in which a fund would sell the asset or transfer the liability with the greatest volume and level of activity. If a fund cannot identify a principal market, the most advantageous market should be used to arrive at fair value. The most advantageous market is the market that would assign the highest fair value to an asset or the lowest fair value in transferring a liability. Transaction costs should be taken into consideration in determining the most advantageous market. In making that determination, a fund must calculate the net amount received from the sale of an asset or the amount paid to transfer a liability. If a fund cannot gain access to the principal or the most advantageous market, it would not be permissible to use that market to estimate fair value. 19. A fund purchases a security on Exchange A. The security is traded on both Exchange A and B. Exchange B has more liquidity and is more active than Exchange A. Does the fund determine the fair value of the security using Exchange A or B prices? When measuring fair value under

should be used to arrive at fair value. The most advantageous market is the market which would assign the highest fair value to an asset or the lowest fair value in transferring a liability. If the fund cannot gain access to the most advantageous market, it would not be permissible to use that market to estimate fair value. If the fund in this case transacts on both exchanges with neither being the principal market, the fund would again use the most advantageous market. If the fund only transacts on Exchange A, the fund would use the price from Exchange A. If the fund does not have access to Exchange B, the fund would use the price from Exchange A. 20. How can a fund determine, in quantitative terms, the definition of an active market? An active market is defined as a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. Currently, there has not been any quantitative guidance issued by the SEC, FASB or other industry participant on the definition of an active market. However, ASC 820 provides factors to consider in determining whether there has been a significant decrease in the volume or level of market activity. The factors that a fund should evaluate include (but are not limited to) the following:

Fair Value HierarchyLevel 1 Considerations

18. How does a fund determine the principal or most advantageous market?

ASC 820, a reporting entity must first determine the principal or most advantageous market. The principal market is the one where the fund has regularly transacted in the security. If the fund cannot identify a principal market, the most advantageous market

36 Rothstein Kass

· There are few recent transactions. · Price quotations are not based on current information. · Price quotations vary substantially either over time or among market makers. · Indexes that were correlated with the fair values of the asset are demonstrably uncorrelated with indications of fair value for that asset. · There is a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the fund's estimate of expected cash flows. · Wide bid-ask spread or significant increases in the bid-ask spread. · Significant decline or absence of a market for new issuances (that is, a primary market). · Little information is released publicly (for example, a principal-to-principal market). In determining an "inactive" market for thinly traded securities, we recommend that a fund download the trading volumes for those securities along with their price feeds on a periodic basis. We also recommend that a fund develop a system that would highlight when a security's average trading volume does not meet a certain quantitative threshold (to be determined by management). This reporting system should generate an exception report for management to evaluate whether securities with low trading volume should be designated as Level 1 or 2 securities.

21. For exchange-traded equities, can a fund use the consolidated tape to price the securities? The "consolidated tape" is a high-speed, electronic system that constantly reports the latest price and volume data on sales of exchange-listed stocks. The data reflected on the consolidated tape derives from various market centers, including all securities exchanges, electronic communications networks and thirdmarket broker-dealers. Under ASC 820, a fund would not use the consolidated tape but choose the price from the exchange that is either the principal market or if no principal market exists, the most advantageous market. (Editor's note: If a fund continues to use the "consolidated tape" for pricing, it should set up an internal accounting system to document that any differences against the principal market or most advantageous market are immaterial throughout the fiscal year.)

able to absorb the entire block without significantly impacting the market price of the security. If a fund determines that the position is not actively traded, a liquidity discount can be taken if, from the perspective of the market participant, the fair value exit price would include this discount. It is important to note that U.S. GAAP currently does not contain explicit guidance on the use of a blockage discount for fair value measurements categorized within Level 2 or Level 3 of the fair value hierarchy. However, as part of their convergence project, the FASB and the IASB are proposing to extend the prohibition of a blockage discount to all fair value measurements of financial instruments. 23. Is a fund required to disaggregate Level 1 investments in the footnotes to the financial statements by industry or geographic concentrations if Level 1 investments are already disclosed on the SOI? To the extent the required Level 1

22. Block Discounts -- Can a fund take a "haircut" off the price of a position in a small cap company? It depends. The first step is to determine whether the security is actively traded. ASC 820 prohibits the use of block discounts for securities traded in an active market (Level 1). Under previous authoritative U.S. GAAP, a block discount was applied to the price of a large position when the market would not be

investments disaggregation information is included elsewhere in the financial statements (i.e., the condensed schedule of investments), there would not be a need to repeat the Level 1 investment disaggregation information in the fair value hierarchy level tabular disclosure. In such cases, we recommend adding a reference to the fair value hierarchy disclosure indicating that the required disaggregation of Level 1 investments are disclosed in the SOI.

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Fair Value Hierarchy--Level 2 and Level 3 Considerations

24. Should a discount be taken when determining the fair value of a restricted stock? A fund must assess the reason for the restriction and whether the restriction would be a consideration by market participants when determining its fair value. If the starting point of valuation is the exchange-traded price of an unrestricted stock, typically a discount would be taken to arrive at fair value since a market participant would assess a higher risk for the restricted position and thus demand a higher than expected internal rate of return. However, when a member of fund management is on the board of directors of a holding and therefore the fund has certain restrictions on sales of the related security, a discount would not be taken since the restriction would not be transferred to a buyer of the security. If the restriction is on the security and such restriction would transfer to the holder (e.g., Rule 144 stock), a discount should be taken. 25. Is it appropriate for a fund to adopt a policy of applying a standard discount rate to its investments (i.e., restricted stock or private investments in public equity (PIPEs)) when measuring fair value?

The application of a standard discount rate to investments such as restricted stock or a PIPE would not comply with ASC 820. A fund would need to consider the quality of the investment as well as the changing circumstances surrounding its restrictions. Careful analysis of all relevant drivers of the discount, including but not limited to the length of restriction, float and market capitalization of the issuer, liquidity of the market place and other qualitative and quantitative factors specific to the security should be evaluated in determining the appropriate discount rate. 26. Are total return swaps where the underlying notional position is an actively traded security (i.e., Level 1 security) considered Level 1 or Level 2? The unit of measure is the total return swap contract and not the underlying stock. A total return swap contract where the underlying notional position is actively traded would likely fall into Level 2, provided that the inputs used to determine the valuation are observable. 27. Where do options fall within the fair value hierarchy? Options that are traded on an exchange in an active market would be assigned a Level 1 designation. Options that are traded on an exchange in an inactive market would typically be assigned a Level 2 designation. For options

valued using a widely accepted and non-proprietary model where the inputs, such as implied volatility, are observable, the options would also typically be assigned a Level 2 designation. Options that are priced via a model using historical volatility, other unobservable inputs, or include significant judgments and adjustments to arrive at fair value, would typically be assigned a Level 3 designation. 28. What is the level designation in the fair value hierarchy for PIPEs including the warrants typically attached to those transactions? For a PIPE investment where the fair value is primarily based on the price of the actively traded public equity similar to the unit of account, the PIPE would typically be Level 2. If a liquidity discount from the underlying public equity price is significant, the securities may fall into Level 3. In addition, for convertible securities that are not "in the money," where the fair value is based upon the underlying borrower's credit worthiness and other unobservable inputs, they will fall into Level 3. Typically, warrants in PIPE transactions will fall into Level 3 since the input of historical volatility into a model is not an observable input. Warrants can occasionally fall into Level 2 if they are in the money and the underlying public security is actively traded or an observable implied volatility can

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be obtained from market data. The challenge is to determine the lowest level input that is significant to the fair value measurement. For in-the-money warrants, the volatility may not be a significant input to its fair value and thus result in a Level 2 designation. It will be up to the judgment of management to evaluate the significance of the inputs.

in the inputs to the valuation technique. A hold-to-maturity mentality does not conform to ASC 820 since it reflects an entity-specific assumption. ASC 820 requires the fair value measurement to reflect an exit price in current market conditions, including the relative liquidity of the market. 30. If there are no recent transactions

should consider the use of valuation adjustments that reflect more current assumptions about market conditions. 31. What level designation should a fund assign to a deferred fee liability which is reinvested into the fund? A deferred fee liability has the characteristics of a host debt instrument with an embedded total return derivative feature which is indexed either to the fund's rate of return, participation in specific assets of the funds, or a combination of both. Since the unit of account of the deferred fee liability is different from the underlying investments of the fund, the deferred fee liability may not be designated as Level 1, even if all of the underlying assets and liabilities are actively marked on a daily basis. Funds may also consider analogized guidance of investments in private investment companies measured at fair value using the practical expedient based on the ability to redeem at or within a near term of the reporting date when determining between Level 2 and Level 3 designation.

29. In an illiquid market (such as the asset-backed security market) there can be a disconnect between the intrinsic value (e.g., the value determined by applying data inputs to a valuation which may presume the position would be held to maturity) and what the current quoted observable prices are for the security in the marketplace. Can the intrinsic value be used in lieu of the quoted prices when the current market is not active and therefore has unusually large bid-ask spreads? The use of unobservable inputs is appropriate only to the extent that observable inputs are not available. ASC 820 states that entity-level inputs (i.e., unobservable) can be used as long as there is not contrary data indicating that market participants would use different assumptions. If such contrary data exists, a fund must adjust its assumptions to incorporate that market information. A fund must also consider the risk inherent in the valuation technique used and the risk inherent

for an asset-backed security and a fund uses matrix pricing comparing asset-backed securities that have similar attributes and vintages, or a fund uses the ABX credit-derivative index to price the security, what would be the resulting level designation for these approaches? Using matrix pricing of similar assetbacked securities that have recent observable transactions or using the ABX credit derivative index as a starting point are Level 2 inputs. Adjustments to Level 2 inputs will vary depending on the factors specific to the security (e.g., comparability, vintage, volume). However, any adjustment to the Level 2 inputs that is significant to the fair value measurement will drop the designation to Level 3. Funds should obtain an understanding of the processes involved in constructing the ABX credit derivative index or other forms of matrix pricing to determine if the matrix pricing is responsive to changes in market conditions in a timely manner. If the outputs of the matrix pricing are indicative of stale transaction data, funds

Rothstein Kass 39

32. When is it appropriate to designate a fund of funds investment in a private investment company as a Level 2 investment in the fair value hierarchy? The unit of account for an investment in a fund of funds is the ownership interest in the underlying investee fund itself (in other words, the investment being evaluated is the limited partnership interest or the offshore shares issued by the underlying investee fund, not the underlying investee funds investments). When determining whether the investment will be categorized as Level 2 or Level 3 within the fair value hierarchy, the reporting fund must consider the length of time remaining until the investment becomes redeemable. As long as the reporting fund has the contractual and practical ability to redeem its investment in a fund of funds at the NAV in the near term at the measurement date, then the investment may be classified as Level 2, even if a redemption notice was not submitted. "Near term" is a matter of professional judgment, and historically has been defined by the FASB as a period of time not to exceed one year from the measurement date. However, a redemption period of 90 days or less would likely be considered near term since any potential discount relative to the time value of money to the next redemption date would not likely be considered a significant unobservable input. It is important to note that a redemption period of 90 days or less should not

automatically be deemed near term. Other facts and circumstances, such as the likelihood or actual imposition of gates, and the liquidity of the investee fund's portfolio, should also be considered by the reporting fund in determining the appropriate level within the hierarchy. In situations when there are material adjustments to NAV to arrive at fair value the result will typically be a Level 3 designation. 33. How does the probable sale of an investment for an amount other than NAV affect the investments fair value measurement and the use of NAV as a practical expedient? ASC 820 states that the use of NAV as a practical expedient cannot be used when it is probable that a reporting entity will sell an investment at an amount other than NAV. A sale is considered probable only if all of the following criteria have been met as of the reporting entity's measurement date: · Management, having the authority to approve the action, commits to a plan to sell the investment. · An active program to locate a buyer and other actions required to complete the plan to sell the investment have been initiated. · The investment is available for immediate sale subject only to terms that are usual and customary for sales of such investments (for example, a requirement to obtain approval of the

sale from the investee or a buyer's due diligence procedures). · Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. If it is probable at the measurement date that a reporting fund will sell an investment, or a portion of an investment, at an amount different from NAV, the portion that the reporting fund intends to sell should be valued according to other provisions of ASC 820. Other provisions of ASC 820 can include a market or income based valuation approach. The remaining portion of the investment that is not probable of being sold may be valued by using NAV as a practical expedient. However, if a fund enters into a plan to sell a group of investments, but the individual investments to be sold have not yet been identified, the individual investments will continue to qualify for the practical expedient. 34. What fair value hierarchy level designation would a fund assign to an investment in a private investment company when the private investment company has a portion of its investment held in a side-pocket? The fair value hierarchy level designation for an investment in a private investment company may be bifurcated between the general class or liquid portion of the

40 Rothstein Kass

investment and side-pocket portion of the investment. The side-pocket portion of the investment would generally be classified in Level 3 and the general class or liquid class may qualify for Level 2 classification. 35. How does a fund conclude that NAV, as most recently reported by the investee fund manager, has been calculated according to the measurement principles of ASC 946? A fund is responsible for the valuation assertions in its financial statements. Determining that reported NAV is calculated consistently with ASC 946, including measurement of all or substantially all of the underlying investments of the investee in accordance with ASC 820, requires a fund to independently evaluate the fair value measurement process utilized by the investee fund manager to calculate the NAV. Such an evaluation is a matter of professional judgment and includes determining that the investee fund manager has an effective process and related internal controls in place to estimate the fair value of its investments that are included in the calculation of NAV. In making this determination, a fund might consider the following key factors relating to the valuation received from the investee fund manager:

· The investee fund's fair value estimation processes and control environment, and any changes to those processes or the control environment. · The investee fund's policies and procedures for estimating fair value of underlying investments, and any changes to those policies or procedures. · The use of independent third party valuation experts to augment and validate the investee fund's procedures for estimating fair value. · The professional reputation and standing of the investee fund's auditor. · Qualifications, if any, of the auditor's report on the investee fund's financial statements. · Whether there is a history of significant adjustments to the NAV reported by the investee fund manager as a result of the annual financial statement audit or otherwise. · Findings in the investee fund's advisor or administrator's SAS 70 report, if any. · Whether NAV has been appropriately adjusted for items such as carried interest and clawbacks. · Comparison of historical realizations to last reported fair value. If the NAV reported by an investee fund is not deemed to be calculated consistently with ASC 946, the reporting fund may need to determine an adjustment to reported NAV in order to use the practical expedient to measure the fair value of a private investment company.

36. What should a fund consider as part of the requirement to disclose information about the inputs and valuation techniques for Level 2 and 3 measurements? Funds should consider the significance and risk factors associated with an investment class in determining an appropriate level of detail for the disclosure of the valuation inputs and techniques used, with an emphasis towards investments with a higher degree of subjectivity in the valuation process (i.e., Level 3 investments). When determining the appropriate detail of valuation inputs, funds should consider quantitative information about the inputs (e.g., prepayment rates, default rates, interest rates, discount rates, and volatilities), the nature and detailed characteristics of the item being measured, and how thirdparty information such as broker quotes, pricing services, net asset values and relevant market data was considered in measuring fair value. In many instances, a qualitative description of valuation inputs may be sufficient to describe the valuation inputs used. However, funds should also consider disclosures of quantitative information on valuation inputs based on assumed market participant parameters (e.g., discount rates, market comparable multiples, market yields, default rates, etc.) when the magnitude of subjectivity intrinsic to the investment valuations warrant a greater degree of

Rothstein Kass 41

transparency in the disclosures. We do not believe that specific quantitative amounts based on unobservable data such as revenue streams and cash flow projections provide meaningful information, especially when aggregated at the investment class level. In addition, we do not believe that inputs that are specific to an individual investment to a class which does not correlate to the class as a whole, such as a quoted price for a stock or debt instrument or a recent round of financing, provide meaningful quantitative detail to the investment class as a whole. However, these inputs would be relevant from a qualitative basis and should be disclosed in the discussion of valuation inputs used. When multiple valuation techniques are used within an investment class, we recommend as a best practice for funds to disclose the aggregate fair values by the valuation methodology utilized.

company, a fund should consider (1) the timing and pricing of a recent round of financing, and (2) whether any material events occurred subsequent to the transaction that would impact the fair value measurement on the measurement date. Since capital structures of a private company can be complex, a full analysis of the contractual terms of a recent round of financing must be part of the fair value measurement process. Generally, private equity investments will be classified as Level 3. ASC 820 encourages multiple valuation techniques when dealing with Level 3 investments. When using multiple valuation techniques, a fund's management may place greater weight on the most recent round of financing over valuation methods such as discounted cash flow projections, or a multiple of revenues or EBITDA derived from market comparables. 38. Should transaction costs associated with the acquisition of an investment be capitalized into the cost of the investment or expensed as incurred? Under ASC 946 a reporting entity should capitalize transaction costs into the initial cost basis of the investment. A reporting entity would then measure the investment at fair value which may result in an immediate unrealized loss on the investment.

39. For a private loan receivable, does ASC 820 require an adjustment to the fair value based on movements of interest rates for similar loans in the marketplace (even though the underlying credit of the borrower has not deteriorated)? Yes. If the private loan receivable is a fixed rate or floating rate loan and interest rates for similar loans have moved, a market participant would factor in that movement into the fair value of the private loan. This poses challenges to funds that originate loans when their existing valuation policy is to generally carry loans at par unless there is a default or impairment (which would require a write down). ASC 820 requires that these funds look to the market to see what the current yields are for similar loans and adjust the carrying value of the loans to reflect market participant assumptions. Funds should also consider collateral values as part of the assumptions of expected recoveries for loans that are nonperforming. 40. Can a fund rely on other disclosures within the financial statements in lieu of applying the disaggregation requirements to the disclosure of the Level 3 rollforward? Generally the other disclosures within the financial statements do not provide sufficient disaggregated detail of the activity of a fund's investments

Fair Value Hierarchy--Level 3 Considerations-Investments in Private Operating Companies

37. For an investment in private operating companies, how does a recent round of financing factor into the fair value inputs in arriving at fair value, as well as the level designation within the fair value hierarchy? When determining fair value for its investment in a private operating

42 Rothstein Kass

by discrete classes of assets and liabilities. The disaggregation of fair value disclosures requires that significant judgment and consideration should be given to the nature and risks relevant to the asset and liability classes measured at fair value on a recurring basis. We believe that consideration of the Level 3 activity components, such as significant investment purchases or significant valuation write-downs, provides a more meaningful basis for granular disclosure for a class of shared economic exposures (e.g., industry, geographic, vintage, etc.) than an evaluation solely based on the significance of investment balances as of the reporting date. For example, a fund may hold a substantial amount of private equity investments that had little or no transaction activity during the reporting period, and is marked substantially at the same value as from the prior period. A disaggregated level of detail may be of limited use to the financial statement users. However, a fund may hold investments in a distressed industry within its private equity portfolio which has been written down to zero. A more granular detail of the classes subject to significant activity in the Level 3 rollforward may provide meaningful information to the users of the financial statements.

We recommend that funds consider the significance of activity within meaningful classes during the reporting period as a primary metric in determining the appropriate level of detail which should be provided for the disclosure of the Level 3 rollforward. 41. What is the expected impact of the proposed disclosure requirement of a measurement uncertainty analysis for Level 3 investments? The proposed guidance from the FASB and IASB joint project to converge fair value measurement and disclosure requirements may require funds to disclose a measurement uncertainty analysis for its Level 3 investments. The analysis would reflect the effects on a Level 3 fair value measurement of the changes in one or more inputs to different amounts that could have been reasonably used in the circumstances and that would result in a significantly higher or lower fair value measurement. The responses received during the comment period for this proposed guidance reflect a consensus of expecting significant costs and additional burden to implement the measurement uncertainty analysis disclosure. Funds with significant positions in Level 3 investments are likely to incur significant costs in performing additional calculations and to aggregate the effects into meaningful classes. Funds may need

to adopt new valuation procedures to track the availability of alternate unobservable inputs on a recurring basis. This may result in substantial costs to retain the use of specialists or to develop the in-house expertise to identify the unobservable inputs appropriate for the circumstances. Funds may be subject to additional scrutiny about the potential impact on their NAVs resulting from the presentation of alternative unobservable inputs. As an additional risk management practice, funds may need to implement documentation processes to justify their use of a given input over other available alternatives as part of the valuation process. Furthermore, funds may need to determine their own benchmark of "significance" in disclosures of the pro forma effects on the fair value measurements. There may be difficulties in performing a measurement uncertainty analysis when the information needed to prepare the disclosure is not available. The availability of inputs may be limited to indicative pricing from single broker quotes where a fund is unable to obtain transparency in the valuation techniques and inputs used by the broker. Funds may also use external pricing services which utilize proprietary valuation models but do not provide access to the components of the model. The proposed guidance may be required for a fund's Level 3 investments unless

Rothstein Kass 43

other accounting guidance precludes this requirement. A separate joint project between the FASB and IASB on Financial Instruments intends to exclude the measurement uncertainty analysis for "unquoted equity instruments." Several comments from constituents point out the uncertainty of which types of instruments (e.g., investments in private investment companies valued using NAV under the practical expedient) are included with the definition of "unquoted equity instruments." Furthermore, the inclusion of the scope exception for "unquoted equity instruments" within the Financial Instruments joint project may result in uncertainty in the application of the scope exception if the effective period is a later period than the initial adoption of the measurement uncertainty analysis. A final standard is expected to be issued during the first quarter of 2011. As of press time, there are many uncertainties relating to the implementation of the measurement uncertainty analysis of which the final resolution of various constituent concerns is not yet determinable. Rothstein Kass continues to monitor the progress of this topic and will provide additional guidance when the final standard is issued.

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About the Authors

Ralph Natilli, CPA, is a principal based in the Firm's Roseland, New Jersey office and specializes in providing financial reporting, tax and accounting services to clients in the financial services industry. He has experience working with a variety of clients including domestic and offshore investment partnerships, funds of funds, investment advisors and related management entities. He is a certified public accountant in New York, New Jersey and Massachusetts.

John Barbagallo, CPA, is a senior manager in the quality control group and is responsible for the Firm's accounting research and development. In that role, John monitors and analyzes current projects, activities and decisions of FASB and IASB and provides comprehensive summaries, interpretations and presentations to clients and members of the Firm. John is a certified public accountant in New York and New Jersey.

Richard Sumida, CPA, is a senior director based in Rothstein Kass' Roseland, New Jersey office. As a member of Rothstein Kass' quality control department, Rich is extensively involved in the research and consultation of complex accounting and auditing issues relevant to the Firm's client practices, particularly within the alternative investment and broker-dealer industries. Rich is a certified public accountant in New York and New Jersey.

Rothstein Kass 45

About the Editors

Howard Altman, CPA, is Co-CEO and Co-Managing Principal and the Principal-in-Charge of the Financial Services Group at Rothstein Kass. He has more than 30 years experience in the financial services arena, with particular emphasis on investment partnerships, offshore funds, private equity funds, funds of funds, registered investment advisers and broker-dealers. A specialist in issues related to hedge fund structures, operations and tax matters, he is recognized nationally for his knowledge of the hedge fund industry, the issues affecting it and prospective trends. Chris Mears, CPA, is the Principal-in-Charge of Rothstein Kass' New York Metro Financial Services Group. He has over 17 years of experience in financial services, with a particular emphasis on investment partnerships, offshore funds, and private equity funds. Chris advises alternative investment clients at the initial organizational phase to address the accounting and tax matters that may have an impact on the fund. After fund formation, he typically oversees all services provided to the fund by the Firm, including the audit and ongoing consultation regarding many diverse operational, transactional and tax matters.

About the Contributors

Vincent Calcagno, CPA, is the Principal-in-Charge of Rothstein Kass' Southern California offices, located in Beverly Hills and Orange County. Vincent specializes in audit, tax and consulting engagements for investment funds, registered investment advisors and broker-dealers. He has extensive operational experience in the financial services industry. Timothy Jinks, CPA, is responsible for Rothstein Kass' compliance with accounting, auditing and professional standards for all offices, and he oversees internal consultation on technical matters, quality control reviews of financial statements, client acceptance, peer reviews, PCAOB compliance, internal inspections and monitoring.

About Rothstein Kass

Rothstein Kass is a premier professional services firm that has served privately held and publicly traded companies, as well as high net worth individuals and families, for over 50 years. The firm provides audit, tax and advisory services to clients including hedge funds, fund of funds, private equity, broker-dealers and registered investment advisors. The Rothstein Kass Financial Services Group is consistently ranked as a top service provider to the alternative investment industry. We are experts in the field, working with clients within the hedge fund industry to anticipate opportunities on the horizon as well as help them to respond to short-term competitive challenges. Beyond audit and tax services, Rothstein Kass provides a full array of integrated services, including strategic business counseling, regulatory compliance and SEC advisory services, insurance and risk management consulting and family office services. Rothstein Kass has offices in California, Colorado, New Jersey, New York, Texas and the Cayman Islands.

46 Rothstein Kass

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