Accountants and pornographers are seldom associated in the public’s mind. One group is generally considered the epitome of dull conservatism and the other the embodiment of titillating debauchery. One group does everything in well-deserved obscurity. The other does everything in public view. But in the last issue of The Atlantic, a rare but important connection between the two industries was made explicit.
Francis Koenig is just 33 years of age but he’s already a well-regarded veteran of the hedge fund business, and last year he launched a new fund focused on the world of . . . ahem . . . adult entertainment. AdultVest’s assets are said to include equity stakes in everything from movie studios and websites to strip clubs and legal brothels. According to Koenig, the fund is up 50 per cent in the past year. That would be a stellar return any time, but against the backdrop of the global economic crisis and plunging stock markets worldwide, it is nothing less than mind-boggling.
There’s no way to verify Koenig’s boast because his is a private business, but The Atlantic saw his purported success as evidence that the sex business is recession-proof. Still, the real lesson to be taken from AdultVest’s remarkable record isn’t about porn at all. It’s about accounting, and a very controversial concept known as “mark-to-market.”
How did Koenig manage to make so much money in such an otherwise dismal year? Is he really the first person on Wall Street to discover that human beings have carnal impulses? Like most hedge managers, Koenig prefers not to give many details about his strategies, but he has said that some of AdultVest’s successful investments include a stake in iPorn, a private company developing adult applications for Apple’s iPhone, and various website domain names, owned by AdultVest, which have apparently risen in value. So how do you come up with a value for a dot-com domain that you own but haven’t sold, or for a stake in an unlisted private company? You use mark-to-market accounting.
Mark-to-market means pretty much exactly what it says. If you hold assets on your balance sheet, every so often you must assess changes in the value of those investments, and report those changes to your investors. For example, say you’re running a bank or an insurance company and you hold millions of very complicated securities based on the changing price of oil, or wood pulp, or mortgages in southern California. Every month or every quarter you must look at all your assets, evaluate what similar assets are selling for, make a few actuarial assumptions and come up with a value. This process generally relies on complicated computer models and outside appraisals. If the values have shot up, you can often declare those gains as profit, and your investors throw bouquets your way. If the values have plunged, then you have to take massive write-offs and losses, and shareholders throw sharper objects.
It wasn’t always this way. Once upon a time, companies and institutions used so-called cost-based accounting, which meant that the values reported on balance sheets frequently bore no resemblance to what those assets could actually be sold for. Mark-to-market accounting was popularized because it provides a more accurate and current picture of the financial health of corporations, banks, pension funds etc.
We all do a little mark-to-market accounting in our own lives. When a house down the street sells for a lot more than you expected, we all mentally mark up the value of our own home, and we feel a bit richer. But does your neighbour’s success really mean that your home is worth more? Does the fact that some outside auditor thinks that the value of www.xxxx.com has risen over the past year really mean that AdultVest is in the money? What if the same auditor next year decides that the value of such Web addresses is plunging? Are investors really poorer?
Believe it or not, that’s a philosophical question, and one that lies at the heart of the current controversy over mark-to-market accounting. The trouble is, mark-to-market involves a lot of subjective judgments, logical leaps, and is susceptible to manipulation. Much of Enron’s massive deception, for instance, was achieved by playing games with the mark-to-market accounting of its assets. As Enron proved, the system can be gamed to make a toad business look like a prince. And sometimes, vice versa.
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