Are Private Asset Valuations Reliable?

With trillions of dollars of assets under management in the alternative investment industry, private investments are a significant driver of global economic activity and represent an expanding share of investors' asset allocations.

Increasingly, private investing is becoming more mainstream as it is no longer limited to sovereign wealth funds, pension plans and the rich and famous.

The advent of “retail” investment vehicles incorporating private investments in their asset mix while allowing more frequent liquidity has created greater access and greater transparency to what was once a haven for skilled investors operating outside public scrutiny. Historically, private fund managers obtained commitments for a fund, drawing capital when new investments were made and returning capital and gains as underlying investments were sold. Ten-year commitments to a fund, which often morphed into 12-15 or more years, was common.

As private funds are entering the retail space, subscriptions can occur as often as daily and exits or distributions quarterly. Certain retail funds with an allocation to private assets may allow daily purchases and daily redemptions.

Daily transactions require daily valuation which is a whole new paradigm for an industry that has historically reported the fair value of investments quarterly and substantially in arrears. Greater transparency is required for retail vehicles, which allows valuation conclusions to be compared between funds and managers. Some argue that private valuations are aggressive and inconsistent. Others argue that new valuation rules may be necessary to improve comparability. Why does it appear that the press, if not investors themselves, feel that private investment managers may need to change how they value investments?

Are Private Investment Valuations Flawed?

To answer the question as to whether valuations are flawed, two key questions must be answered: What rules apply to valuing private investments, and what drives private investment values?

Since 1940, private investment managers in the U.S. have been required to value their investments for financial reporting purposes at “fair value.” Fair value was historically defined as the price a willing seller and willing buyer would transact. In 2006, the U.S. Financial Accounting Standards Board changed the fair value definition to the “amount that would be received in an orderly transaction using market participant assumptions at the valuation date.” In 2011, the International Accounting Standards Board adopted the same definition of fair value. So, when private investments are valued for financial reporting purposes in accordance with International Financial Reporting Standards, U.S. Generally Accepted Accounting Principles or International Private Equity and Venture Capital Valuation Guidelines, they are valued at the amount that would be received today if the investment were sold in an orderly transaction.

Fair value is not a conservative value. Conservatism, while deemed a good practice in the past, has now come to mean “purposefully understating” value; not a good practice. Fair value is not an aggressive value, deemed overstating value. Fair value is not the amount that will be received upon ultimate exit; it is the amount that would be received in an orderly transaction today given current market conditions. Judgement is required to determine fair value. While alternative bases of value could be used, such as tax fair market value, prudential value or some other value, fair value has proven to provide the most decision useful information over time for investors.

The second key question is how private investment values change. The value of a private investment changes due to four basic reasons:

• Changes in market conditions: Will a buyer pay more or less today than yesterday?
• Changes in performance: is the underlying investment generating more or less cash flow than expected? Is it increasing its future potential? Is it meeting, exceeding or missing investment milestones?
• Changes in financial position: Has it generated cash? Are its assets and liabilities worth more or less today than yesterday?
• Idiosyncratic factors: Has the underlying portfolio company filed for an IPO? Has it changed management? Has there been a ransomware or other cyberattack?

With the questions of what rules apply and what drives value as background, the question of flaws in valuation is more easily answered. Most managers seek to provide their best estimate of fair value. Many managers engage a qualified, experienced third-party valuation specialist to assist them in processing and/or validating their fair value conclusions. While the manager is ultimately responsible for each fair value conclusion, they do seek support to ensure objectivity and consistency.

Fair value flaws may occur for a number of reasons. For example,

• Flaws occur when a manager holds an investment at cost for an extended period of time.
• Flaws occur when a manager seeks to “manage” volatility by moving the value of an investment infrequently. (Interestingly, volatility exists whether or not it is reported. Failing to report changes in value does not make volatility go away; it is just not reported).
• Flaws occur when a manager does not take into account all information which is knowable at a valuation date.
• Flaws occur when a manager does not apply informed judgement or misapplies accounting rules or valuation techniques

Most managers seek to mitigate or avoid flaws in their valuation process. Following established fair value sound practices and enhancing valuation processes by using tools, data and valuation specialist assistance helps prevent flaws in estimating fair value.

Why then do values differ between managers? The nature of private investing requires informed judgement. Consider a scenario in which two managers invest in the same portfolio company. The first manager believes that the company will grow cash flows at 7% a year, and the second believes (through their own analysis) that the company will be able to grow cash flows at 8% a year. The second manager will value the investment a little higher than the first manager. Both are correct, though, as the inputs to the valuation are based on informed judgement. Of course, if another manager without any support assumed a growth rate of 20%, their valuation would be flawed.

This leads to the question of the reliability of daily valuations. In the market today, there are managers who have a valuation process that they deem to be good enough while other managers have a daily valuation process which is rigorous and robust. A strong daily valuation process is built on the way that private investment values change. Fundamentally, the process starts with yesterday’s value, adjusts for market movements (appropriately corelated through back testing), adjusts for new performance information when it is obtained (generally monthly or quarterly), adjusts for cash flows and then adjusts for idiosyncratic items, if any. Valuing fund interests on a daily or monthly basis follows the same process.

Fund interest valuations have received additional scrutiny in recent months. This is because of the application of the so-called “practical expedient” which is used to value fund interests. The practical expedient basically follows the same process as is outlined above, with a few additional caveats. First, the investor in the fund interest must satisfy themselves that the fund manager is reporting net asset value based on the fair value of all underlying investments. Reported net asset value (NAV) must then be adjusted to match the valuation date, meaning a market adjustment factor needs to be applied. Further cash flows, holdings of exchange traded investments and idiosyncratic items need to be considered.

The practical expedient was established to prevent the negative consequences that would occur if secondary market pricing were used to value fund interests. For example, assume “Public pension fund A” invests $100 in “fund of funds B,” which then invests that $100 in “fund interest C.” Further assume that fund interest C reports the fair value of its investments as $ 100. If fund of funds B were to use secondary market pricing and value the interest in fund C at a 20% discount, they would report fair value of $80 to Public pension fund A. Public pension fund A would then also be required to report at a discount, meaning that they would report fair value of $64.

In 2008, the Financial Accounting Standards Board (FASB) focused on this conundrum and established the practical expedient that allows Public pension fund A to report based on the $ 100 fair value of the underlying investments, as does the funds of fund B. If the investment were sold by fund C at its fair value of $100 then $100 would flow back up the chain. Hence reporting a value of a $100 provides much more decision useful information than would reporting a value of $80 or $64.

Further, if secondary market pricing were used and Public pension fund A was required to report $64, it is likely that their board would question the efficacy of investing in private markets. As such, they would not follow asset allocation models which are designed to maximize returns. If returns suffer, then payments to beneficiaries could suffer, or taxpayers (the ultimate obligor for Public pension funds) would be required to make up the shortfall in investment returns to backstop contracted pension obligations.

A consequence of the practical expedient is that secondary market investors—investors who often purchase fund interests at a discount—are allowed to revalue those fund interests incorporating reported NAV (if fair value-based) in their valuation conclusion. While on the surface this may seem egregious, NAV continues to be the amount that the ultimate investor would receive if all underlying investments were sold at the valuation date.

Fair value is a long-established requirement of private investment funds. It is easy for pundits to cherry pick data and draw conclusions based on incomplete facts. What investors need is transparent fair value estimates based on robust and validated fair value procedures and judgements. Many managers seek to do just that. The exception should not be confused with the rule. Rather than being vilified, fair value should be embraced as the best (albeit imperfect) basis for measuring investments to meet the needs of investors, managers, regulators and ultimately the public at large. Valuation rigor best serves all constituents.