The dark art of valuation

The valuation of alternative investments has attracted much public scrutiny, and rightly so since it is fundamental to the determination of net asset value, entry and exit prices, performance and management fees. Despite the raft of valuation standards, regulation, guidance and principles, it is fundamentally an opaque art form rather than a transparent science.

Most investment fund valuation policies, processes and methodologies are designed to comply with International Financial Reporting Standards (IFRS 9) or accounting principles generally accepted in the ASC 820. The administrator measures investments at fair value using a matrix which identifies and classifies securities as Level 1, Level 2 or Level 3, based on the inputs used to value the securities which relate to the varying degrees of pricing transparency.

Securities defined as Level 1 are quoted in active markets, and they are marked to market using the closing bid price on the security’s primary market. Level 2 securities have observable inputs, either directly or indirectly, other than quoted prices in active markets. Inputs include quoted prices for similar securities in active markets, interest rates and yield curves at commonly quoted intervals and market corroborated inputs. Level 2 securities also include over-the-counter and other non-publicly traded instruments, including fixed income securities that have observable inputs other than quotes.

Level 3 securities have no observable inputs, and they include private equity interests, less liquid debt and derivatives. Level 3 valuations are typically driven by a financial model and rely on the administrator’s best estimate of fair value. However, the pricing objective remains the same, i.e. an exit price at the measurement date. Therefore, Level 3 inputs reflect the assumptions that market participants would use when pricing the investment, including assumptions about risk.

This is where the art starts, because a small change to a key assumption in a valuation model can easily generate a ten per cent pricing variance. The standards generally permit common pricing models and techniques, such as discounted cash flows, option pricing models (Black- Scholes-Merton and the binomial model) and price-earnings models. Post Lehman investors are generally well aware that sophistication and complexity in financial models is often associated with sophistry and confusion! Hence the the importance of working with the fund administrators and managers to understand the basis of their valuations, to compare actual results with forecast results from previous periods, and to benchmark key data such as valuation multiples and discount factors against industry indices and similar valuations.



Geoff Woodhouse