Asset Owners and the Private Equity Valuation Lag
Diving into the history of private equity valuation, asset owners need a flexible system to properly implement both estimated and final valuations.
Marking a private investment to market is a notoriously slower and more involved process than marking a public investment. For any investment made by an asset owner in the public market, these assets get marked to market on a daily basis given the deep liquidity across global financial markets. For private investments, there is no exchange for daily liquidity. This lack of exchange means there is no place to uncover a daily mark for private assets. At period end, general partners can’t go to an exchange to price private portfolio companies. Instead, they have to use valuation models—often at times hiring a valuation agency to make a current estimate.
For accounting purposes, books may be closed a few days or weeks after period end—and in many instances, before an LP has received final valuations for her private investments. In addition to needing to determine how to incorporate valuation estimates, asset owners need flexible systems to properly incorporate final valuations.
There’s a rich history behind this problem. Starting about 15 years ago . . .
Fair Market Valuation, Accounting Standards Codification (ASC) 820
In 2006, the Financial Accounting Standards Board clarified how to mark assets to market via Financial Accounting Standard (FAS) 157, Fair Market Valuation. Later recoded ASC 820, FAS 157 intended to promote Fair Value for balance sheet assets. Applied to the private equity industry, ASC 820 fosters more consistency across the industry to value illiquid portfolio companies and more accurate net asset values. For LPs, ASC 820 meant better insight into private equity performance and dare we say better comparability of private equity performance to other asset classes. This “better comparability” is relative and far from perfect.
Before ASC 820, industry practice centered on entry price for valuations. Portfolio companies were typically valued at cost or based on the latest funding round. Valuations failed to reflect market dislocations or re-ratings until a liquidity event. ASC 820 requires Fair Value to be based on an estimated exit price or the price it would receive if it sold an investment.
ASC 820 breaks valuation into three buckets:
- Level 1 assets enjoy readily observable market prices. Valuation is based on quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.
- Level 2 assets and liabilities do not have readily observable market prices, but fair value can be derived from quoted prices in inactive markets (direct) or models with observable inputs like rates or yield curves (indirect).
- Level 3 assets are the most difficult to mark to market with asset values based on either models or unobservable inputs. Values are estimated using complex market prices, mathematical models, or subjective assumptions.
The International Private Equity and Venture Capital Valuation Guidelines (IPEV) shares that Fair Value is the price that would be received to sell an asset in an Orderly Transaction between Market Participants at the Measurement Date. A Fair Value measurement assumes that a hypothetical transaction to sell an asset takes place in the Principal Market or in its absence, the Most Advantageous Market for the asset. For Actively Traded (Quoted) Investments, available market prices will be the exclusive basis for the measurement of Fair Value for identical instruments. For Unquoted Investments, the measurement of Fair Value requires the Valuer to assume the investment is realized or sold at the Measurement Date; the assumption is based on whether the instrument or the Investee Company is prepared for sale, or whether its shareholders intend to sell in the near future.
Some funds invest in multiple securities or tranches of the same Investee Company. If a Market Participant would be expected to transact all positions in the same underlying Investee Company simultaneously (for example separate investments made in series A, series B, and series C), then Fair Value would be estimated for the aggregate investment in the Investee Company. If a Market Participant would be expected to transact separately (for example purchasing series A independent from series B and series C, or if Debt Investments are purchased independent of equity), then Fair Value would be more appropriately determined for each individual financial instrument.
Fair Value should be estimated using consistent Valuation Techniques from Measurement Date to Measurement Date unless there is a change in market conditions or Investment-specific factors, which would modify how a Market Participant would determine value. The use of consistent Valuation Techniques for Investments with similar characteristics, industries, and/or geographies would also be expected.
The guidelines also share that private equity portfolio companies are typically categorized as Level 3 or unquoted assets. Because ASC 820 requires Fair Value to be based on an estimated exit price rather than at cost, private equity net asset values now (in theory) reflect the aggregate value of its collection of portfolio companies. Without readily observable market prices, quoted prices in inactive markets, or quotable observable inputs to value portfolio companies, how does a GP derive valuations? There are three general methods to value portfolio companies—market approach, income approach, and replacement cash approach—but none of these is as easy as pulling up the security on a Bloomberg terminal to price the investment. Rather, each method takes time, modeling, and judgement.
LPs typically close their accounting books a week or two after quarter end. For investments in liquid markets, this is reasonably easy, so valuations are timely. It takes longer to value illiquid investments—months longer. Each quarter, GPs need to work through the appropriate valuation method to value each portfolio company. Annually, GPs hire valuation agents to independently value each portfolio company to ultimately strike a NAV for partnership interests. Unfortunately for LPs, the time it takes to value illiquid investments means final NAVs are reported months after LPs have closed their books.
Ledger by SEI Novus
Comparing private equity investments to other asset classes is already hard to do given the differences of capital commitments and the drawdown model relative to the ease of computing time weighted returns for liquid investments. Valuation lags for private investments further complicate life for LPs as investment performance on the books does not align with benchmark timing. Recently, SEI Novus℠ introduced Ledger to bring much needed transparency to an LP’s Investment Book of Record (IBOR). Through Ledger, LPs can maintain both the official accounting records that may be lagging, as well as an IBOR with either estimated or finalized NAVs, matching the appropriate performance period. By using estimated NAVs until finalized NAVs are available, and matching finalized NAVs to the appropriate performance period, LPs can overcome the frustration of the benchmark timing mismatch.
The above screenshot of Ledger shows that users can specify between trade date, post date, and settlement date for appropriate transactions. Additionally, users can tag a record as an “estimate.” When pulling a NAV estimate for the entire IBOR, users select which date type will be used in the valuation, and determine whether to include or exclude estimates.
Ledger ensures LPs enjoy IBOR transparency, control, timeliness and ultimately accuracy. Click here to learn more about Ledger by SEI Novus.
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Information provided by SEI through its affiliates and subsidiaries. This information is for educational purposes only and should not be considered investment advice. The strategies discussed herein are complex and are not suitable for all investors.