Private Market Valuations: What Are You Really Looking At? A Practical Guide for Advisors

Unlike publicly traded stocks, private investments do not have real-time pricing. At best, private investments publish their valuations monthly, but more often, marks are produced quarterly, or even annually.

Due to the illiquidity of many private investments, values are usually managers' estimates, and the methods used to report these values can vary by each manager’s valuation policy. In theory, two identical private funds with the same holdings, but using different valuation methods, could report drastically different values for the same assets. This paper will walk through the main types of valuation techniques managers use and the questions you should be asking managers about their valuation policies prior to making an investment.

Valuation Approaches

Private market valuations generally fall into one of these general categories.

Fair Value - ASC 820 Framework

This approach is the most comprehensive, with a focus on market comparables, modeling, often using discounted cash flow modeling, and income analysis. Even under fair value (ASC 820), many private assets are valued using models and estimates (“mark-to-model”), as observable market prices are often not available, and is generally considered the most current and market-aligned approach.

Fair Value - ASC 820 Framework – Event-Driven / Appraisal-Based

Valuations utilize financing events, third-party appraisal, and periodic reviews. Due to the infrequent timing of these updates, valuations can make drastic changes after a long period of no valuation change.

Cost-Based or Cost-Less Impairment

Assets are often held at the original purchase price, or cost. Gains or losses are only recognized when impairment is identified or the asset is sold.

Timing Ramifications

In addition to the valuation process used, the frequency of updating values will also impact the timeliness of the valuation. A manager using monthly Fair Value reporting will produce a more timely and potentially more current picture of the investment compared to a manager who uses Cost-Based valuation and only updates values when an asset is written down or sold.

Portfolio Construction Impact

With different valuation techniques combined with varying timing of these valuations, the impact on portfolios can materially impact allocation decisions, rebalancing, and abrupt changes in valuation.

Example

An investor made an investment in a private, closed-end fund for $1,000,000.

One year later, the estimated value, as determined by comparable sales in the market, cash flow and discount rate modeling, indicates the value to be $800,000.

A manager using Fair Value, or ASC 820 Framework, would show the investment on the client’s statement to be $800,000.

A manager using Cost-Based, or Cost-Less Impairment, would state the value to be unchanged at $1,000,000.

The investment is identical in both cases, but the only difference is the valuation process each manager is using.

Do managers hide bad investments through their valuation techniques?

Not necessarily, as some asset classes are extremely illiquid or event-driven businesses, making a fair value approach almost impossible to be effective. Once a manager establishes a valuation approach, any change in the level of complexity (e.g., from fair value to cost-based) will yield scrutiny from any sophisticated investor.

Generally speaking, a strong valuation framework will use market inputs when possible, apply consistent valuation methodology across all assets, be willing to reflect losses and gains, and produce valuations appropriate for the asset class they are investing in.

Questions every advisor should be asking managers

1. Who audits your reporting?
   1. Good answer: A third-party accounting firm with a focus on third-party valuation of private equity.
   2. Potential Red Flag: We are not audited.
2. How often are assets revalued?
   1. Good answer: Monthly or quarterly for more liquid assets. Annually for less liquid.
   2. Potential Red Flag: Less frequently than managers in the same asset class.
3. What valuation process is used
   1. Good answer: Fair value or ASC 820 Framework using market data and appraisals.
   2. Potential Red Flag: Cost-Based or Cost-Less Impairment essentially holds investments at cost unless there is a significant reason or event to mark the value other than at cost. However, the manager may have a valid reason why fair value is not appropriate for their asset class. This method requires additional diligence depending on asset class and valuation policy.
4. Are both gains and losses reflected over time, or primarily at exit?
   1. Good answer: Reflected over time and as often as practically able
   2. Potential Red Flag: At exit
5. Have you changed your valuation methodology for any assets? If so, why?
   1. Good answer: We have valued at Fair Value throughout our firm’s history
   2. Potential Red Flag: Yes, unless moving closer to Fair value or ASC 820 Framework
6. Can you share your firm’s valuation policy and the date of when the current policy was implemented?
   1. Good answer: Yes, and it has been in place since we started the firm.
   2. Potential Red Flag: No and/or yes, but we made multiple changes over the last couple of years.
7. Question any marks for unrealized gains or any assets held at cost.

Main point

Valuation techniques provide insight into the manager’s transparency and willingness to communicate. The appropriateness of a valuation methodology depends on the liquidity, structure, and characteristics of the underlying assets. A manager who is willing to invest the additional time and energy in a fair value process compared to a cost-based approach may demonstrate a commitment to transparency and frequent investor communication.

Important Information 

This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.

The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.

Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.

Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.

Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.