With the expansion and broad adoption of private assets, investors and regulated fund managers are seeing increased access to investments once reserved for large, highly sophisticated institutional investors. Investment vehicles offering enhanced liquidity such as mutual funds and interval funds, however, face valuation challenges for underlying private investments which are illiquid in nature.

Increasing Allocations to Private Assets

While investments in alternative assets such as private equity and private credit have historically been illiquid with less transparent pricing, large institutions with longer-term investment objectives accepted the lower liquidity and opaque pricing in exchange for an expected higher risk-adjusted return. With no interim liquidity or reporting requirements, there is no real need for actively marking investments beyond the quarterly valuations provided by the underlying asset managers.

In recent years, mutual and interval funds with shares transacting on a more frequent basis have been increasing allocations to private assets. Shares are usually offered to investors at net asset value (NAV), whereby assets comprising the fund and driving the NAV values are required to be fairly valued at the time of exit or redemption. This could be monthly, weekly, or even daily and therefore require more frequent valuations than the quarterly cadence of the underlying managers.

Valuation Challenges and Practical Expedients

The challenge for private or alternative asset valuations in mutual funds or interval funds is that when it comes to determining NAV, the quarterly marks received from the manager are often stale and obsolete. These prices therefore do not represent fair values that must be used in NAV determination at the time fund shares are offered in the regulated market.

Many investors value private assets by using the “Practical Expedient.” This is effectively using the manager’s last reported value adjusted for any intra-period cash movements. Since reported values from the underlying manager are stale, the cash adjusted values may not fairly represent the value of the asset subsequent to the manager’s last valuation date for that investment.

Example Scenario

For example, consider an interval fund that is priced daily and holds an investment in a private equity fund with investments concentrated in technology investments. As of April 30, 2024, the interval fund’s most recent valuation from the underlying manager is as of December 31, 2023. As four months have passed, more recent market conditions, however, should influence the reported Fair Value as of the more recent Measurement Date.

In the first four months of 2024, based on the S&P 500 Information Technology Index, technology stocks were down 6.0%. If a holder of the interval fund shares can sell at December NAV, they could be avoiding a potential write down of the underlying assets. Based on SEC rule 2a-5, however, the registered fund is required to report share values and therefore the NAV at fair market values based on prevailing market conditions on the measurement date.

The above example is oversimplified and may be even exaggerated since the private investments may not move in lock step with the public markets, and implicitly the private investments in the underlying fund may not be perfectly correlated to any public index. Material changes in market conditions which could affect the fair value or the NAV of the fund shares, however, cannot be ignored.

Valuation Controls, Adjustment Methods, and Back Testing

Daily valuation controls should therefore be established to assess the value changes in private investments that could materially impact the NAV of the fund. According to the SEC rule 2a-5, a registered fund must test the fair valuation methodology deployed to value fund investments. Back testing is one mechanism that can help establish the most appropriate set of benchmarks and adjustment factors a fund can use to evolve asset fair values and ensure the valuation approach deployed for fund investments is robust.

To bring valuations in line with current market conditions, a market adjustment factor calibrated through back testing mechanisms can be employed. They can be derived from a series of suitable benchmarks, such as similar indices, investments, or trading multiples of companies deemed similar to the subject company.

In addition to market influences, the valuation should also consider any idiosyncratic events that occurred between the underlying manager’s last reported valuation and the current valuation date for determining NAV. As another example, assume the registered fund has a direct investment in a widget maker (“WidgetCo”) that was last valued by the manager (a private equity sponsor) at cost.

Since the manager’s last report, it was announced that WidgetCo had been fraudulently reporting revenues and earnings for several years. As a result of the scandal, WidgetCo was also going to lose several key contracts. This would almost certainly have an impact on the value of WidgetCo’s securities, and some valuation adjustment would need to be made to account for the recent development.

Operational Complexity and Compliance Considerations of Valuing Private Assets

For publicly traded securities, the price times quantity valuation equation is relatively simple, but valuing a portfolio of private assets on a daily basis can be a daunting task. The private asset valuation life cycle is more complex since, besides developing and periodically testing suitable set of benchmarks, the process also includes cash adjustments, market adjustment factors, correlation, and idiosyncratic events.

Additionally, there are several nuances that funds may have to address as it relates to sourcing and calibrating public benchmarks. Equally important is the fact that the private asset valuation process is operationally difficult to execute given the compressed timelines registered funds have to publish daily NAVs. Therefore, developing and deploying valuation technology is a critical consideration fund managers need to evaluate to comply with regulation.

Last but not least are the SEC requirements related to the documentation of a fund’s valuation methodology. Given the lack of direct and transparent valuation data, the industry may need to develop individual investment valuation methodology documents that will include a set of calibrated benchmarks, selection criteria, market adjustment factor procedures, and other material considerations to ensure compliance with regulation.

At Stout, we work with our clients to help manage various degrees of complexities embedded in the valuation process while managing regulatory and other risks. We created tools, technology, processes, and accelerators as well as independent advisory capabilities to address diverse client needs. Reach out if you would like to learn more.