Strategic importance of fair valuation measurements
May 03, 2016
PitchBook Dealmakers Column
How can alternative investment fund managers measure their returns and demonstrate to investors that they are creating superior value? The core of this conundrum lies in the fair value of a fund’s assets and is intertwined in four core beliefs:
1. Consistency, Comparability and Information
Before deploying capital to a GP, LPs diligence a manager from several perspectives, including evaluating the GP’s past returns. Under both GAAP and IFRS, periodic returns are calculated in a homogeneous, consistent manner congruent with market participant assumptions as of the measurement date. A well-developed accounting regime (i.e., GAAP or IFRS) provides investors the ability to compare historical returns in a homogeneous manner, enabling LPs to make informed investment decisions.
2. Value Measurements Depend on Valuation Assumptions and Approaches
The fair value process for valuing illiquid debt, equity and derivative investments is very different than the process for valuing liquid financial instruments. It begins with determining the instrument’s fair value classification as a Level 1, Level 2 or Level 3 instrument. Fair value measurement becomes increasingly difficult to calculate along the Level 1 to Level 3 spectrum, and regardless of the fair value Level, the GP must measure the asset’s value assuming a price which would be consummated amongst market participants.
3. Valuation Scrutiny
The valuation process entails more than just quantitative financial analysis. It also encompasses governance, responsibility segregation, transparency and strong internal controls and documentation. A valuation committee should establish policies and processes for regular portfolio valuations, oversee their execution, engage third parties for independent services and conclude on the valuations.
4. Ability to Create Value
Value is created by fund managers implementing business and investment strategies based on market conditions. Regular valuations provide GPs with information to calibrate and execute their strategies.