Valuation Outlook

Historically, private investing has been the domain of institutional investors such as pension funds, endowments, family offices, sovereign wealth funds and select high net worth Individuals, mainly due to factors including:

• Capital commitments: Private fund investments generally require large capital commitments that are funded over time.
• Investment horizon: The life cycle of PE funds has traditionally been around 10-15 years but can be extended beyond that.
• Risk tolerance: Private equity investments require a minimum level of sophistication due to complex deal structures, significant leverage, limited liquidity and due to an elevated risk of failure.

Therefore, regulatory bodies have been more comfortable limiting participation in private funds investing in private credit and equity to institution investors.

Retail investors on the other hand, represent a more recent phenomenon as a source of capital to the private markets

Retailization of Private Equity

While institutional investors continue to provide significant capital commitments to private investment vehicles, the retail market represents a large pool of untapped capital. According to industry research, individual investors hold about half of global assets under management but only represent 16% of alternative assets under management (AUM)¹, presenting “a massive, massive untapped part of the market.” Additionally, the Trump administration has issued an executive order which would allow 401(k) participants to have access to private investment vehicles.

“New” products such as interval funds and tender offer funds, are being launched that allow their investors to sell shares at set intervals, usually monthly, quarterly or annually, and to buy shares more frequently, generally daily or monthly, in order to tap this additional source of capital Long Term Asset Funds, (LTAFs) and other similar vehicles are being launched outside the United States.

The growth of retail capital results in the need for more timely and more frequent valuations.

Regulatory Valuation Framework

With more frequent subscriptions, redemptions, and transactions, managers need to change the historical paradigm of valuing investments quarterly and reporting the quarterly valuation 45 to 120 days after quarter end, to a paradigm where private investments are valued monthly, weekly or daily. Since the regulatory examination framework is still evolving in the more frequent private valuation space, some managers may focus on a simplistic valuation approach. However, the best way to prepare for scrutiny from investors, independent boards and regulators is to develop and execute a rigorous and robust valuation approach that takes into account all information that is known and knowable at each measurement (valuation) date; as often as daily if required.

Why does the fair value of a Private Investment change?

In developing a robust valuation process that determines the Fair Value as often as daily, consideration should be given to how the value of private investments moves from period to period. The Fair Value of a private investment is the amount that would be received in an orderly transaction using market participant assumptions as of each measurement or valuation date. Fundamentally, the value of an investment changes for one of or a combination of three reasons:

• Changes in the market
• Changes in performance
• Idiosyncratic factors specific to an investment

How is fair value determined on a frequent basis?

A rigorous valuation process takes into account information which is known and knowable each day. Fair value is best determined by starting with the ending fair value of the prior period and adjusting as follows:

• Prior period fair value; plus/minus
• Market adjustment factor (capturing changes in the market and anticipation of performance); plus/minus
• Cash flows; plus/minus
• True-up (receipt of updated performance, market movement, other indicators of value); plus/minus;
• Idiosyncratic factors changing value of the investment;
• Equals the New Fair Value estimate.

This process works whether fair value is determined on a monthly, weekly or daily basis.

The true-up information is provided by:

• Fund managers for Fund Interests and Co-Investments.

  –If it has been determined that the fund manager provides a robust fair value-based NAV, then the manager provided information can be used on a prospective basis to inform the market adjustment factor and to provide a recalibration of the fair value model. Because managers report on a lagged basis, such manager information is used as an input at the time it is received, not as a definitive assessment of value unless it is received real time.

• Deal teams for self-directed investments.

  – Performance is generally available monthly and as such the true-up would occur at or near month end.

Market adjustment factors are determined based on facts and circumstances associated with the underlying investments, capturing market movements, and backtesting to prior valuation movements. The establishment and updating of market adjustment factors require the application of informed judgement and experience.

Impact of the Retailization of Private Investing

With the avalanche of capital moving to retail vehicles that invest in private investments, the need for consistent, reliable, supportable, and robust valuations becomes ever greater. Regulators are paying more attention to this segment of the industry. Politicians are pushing for greater access to rank-and-file investors. As such, the need for a rigorous valuation process and approach cannot be underestimated. There is an established framework, using accounting standards and AICPA guidance to provide reliable determinations of fair value on a more timely and more frequent basis. Shortcutting the valuation process, using stale information, or failing to apply informed judgment, will lead to situations where managers cannot adequately support their fair value estimates and NAV calculations for investors and regulators.

The need for rigorous, robust and consistently determined private investment valuation estimates, following established standards, and utilizing informed judgment is as great today as it has ever been. The value of private investments can be reliably determined when valuation processes are executed with sufficient foresight and experience. Technology can help but cannot replace experienced valuation judgment.

 

Sources
¹ Why Private Equity Is Targeting Individual Investors | Bain & Company
² https://fortune.com/article/private-equity-deals-fundraising-blackstone-wealth-products-private-markets-etfs-401ks-vanguard-apollo-global-carlyle-group/