Fair Value of Level 3 Assets

Hedge Fund & Private Equity Fund Operational Due Diligence Since 2009



The fair value estimation ‘process’ is key to revealing and demonstrating the fair value of investments. While a private security or loan may not have changed very much at first glance, it doesn’t mean that the instrument should remain at cost on the balance sheet and in the income statement. The answer is in the process and in the details.

Investors allocating money to private markets do so with the knowledge that they themselves will have limited liquidity, and the underlying portfolios do not have a readily ascertainable market. This assumption can cause one to sometimes overlook the fair value changes that come throughout the life of the investment, whether or not there were any capital transactions or impairments. This brings in the need for valuation experts, and the desire by LPs to have the periodic valuations performed by outside parties. Some of these valuation firms include Houlihan Lokey, Duff & Phelps, Sterling, and the well-known accounting and consulting firms.

Private equity and debt managers should have documented robust valuation policies and procedures that are executed by a qualified CPA CFO. The important aspects are expertise, independence from the investment personnel, and documentation. The process should be vetted by the auditors and other service providers to ensure quality and consistency. In the best practice scenario, and almost always with multi-billion dollar funds, an outside valuation firm will opine on each investment at least once a year, but preferably semi-annually or quarterly. Fair value reporting applies to both open ended funds and closed ended funds. Whether an outside valuation firm is used, the fair value process should be performed by the back office, and the financials of the company should be obtained by the back office or a third party to reduce conflicts of interest.

LPs review fund performance and they review fund audits, looking for some evidence that the financial and operational details of each investment were assessed and incorporated into the fund P&L. After all, management fees are paid on AUM, and management fees are a long term commitment in a permanent capital fund. Hearing the words “kept at cost” or seeing no change in cost in the audit, will trigger further due diligence.