Obtaining an Accurate Valuation of Private Assets

How Hedge Funds Can Obtain Better Pricing

Peter J. Leitner, CEO, Numeria Management LLC

Hedge fund managers, we assume, are expert in valuing the assets they buy and sell, for that ability – coupled with prodigious trading skills – is their stock in trade. If not, they will soon be out of business.

This is particularly so with private equities and other illiquid assets, whose price inefficiencies offer highly attractive returns but can cause real problems when it’s time to report fund performance or a fund investor seeks a secondary trade of its LP interest. Both instances hinge on valuation estimates, which are not only tricky – because the assets are usually neither quoted nor liquid – but are a big problem if the valuation estimates are inaccurate, untrustworthy, or both.

Despite significant advances over the past fifty years in both methods and professionalism, serious concerns about the traditional approach to valuation remain and are echoed loudly by investors and regulators who have transparency, accuracy and risk management at the forefront of their minds. Indeed, appraisals have long been accepted because, in the absence of market prices, they were the next best thing. But there now is an alternative.

The Rise of Information Markets

Private and otherwise illiquid assets can be valued by using information markets, which harness the power of price discovery – and the ability of prices and price changes to convey valuable information – for the purpose of making estimates or to forecast future events.

Known also as prediction or decision markets, information markets have proven highly accurate because, like any marketwith many participants, with unfettered flows of information and liquidity, they aggregate almost all known information about a particular asset, be it the future prospects of a firm or the likely price of copper.

Information markets in modern terms began with the Iowa Electronic Market, which was created by professors at the Tippee School of Business at the University of Iowa in 1988. As adherents to the efficient market hypothesis, they created a futures market to forecast national elections for the US Presidency and Congress. The Iowa market has proven more accurate than surveys and polls over 80% of the time.

Given the near ubiquity of the Internet, which enables people to participate world wide, information markets are quickly being adopted by industry leaders, such as Google, Microsoft, GE and HP. They use these markets for mission-critical forecasts, ranging from predicting the likelihood that a new product will launch on schedule to the price to bid for DRAM chips on the global market. In these cases, the market participants are company employees whose collective wisdom, with its accuracy and candor, is proving to be powerful.

So, how does this work with valuing private equity or other illiquid assets for reporting performance and effecting secondary trades of LP interests?

The participants in the information market are none other than the appraisers, financial advisors and investment bankers who provide traditional services. But instead of being the sole provider of a valuation opinion, a valuation expert is one of many whose opinions – delivered in both quantitative and qualitative forms – blend together seamlessly into one opinion, much like the bid and asked prices for any asset reflect the market’s sentiment. But before we explore this novel approach further, let’s first review how valuation experts and their hedge fund clients traditionally approach the question of valuation.

Traditional Means of Valuation

The traditional valuation services market is estimated to be $1 billion in the US and another $1 billion elsewhere globally, though there is some disagreement about its true size.

This reflects both the “cottage industry” nature of this market, plus the fact that a large number of valuations are delivered as part of other services, such as capital raising or M&A advisory, and thus are not paid for as a discrete service or, in many cases, not paid for directly at all.

When a hedge fund needs to mark its private assets to market for reporting purposes, or an investor wants to make a secondary trade of its LP interest (typically before redemptions are allowed), one can traditionally address the question of valuation in one of several ways. Hedge funds can:

  • Report the book value of the asset, which pleases those with a financially conservative bent, but this can be grossly misleading to investors as they review performance, or they enter or leave the fund, if market value is significantly higher or lower than book value.
  • Value it themselves, but this raises unavoidable and many would say unacceptable issues about objectivity and independence.
  • Task their administrator or prime broker with valuing it, but this isn’t what they do for a living, and their objectivity and independence is only marginally better than the fund managers themselves.
  • Engage a valuation expert, such as an appraiser, investment banker or financial advisor, or another source of impartial expertise, such as a data source of direct OTC trades.

Most investors and regulators consider the last option above the only realistic option, knowing full well that it has drawbacks. Even skilled and independent valuation experts are limited either to estimating the present value of the asset’s cash flows, which offers great precision but questionable accuracy, or using comparable assets for the basis of estimating value.

The only other alternative is a proxy market – such as for futures, for example – whose asset values are tied directly to the asset in question. Hence, the role to be played by information markets.

Using an Information Market for Valuation

Instead of relying on one firm for an evaluation, a hedge fund or hedge fund investor would go to an information market in which multiple valuation experts participate. The independent experts would analyze the asset in question, submit bids to a secure real-time market platform, and then argue the merits of their positions while simultaneously submitting revised blind bids, thereby producing a marked-to-market value for the asset.

Information market valuations yield independent, objective and robust assessments of fair market value because they allow multiple experts to competitively value the asset, as if they were pricing an initial public offering of shares and then trading them during their first few hours on the market.

The markets as described here use a hybrid of the open outcry and electronic market models, since most of the assets are not fungible and therefore their pricing benefits from debate among the participants.

The analysts who price the asset come from the vast ranks of valuation experts around the globe. Each is screened, vetted, and agrees to the rules of the marketplace – including extensive confidentiality provisions – before being allowed to participate. They include investment bankers, financial advisors, corporate development officers, and appraisers; all are seasoned analysts whose valuations preceded transactions based on their work.

Information market valuations offer significant benefits to hedge fund managers and their investors including a robust data set; the objectivity, independence, and diversity of the analysts; the enhanced quality of their work; and unexpected insights about the asset being valued.

Having multiple analysts value an asset in parallel, each submitting an initial value in a formal written report and then unlimited revised values based on what is learned in the market, dynamically generates a rich data set. The mean and standard deviation of the most recent values by each analyst are calculated continuously, allowing the market maker and observers to see in real time how the final, central value emerges. The table below shows the value of a firm at the beginning and the end of a pricing session.

Five analysts independently valued this asset, which was a private equity investment in a middle market firm. Their initial valuations ranged from $17 million to $65 million with an average – or opening – value of about $34.8 million. After rigorously debating each report and submitting revised values, the pricing session formally ended with a closing value of $31.2 million. The range of initial values – with a standard deviation of $18.6 million – reveals the core benefit of this robust approach.

Core and Ancillary Benefits

First, with multiple independent analysts working in parallel, the spread of values from different experts is clearly visible; this isn’t possible when relying on one source for a valuation opinion. Second, the standard deviation quantifies the spread in dollar terms, thereby revealing the statistical error the hedge fund or investor avoids by using a market-based valuation instead of relying on one source, like an investment banker or appraiser. Some have equated this to an insurable risk, which if left unhedged can lead to an expensive – in this case, $18.6 million – error.

There are important ancillary benefits as well, including enhanced independence and objectivity; a diversity of professional views about value; intense peer scrutiny; and complete transparency.

Independence and objectivity are like the two sides of a coin: the former relates to the relationship between the analysts and the hedge fund, while the latter pertains to the analyst’s state of mind as a result of the relationship. Market-based valuations by their very nature permit analysts to be more independent and objective than they otherwise might be. This is because the hedge fund is not their client, and thus has little influence on their thinking and behavior, while the analysts are motivated to provide the highest quality and most accurate valuation possible.

Close behind is the diversity of views about an asset’s value, not only from multiple analysts but also their orientation and experience. For example, investment bankers and financial advisors tend to have a keen sense for market values at a given time, whereas appraisers offer deep technical competence, often in tax and legal matters, adding specificity to understanding a complex situation. When all of these voices are blended, valuations are richly balanced.

The intense scrutiny of every analyst’s work by his or her peers raises the quality of the work they produce. As one analyst said, “Nothing sharpens iron like iron.” Moreover, since the market is transparent in real time to analysts and hedge fund management (or the investor) alike, shoddy or incompetent work, or an unsubstantiated point-of-view, is quickly and mercilessly rejected. This prompts competent analysts to be well prepared, and discourages all others from participating in the market.

Transparency also assures the hedge fund or investor that the valuation is real. They receive the initial analyst reports and can watch the value of the asset rise and fall during the pricing session. They also hear the debate among analysts, who pull no punches, so each analyst’s final price, and thus the final mean price, is neither abstract nor muddied.

A bonus from the open outcry-electronic hybrid model is what the hedge fund or investor learns from the frank, unscripted dialogue among competing analysts. They hear individual and consensus views about the asset’s status and prospects, which can actually change the course of decisions. To wit, a decision to sell or hold a private equity asset may change after hearing a marketplace of independent analysts render their opinions.

Why This Matters

The rise of information markets coincides with three significant trends, namely the explosive growth of hedge funds, private equity and other alternative assets; the convergence of hedge funds and private equity; and the increasing demand by investors, regulators and society for more transparency in alternative assets. Taken together, these trends mean that savvy hedge funds will satisfy their fiduciary duty as stewards of investment capital by using an objective, independent and robust means to value of their private assets. This enables them to:

  • Treat their investors fairly when they invest in or redeem their shares, because private equity, venture capital and other illiquid equities are marked-to-market through dynamic pricing, allowing the fund to report truer performance;
  • Realize the value appreciation in private or illiquid investments, even when a sale of the investments is not imminent, because they are marked-to-market by an intermediary using a market-based valuation approach;
  • Eliminate questions of objectivity, independence and accuracy in the valuation of its private and illiquid equities, whether or not the hedge fund is subject to ERISA (Employee Retirement Income Security Act).

This combination of ensuring fairness, realizing value appreciation and ensuring confidence in the valuations is particularly necessary for hedge funds that invest in private equity, venture capital and PIPE assets, but certainly applies to any illiquid or hard-to-value investment.

Conclusion

Information markets offer an exciting alternative to a vexing problem. Perhaps best of all, they utilize a nearly ubiquitous communications platform to tap into the vast pool of valuation experts whose collective wisdom best expresses itself in a dynamic marketplace of their peers.

Peter J. Leitner is the founder and CEO of Numeria Management LLC, Princeton, New Jersey. Numeria is an information market for valuing private firms and other equity-based corporate assets.