INSUBCONTINENT EXCLUSIVE:
By Satyajit DasThe world is wealthier now than it’s ever been — but only on paper
Much of this prosperity may prove illusory as a global shift toward less liquid investments undermines the basis of valuation.
Private
equity, infrastructure and private credit have become a bigger share of investment portfolios, making mark-to-market values increasingly
The standard method of valuing assets assumes prices are available and that there is adequate trading liquidity to be able to sell at those
This may hold for traditiona l investments such as stocks and bonds
But assets such as private equity are rarely traded or not tradable at all, necessitating the use of models or proxies instead.
Even for
publicly traded assets, mark-to-market values may be less reliable than in the past
Over recent years, trading volumes have declined for most asset classes due to a reduction in dealer numbers, regulations that make it more
expensive to hold trading inventory, and central bank intervention
Meanwhile, prices for smaller-cap shares, as well as many corporate and structured bonds, emerging- and frontier-market securities, and
distressed debt may not be consistently available
These factors combined with the growth of large funds and the size of holdings mean that the ability to sell at quoted prices is
Model-based valuations are unsurprisingly sensitive to assumptions about key inputs that may not be easily verifiable
For example, values of private credit may be highly sensitive to presumed default rates and correlation between defaults
For private equity and infrastructure, the models rely on discounting future cash flows
These may be distorted by low rates and decreased risk premiums
The models typically require a residual value to be assigned to the asset at the end of the chosen projection period
Changes in assumptions about termination values can significantly influence model outputs, especially at the abnormally low interest rates
that have prevailed since the global financial crisis — the result of central bank efforts to maintain asset prices and boost spending
through the wealth effect.
Sometimes, known sales are used as proxies to establish or calibrate model values
These suffer from the problem of small sample sizes and a lack of exact correspondence to the asset being valued
Adjustments are necessarily subjective
Proxies are sometimes based on sales between funds that are related to each other
This increases the risk of manipulation or error.
All mark-to-market valuations assume the investor or fund can sell the underlying asset
Managers have considerable discretion and, as was the case in 2008, can impose “gate” provisions to prevent fund withdrawals
In a major downturn or under volatile conditions, investors in funds holding private assets are likely to face restrictions on redemption
where the managers cannot liquidate holdings
In such conditions, the mark-to-market value won’t be realizable
It may change between the decision to sell and receipt of proceeds
Where the investment is overseas, the ability to repatriate funds can no longer be assumed in an era where globalization and the free
movement of capital is under threat.
In addition to misstating wealth, valuation problems create several systemic issues
First, market-to-market values are asymmetric in nature
Unrealized gains that produce no cash require borrowing against the investment to finance consumption
This has been a factor in rising debt levels
If the mark-to-market value then falls, wealth is reduced but the borrowing must still be repaid
Where the asset value secures borrowings, unrealized losses may trigger margin calls, creating a liquidity squeeze and forced sales that
further depress prices.
Second, incentive structures are skewed
Performance-based compensation encourages aggressive valuations that increase assets under management and generate higher fees for managers
This may not be fraudulent as there is ambiguity about the value of non-traded assets
As history shows, independent audits and assurance processes are no guarantee of accurate valuations.
Third, where assets are incorrectly
valued, fund managers and administrators may misstate exit and entry prices
This creates potential transfers of wealth between investors
Where fund values are overstated, selling investors gain at the expense of new ones; and vice-versa when they are understated.
True value
lies in the ability to turn investments into cash
The problem of mark-to-market, especially of private investment assets, is another known unknown of modern markets and finance
The risks frequently aren’t revealed until it’s too late
Unfortunately, as investors may discover in the next downturn, one of the uses of financial crises is to expose what financiers overlooked,
deliberately or accidentally, and what those responsible for oversight failed to find.
(This column does not necessarily reflect the opinion
of economictimes.com, Bloomberg LP and its owners)
