Illiquid Asset Valuation
Definition
Illiquid asset valuation for interval funds follows FASB ASC 820 fair value framework establishing three-level hierarchy, with Level 3 assets (no observable market inputs) requiring complex appraisal methodologies. Private credit valuation: Performing loans marked using discounted cash flow (contractual interest payments and principal discounted at current market rate reflecting credit spread environment), comparable transaction analysis (recent BWIC secondary market trades for similar loans establishing pricing range typically 95-102 cents for performing, 40-80 cents for distressed), broker dealer quotes (non-binding indications from market makers, used with caution as often stale or wide bid-ask spreads). Impaired loans require probability-weighted scenarios: restructuring outcome (extended maturity, reduced rate, partial principal forgiveness), liquidation outcome (enterprise value as going concern versus collateral liquidation value less bankruptcy costs). Real estate valuation: Income capitalization approach (stabilized NOI divided by market cap rate, typical cap rates 5-7% multifamily, 6-8% industrial, 7-10% retail/office depending on location and quality), sales comparison approach (recent comparable property transactions adjusted for size, location, quality, condition differences), cost approach (land value plus replacement cost less depreciation, primarily for development properties or special-use assets). Appraisal frequency quarterly desktop updates (appraiser revises prior valuation incorporating new rent rolls, occupancy data, market conditions without site visit), annual full appraisals (physical inspection, comprehensive market analysis, detailed reporting). Venture capital/private equity: Recent funding round valuation (latest preferred stock financing round establishes post-money value, common stock marked at discount 20-40% for liquidation preference and rights differences), public company comparables (select similar publicly-traded firms, apply median EV/Revenue or EV/EBITDA multiples with 25-35% illiquidity discount), option pricing models (Black-Scholes variants valuing equity as call option on enterprise value particularly for distressed/pre-revenue companies). Valuation triggers requiring updates: New financing rounds (up or down rounds materially changing value), operating performance significantly better/worse than projections (revenue or EBITDA variance >20%), comparable company movements (public peer median valuation multiples declining 30%+ suggesting private marks should follow), restructurings or defaults (impairment requiring immediate markdown).
Why it matters
Illiquid asset valuation subjectivity creates 10-30% NAV uncertainty in interval funds with 60-70% Level 3 holdings, determining whether shareholders receive fair value in tenders or subsidize others. Critical dynamics: (1) Marking discretion enables manipulation—fund marking private loans at par (100 cents) while comparable BWIC trades occurring 85-90 cents creates artificial NAV inflation, exiting shareholders receive inflated prices funded by portfolio deterioration imposed on remaining holders, secondary market discounts to NAV (often 10-20%) signal market skepticism of reported values, (2) Appraisal timing mismatches create stale pricing—quarterly valuations for private holdings mean reported NAV reflects 0-90 day old information depending on position within quarter, rapid market movements (credit spread widening 200bps in March 2020) not captured until next quarter creating opportunities for informed shareholders to tender at stale NAVs, uninformed shareholders unknowingly accepting overvalued prices, (3) Model assumption variance compounds over time—discount rate difference 12% versus 15% creates 15% immediate valuation gap expanding to 25-30% over 3-5 year holding period as compounding effects accumulate, growth rate optimism (8% CAGR versus realistic 5%) creates 20-25% terminal value overstatement, seemingly minor assumption differences produce material NAV differences. Real-world outcomes: March 2020 COVID crisis highlighted illiquid valuation challenges—private credit interval funds experiencing divergent responses: Conservative funds (Stone Ridge, Cliffwater) marked loans down 10-20% March-April reflecting credit spread widening and payment deferrals, suspended tenders citing inability to fairly value, Aggressive funds maintained near-par marks (95-98 cents) arguing 'temporary dislocation' not permanent impairment, continued tenders allowing shareholders to exit at optimistic NAVs, Subsequent analysis showed conservative funds recovered to pre-crisis NAVs by Q4 2020 (markdowns proven temporary), aggressive funds experienced gradual 15-25% declines over 2020-2021 (delayed recognition of actual impairment), investors who tendered early from aggressive funds (March-June 2020) received significantly better execution than those who remained or tendered from conservative funds post-reopening. Understanding valuation mechanics critical for: Investors evaluating reported performance (Sharpe ratios/volatility statistics misleading if based on smoothed stale valuations rather than true economic marks), advisors conducting due diligence (request valuation policies, third-party engagement terms, comparison of manager marks to independent appraisals and subsequent transaction prices), platforms selecting funds (preference for conservative marking, frequent independent appraisals, transparent assumption disclosure, demonstrated history of marks tracking realized transaction values within 5-10%).
Common misconceptions
- •Independent appraisals aren't independent from conflict—appraisers hired and paid by manager creating subtle bias, rely on manager-provided data (financial statements, projections, market assumptions) without independent verification, face incentive to maintain relationship (future assignments) moderating disagreements with manager marks. True independence requires investor-selected appraisers or regulatory mandate.
- •Fair value doesn't mean market value—FASB defines fair value as 'exit price in orderly transaction,' but illiquid assets have no active market so 'orderly' is theoretical construct. Two valid approaches: (1) Hypothetical market participant assumptions (what rational buyer would pay given available information), (2) Company-specific assumptions (value to current holder considering unique synergies/constraints). Both GAAP-compliant but can produce 15-25% different values for identical asset.
- •Quarterly valuations don't mean quarterly pricing—appraisals conducted quarterly but incorporate 30-60 day data lags (financials, market comps, projection updates). Reported 'Q1 valuation' actually reflects end-of-Q4 through mid-Q1 information creating 45-90 day staleness. Unlike daily mutual fund pricing reflecting yesterday's closing prices, interval fund NAVs are inherently backward-looking for illiquid holdings.
Technical details
Private credit valuation methodologies
Discounted cash flow approach: Cash flow projection—contractual loan payments (interest and scheduled principal), prepayment assumptions (base case maturity, scenarios for early payoff 25-50% annual voluntary prepayment rate typical), default probability (historical loss rates 1-3% annually for performing loans, 15-30% for stressed borrowers), recovery rates (50-70% of principal upon default for senior secured, 20-40% for unsecured or subordinated). Discount rate selection—base rate (SOFR or Treasury curve), credit spread (comparable market spreads for similar risk loans, currently 300-600bps for BB-B rated private credit), illiquidity premium (additional 50-150bps compensating for inability to sell quickly). Typical total discount rates: 7-10% for performing senior secured loans, 12-18% for mezzanine/subordinated, 20-30% for distressed.
Market comparable approach: BWIC transaction analysis—identify recent broadly syndicated loan (BSL) or middle market loan (MML) trades in secondary market, adjust for differences in seniority, credit quality, industry, size, compare spread to new issue market. Challenge: Limited transaction volume (private credit secondary market <10% of total market versus 80%+ for BSLs), wide bid-ask spreads (5-10% of par common), may not reflect orderly transactions (distressed sellers, opportunistic buyers). Example: Hold $10M private loan to healthcare company. Recent BWIC showed similar healthcare loan trading 92 cents. Adjust for our loan having stronger covenant package (+3 points), slightly weaker sponsor (-2 points) = implied 93 cents fair value. Manager internal mark at 96 cents. Independent appraiser at 91 cents. Board selects 93 cents (midpoint near market evidence).
Impaired loan valuation: Collateral-based approach—appraise underlying collateral (real estate, equipment, inventory, A/R), apply liquidation discounts (real estate 20-40% below appraised value in forced sale, equipment 50-70% discount, inventory 60-80% discount, A/R 10-30% collectability loss), deduct bankruptcy costs (legal/administrative 10-20% of recovery), senior lien priority (first lien holders paid before junior), timeline value (discounting to present expected 1-3 year recovery timeline). Example: $10M loan secured by $15M property, borrower defaulted. Liquidation scenarios: Optimistic (property sells $12M, 1 year, recover $11M post-costs = 110% of loan), Base (property sells $10M, 18 months, recover $8.5M = 85%), Pessimistic (property sells $8M, 2+ years, recover $6M = 60%). Probability-weighted: 20% optimistic + 60% base + 20% pessimistic = 81 cents fair value. Enterprise value approach—value borrower as going concern using EBITDA multiples or DCF, allocate value to debt instruments via absolute priority rule, compare to collateral value (use higher of enterprise value allocation or collateral value). Used for businesses with sustainable operations despite financial distress.
Real estate appraisal techniques
Income capitalization method: NOI calculation—gross rental income (in-place rents, vacancy assumptions 5-15% depending on market and quality), operating expenses (property management 3-5% of revenue, repairs/maintenance 10-20%, property taxes, insurance, utilities where applicable), capital expenditure reserves (roof, HVAC, parking lot resurfacing amortized $500-$2,000 per unit annually for multifamily). Stabilized NOI—adjust for current below-market rents transitioning to market over lease renewal period, temporary vacancy from recent turnover, one-time expenses. Cap rate application—direct cap (NOI ÷ Cap Rate = Value), select cap rate from comparable sales (recent transactions of similar properties in same market, adjust for quality/location/timing differences). Cap rate ranges: Class A multifamily urban 4-5.5%, Class B suburban 5.5-7%, Class C tertiary 7-9%, Industrial 5.5-7.5%, Retail 6.5-9%, Office 7-11% (post-COVID widening). Example: Property generating $1M stabilized NOI, comparable sales indicating 6.5% cap rate = $15.4M value.
Sales comparison approach: Comparable selection—identify 3-10 recent sales (<12 months ideally, <24 months acceptable) of similar properties (same property type, similar size within 25-50%, same submarket or comparable location, similar quality/age), Adjustments—size (larger properties command lower price per SF, 10-20% adjustment typical), location (superior location +5-15%, inferior -10-20%), quality/condition (Class A premium +15-25% vs Class B, +30-50% vs Class C), timing (market appreciating 5-10% annually requires upward adjustment for older comps). Adjustment methodology—percentage adjustments for qualitative factors, dollar-per-SF for quantitative, reconcile to indicated value range. Example: Valuing 100-unit multifamily. Comps: Property A (90 units, same location, sold $18M = $200K/unit 6 months ago, adjust +3% for market appreciation = $206K/unit), Property B (120 units, slightly worse location, sold $19.2M = $160K/unit 3 months ago, adjust +10% for location difference = $176K/unit), Property C (100 units, better condition, sold $22M = $220K/unit 9 months ago, adjust -10% for condition, +5% for timing = $209K/unit). Reconcile: Weighted toward Property A (most similar) suggests $205K/unit × 100 units = $20.5M value.
Cost approach: Replacement cost—land value (recent land sales per SF or acre, adjusted for zoning/entitlements, utilities access, location), construction costs (regional hard costs $150-$300/SF for multifamily, $80-$150/SF industrial, $200-$400/SF office, architectural/engineering, permits, financing, developer profit), indirect costs (impact fees, loan interest during construction, marketing/lease-up). Depreciation—physical deterioration (deferred maintenance, component end-of-life), functional obsolescence (outdated layouts, insufficient parking, no elevators in 4+ story building), economic obsolescence (neighborhood decline, overbuilt market). Most applicable: New construction (cost approach closely approximates value), special purpose properties (limited comparable sales), highest-and-best-use analysis (land valued for redevelopment). Example: Aging office building. Land value $5M (recent land sales). Replacement cost $40M new building (200K SF × $200/SF). Less depreciation: Physical 25% ($10M), Functional 15% ($6M), Economic 10% ($4M) = Cost approach value $25M ($5M land + $20M improvements).
Venture capital and private equity valuation
Recent transaction valuation: Preferred stock financing rounds—last round price establishes post-money valuation (Company raises $20M Series B at $100M post-money = $5/share price), common stock discount (lacking liquidation preference, anti-dilution protection, board seats commands 20-40% discount to preferred), time decay (valuations >12 months old lose relevance, require adjustments for: operating performance versus plan, market multiples changes, sector sentiment shifts). Example: Company valued $100M in Series B (12 months ago). Current performance: Revenue tracking 80% of plan, public SaaS comps down 30%, fundraising environment tightened (Series C delayed). Adjust Series B price: -20% for underperformance, -25% for market multiples, -10% for time value = $45M current fair value (55% markdown from $100M).
Public company comparable multiples: Comparable selection—identify 5-15 publicly traded companies (similar business models, revenue scale within 0.5x-2x, growth profiles, unit economics), calculate valuation multiples (EV/Revenue, EV/EBITDA, P/E for profitable, EV/ARR for SaaS), apply median or mean multiple to portfolio company metrics. Adjustments: Size discount (smaller private companies 20-35% discount), illiquidity discount (cannot sell publicly 15-25% discount), growth premium (if growing faster than public comps +10-20%), profitability discount (if pre-profitable while comps profitable -20-30%). Example: Private SaaS company $30M ARR growing 60%, public SaaS comps trading 8x ARR median. Adjustments: -25% size, -20% illiquidity, +15% growth = 6.4x ARR × $30M = $192M pre-money value. If investors own 40% post Series A = $77M position value.
Option pricing model (OPM): Black-Scholes variant—model equity as call option on enterprise value, strike price equals liquidation preferences plus debt, volatility estimated from comparable public companies (40-80% typical for venture-stage), time to liquidity event (expected exit timeline 2-5 years). Most applicable: Complex capital structures (multiple preferred series with participating liquidation preferences, ratchets, PIK dividends), distressed scenarios (enterprise value below liquidation preference, common equity deep out-of-money), pre-revenue companies (DCF and multiples unreliable). Example: Company with $100M enterprise value estimate, $120M liquidation preference to preferred, $0 debt. Common equity modeled as call with $120M strike, 5 years to exit, 60% volatility = $15M common equity value (versus $0 using simple waterfall), reflects probability of upside if company exceeds expectations and enterprise value grows above preference stack.
Governance and quality control
Third-party valuation engagement: Scope definition—specify assets to be valued (rotating 10-30% of Level 3 portfolio quarterly ensuring full coverage annually), valuation approaches permitted (DCF, multiples, market transactions), reporting requirements (formal opinion letters, detailed workpapers, management discussions). Selection criteria—specialized expertise (private credit, real estate, VC/PE sectors), independence (no business relationships with fund/manager beyond valuation), credentials (ASA, CFA, MAI designations). Rotation—some funds rotate firms every 3-5 years preventing over-familiarity, others maintain primary relationship for consistency while rotating coverage (different assets each quarter). Cost: $50K-$500K annually depending on portfolio complexity, coverage percentage, and appraisal frequency.
Valuation committee oversight: Committee composition—3-5 independent trustees (board members unaffiliated with manager), financial expertise (audit committee members, CFOs, accounting professionals), meet quarterly. Review procedures: Examine all Level 3 valuations quarterly (100% of holdings reviewed, vs 10-30% independently appraised), investigate variances (manager mark differs from third-party appraisal >10%), assess methodology appropriateness (DCF versus multiples, key assumptions reasonableness), approve final NAV incorporating valuation decisions. Escalation: Material valuation disputes (manager and appraiser >15-20% apart) elevated to full board, may engage additional independent appraiser to resolve, document decision rationale in meeting minutes.
Post-valuation verification: Subsequent transaction testing—compare prior valuations to eventual sale prices (validates model accuracy or reveals systemic bias), Example: Fund marked private loan $9.5M (95 cents on $10M par) Q4 2023, loan sold secondary market $9.2M (92 cents) Q2 2024. Variance analysis—was 95 cent mark reasonable given information available Q4 2023? If subsequent 92 cent transaction was distressed sale (forced liquidation) then 95 cent mark defensible. If orderly transaction then suggests 3 cent (3%) systematic overvaluation. Tracking over time—funds maintaining <5% average variance from eventual transaction prices demonstrate valuation quality, >10% sustained variance suggests bias requiring methodology/governance changes. Auditor scrutiny—external auditors test valuation reasonableness annually (select sample of Level 3 assets, perform independent analysis, compare to fund marks), audit opinion qualified if materially misstated (typically >1-2% of NAV threshold), investors should view audit opinion as validation of processes not guarantee of accuracy.