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Mike Boswell
TriPoint Capital Advisors, LLC

Best Guess Valuations Are No Longer Good Enough


By: Espen Robak | April 25, 2007

Until now, many hedge fund managers have used methods to value restricted securities that are a step above reading tea leaves or picking numbers out of a hat.

However, new standards should result in more realistic valuations.  The Financial Accounting Standards Board’s FAS 157 requires valuations to be as close as possible to "fair value" market prices.  In addition, the International Organization of Securities Commissions is seeking feedback on nine principles it has developed to improve accuracy of valuations.

How far-reaching the new standards will be remains uncertain, but failure to follow defensible standards could have dire consequences:

  • Your fund’s NAV could become increasingly inaccurate, until a large one-month markdown is needed to adjust it.
  • In extreme cases, poor valuation practices could lead to litigation, since the illiquid assets in a portfolio may be the easiest place to hide losses.
  • Auditors may refuse to sign off on financial statements.
  • Hedge funds that cannot file statements with unqualified audit opinions may face increasing investor redemptions or they may find it difficult to raise money.

In addition, if enough hedge funds fail to value investments accurately, regulators are more likely to support stricter regulations.

"Fair Value" Standards
So how can you comply with "fair value" standards?

FAS 157 defines "fair value" as a "market-based measurement" that is based on what an asset would sell for, rather than what it was purchased for.  The two values are likely to differ not only because asset values fluctuate, but because values differ from one market to another.

According to FASB, a fair-value measurement should be "based on the assumptions that market participants would use in pricing the asset."  Referring to restricted securities, FASB says FAS 157 "clarifies that market participant assumptions also include assumptions about the effect of a restriction on the sale or use of an asset."

FAS 157 also establishes a hierarchy requiring that valuations be based on the best information available.  The fair-value hierarchy gives highest priority to market data obtained from sources independent of the reporting entity and lowest priority to assumptions based on "unobservable inputs."

FASB adds that "the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort."

While there is no public market for restricted securities, values can be calculated based on private sales.

Restricted Securities
Brokerage firms have always arranged private sales for restricted securities of very large public companies.  Over the past few years, a market has been evolving for restricted securities of small- and micro-cap companies.

One example is the Restricted Securities Trading Network (RSTN) (www.RestrictedSecurities.net).  Pluris Valuation Advisors used data from trades on the RSTN to create the LiquiStat™ database, which is in turn used to calculate market-based valuations for restricted stock and warrants.  With more than 200 transactions, it is believed to be the largest database of restricted securities trades anywhere.

Pluris bases valuations on the sale price of restricted securities in the database with the most similar characteristics, but the database is just the starting point.  Other factors considered include days left before restrictions lapse, the market price of the underlying stock or warrant, volatility and the nature of the restrictions.

All transactions on the RSTN are time- and date-stamped, so the discount at which a restricted security sells can be easily calculated.  That’s important, since securities continuously fluctuate in value.  RSTN data is also compared with the results of other studies of discounts of restricted securities for validation.

The average discount in the LiquiStat database is 30.7 percent, with a standard deviation of 16.5 percent.  Trades show a significant reduction in the discount as the end of the restriction period approaches.  With 330 days remaining, discounts range from 33 percent to 68 percent.  When the restriction period is a week, discounts range from 10 percent to 16 percent.

Many factors figure into the valuation of restricted securities, but, given today’s regulatory environment, the "best guess" techniques that have been used to date should be abandoned.