Lesson 4 of 10 · All lessons in this module
- Why appraisal is harder: the life cycle and the J-curveVideo lesson
- Measuring returns: IRR versus MOICVideo lesson
- Leverage: magnifying gains and losses
- Valuation: fair value levels and smoothed returns
- Fees, custom terms and redemption provisions
- Hurdle rates, catch-up, waterfalls and clawbackVideo lesson
- High-water marks, investor timing and either/or feesVideo lesson
- Integrated case: hurdle rate and high-water mark in one fee
- Integrated case: three investors, one fund, four years
- Funds of funds, benchmarks and index biases
Lesson 4 of 10 · 11 min
Valuation: fair value levels and smoothed returns
Illiquid alternatives are often valued by models rather than prices, which tends to smooth reported returns and understate their true volatility.
In short
- Investments must be reported at fair value: the exit price market participants would agree in an orderly transaction at the measurement date.
- Level 1: quoted prices in active markets for identical assets. Level 2: other observable inputs. Level 3: unobservable inputs.
- Private equity and real estate are typically Level 3, valued mark-to-model.
- With little new information, values stay anchored near cost; returns look smoothed, volatility and correlations look too low.
- Level 3 models should be independently tested, benchmarked and calibrated, and valuation procedures disclosed and applied consistently.
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