The Fair Market Value of Alternative Investments

Alternative investments include a variety of different asset classes, such as hedge funds, private equity funds, limited partnerships, venture capital funds and funds of funds.

The increasing use of alternative investments as an asset class within Family Limited Partnerships (FLPs) has drawn attention to the challenge of determining a fair, market-based value for an asset which essentially does not have an active market and thus impacts the value of the FLP. Simply relying on reported pro-rata Net Asset Value (NAV) may not be appropriate, as the fair value of the investment may be materially less.

The Financial Accounting Standards Board and the Internal Revenue Code basically state that the fair value of an asset or liability should be determined based on a hypothetical transaction at a measurement date, considered from the perspective of a market participant. In some cases it may be relatively easy to determine the value of an alternative investment fund as represented by the fund’s NAV. However, if provisions within the fund restrict the investor’s ability to redeem, the NAV may not represent fair market value as these restrictions create illiquidity, which would cause the investment to be traded or exchanged at a discount.

An approach to determine the value of an investment in an alternative investment involves finding similar transactions with the same or similar type of investments. Information on transactions involving Limited Partnership (LP) interests is not usually available in the public domain. Although there are some sources that can be used to gather information on historical transactions, these sources typically exclude important background information on the nature of the transactions. For example, information provided may not reveal if the buyer was selling the shares to reallocate an existing portfolio or to raise cash to meet other obligations. These types of transactions may have been entered into under distress and therefore may not represent fair value.

Absent an active market or data representing a fair proxy to the fund investment, the valuation of the investment can be quite complicated. Liquidity discounts should be considered in determining the fair market value of an alternative investment (or an FLP that holds the investment) whereby no active market exists and the investor’s ability to withdraw from the fund is restricted. A detailed analysis is required to determine the economic impact of these restrictions and arrive at an appropriate and defensible discount. Some factors that may impact the discount include the following:

  • Assessment of any transactions involving the transfer or sale or an interest in the fund including an analysis of terms, price per unit, date of transaction, and other relevant factors.
  • Consideration of any transactions presented and not permitted by the General Partner (GP)/Investment Advisor.
  • Transactions that took place over the previous twelve months involving alternative assets of identical or similar characteristics.
  • Additional “lock-up” provisions imposed over the previous twelve months or modifications (redemption fees, extension of lock-up periods, notification periods, gates, etc.) to redemption policies.
  • Distributions paid to investors over the previous twelve months.
  • If dividends or distributions are expected in the future.
  • Whether or not there were redemptions made from the fund. If so, were the withdrawn interests perfected at NAV, below NAV or above NAV?
  • Whether or not there were any fund subscriptions over the previous twelve months. If so, were the subscriptions being accepted? Are subscriptions under the same terms as previous subscriptions?
  • Whether or not there were any liquidations of investments within the portfolio during the previous twelve months.
  • The existence of allegations of fraud against the fund or fund manager.
  • Any changes in financial strength within the fund or changes to key personnel within the fund’s management team.
  • The track record of the fund over the last five years, three years, one year and six months.
  • The fund’s vintage.

While assessing these factors and determining the impact of each on the investment’s illiquidity is subjective and reasonable minds will differ, most parties agree that there are additional costs in terms of time and money when trying to locate a willing buyer for such an interest. A well reasoned assessment of the facts and circumstances can quite often result in a fair value of an alternative investment that is materially less than the pro-rata net asset value.