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Study: Portfolios Bulging with Illiquid Assets

Is the surge just a matter of a change of perception stemming from the implementation of the FASB fair-value standard?
David M. Katz, CFO.com | US
April 28, 2009

The investment portfolios of hedge funds and private equity firms are increasingly stuffed with assets of uncertain value, a recent survey by Duff & Phelps suggests.

Indeed, 48 percent of the 114 asset managers surveyed by the valuation firm  report that between 76% and 100% of the value of their firms' portfolios is classified as Level 3 assets under the Financial Accounting Standards Board's controversial standard No. 157, Fair Value Measurements. What's more, 34% of the executives said that their firms have increased their holdings in Level 3 assets over the past 12 months.

Under the standard, Level 3 assets are holdings that are marked to what is, essentially, a non-existent or illiquid market. In such circumstances, fair value can be determined only through "unobservable inputs" and prices that could be based on internal models or estimates. (In contrast, the values of assets slotted in levels 1 and 2, represent, respectively, a quoted price in an active market and "observable market data" other than a quoted market price.)

Is the rise in the percentage hard-to-value assets a true increase resulting from a meltdown that has disrupted normal market behavior? Or is the surge just a matter of a change of perception stemming from the implementation of the FASB fair-value standard?

While the results aren't totally conclusive on this point, the survey respondents appear to tilt to the latter explanation. Seventy-seven percent of the executives say that the imposition of FAS 157 has boosted scrutiny of the valuation of their Level 3 holdings.

Duff & Phelps, as a leading valuation firm, has a lot to gain from such uncertainty in the valuation markets. The survey, however, is based on a nearly equal division of respondents from companies that use a third-party valuation firm in their valuation process (51%) and those that do not use such a firm (49%). Further, 87% of the respondents say they're confident in their firms' valuation processes for Level 3 holdings.




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