Pricing illiquid assets

The New York Times had a recent article on the sharp decline that university endowments have suffered over the twelve months ending in June.  The worst of the results reported, those from Harvard and Yale, are roughly the same loss as the S&P 500 suffered over that period.

One question jumps out at me that this article, and other similar recent articles chronicling college endowment woes, doesn’t address:  How do they know?

The hallmark of university endowment investing strategy for more than ten years has been deep involvement in illiquid “alternative” assets.  Yale and Harvard have been leaders in this movement.  In the case of the S&P 500, Standard and Poors furnishes the index numbers, which are supported by billions of daily transactions in the S&P 500 constituents.  The main feature of illiquid assets, on the other hand, is just that.  They’re illiquid–they seldom, if ever, trade. So where do the prices that the holders use come from?

In approaching the issue of how private equity, hedge fund or exotic emerging market assets are valued, it might be useful to look first at some simpler past instances of illiquid asset problems.

Real estate–no transactions in bad times

The academic world, as usual, was pretty slow on the uptake about illiquid assets.  When I was entering the business in the late Seventies, the “wonder asset” was real estate.  Numerous academic studies reached the remarkable conclusion that, among stocks, bonds, cash and real estate, the last had not only the highest return but lowest risk.  (Risk was defined, in the academic way, as short-term volatility.  Yes, that makes no sense for most investors.  But the data for making the calculations are easily available, and that’s usually enough for the ivory tower.)

Many institutions took this research seriously, backed up their trucks and loaded the real estate in.

A couple of real estate crashes later, we know property doesn’t have all the virtues business school professors claimed for it.  What went wrong?

The research based its calculations of price volatility on transactions–unaware that in bad times buyers get cold feet and are unwilling to commit.  All but the most desperate sellers pull their properties off the market–sometimes for years–to await price recovery.  So very few transactions occur.  What otherwise might be a 30%-40% decline in prices never gets documented.

High-yield (junk) bonds–no trading, therefore “mark to model”

The first junk bonds were “fallen angel” corporate bonds.  That is, when they were issued, they were high-quality corporate obligations, with appropriately low coupons, whose issuers subsequently hit on hard times.  Drexel Burnham Lambert, an early player in this market, had the clever idea of making original issues of high-yield bonds.  The market for this “junk,” previously the province of commercial bank lending departments, exploded.  The money to buy the IPOs came, not only from insurance companies and pension plans, but also from  specialized bond mutual funds that focused on high-yield.

Mutual fund involvement added a new dimension to the illiquidity issue.  After the IPO, however, trading in junk bonds may be extremely thin–or there may be no trading at all.  Nevertheless, junk bond funds have to calculate a daily net asset value and process daily transactions in shares of the fund.  What to do?  The answer:  mark to model!

Whose model do you mark to?  Initially, fund groups typically used their own internal models (the same way the banks calculated the value of their derivative portfolios–and we all know how that worked out).  But as the junk bond crisis of the late Eighties unfolded, mutual fund companies realized the potential trouble this approach could cause, and switched to outside pricing services.

Third-party pricing services

When we’re talking about financial assets in the US, there are plenty of highly computerized third parties who are available to provide pricing services.  Many bond mutual funds routinely use them.   Equity funds that have large foreign holdings get New York closing values that factor in global market movements that have occurred after overseas markets have closed.  US index values are calculated and disseminated every 15 seconds.

These services can be wrong.  The rating agencies might be seen as an extreme example of pricing gone bad.  (To be honest, I still find it hard to believe that anyone depended on ratings without doing some checking themselves.  In my experience, Wall Street has always understood that the rating agencies were way behind the curve in assessing risk.) Nevertheless, the methodologies are well-understood, there are plenty of finance MBAs to do the work, and in each field there are a number of firms competing for the business.

Private equity–the manager has all the information

Other assets aren’t so easy for investors to get a handle on, however.  Take private equity.  We know that these firms bought large numbers of low-quality, commodity-like–and in the case of the semiconductor firms they acquired–highly cyclical companies at peak valuations when money from the banks was flowing freely a few years ago.  There is no public market any more for these acquisitions.  The private equity firms, which have already taken hefty writedowns, are effectively the only source of information about them.  How do we know these writedowns are enough?   We might think that the private equity firms have a vested interest in reporting optimistic values, to collect higher management fees and to encourage the flow of new money.  But the short answer is that, as outsiders, we don’t know.

Guy Hands, one of the leading lights of private equity, gives his thoughts on this topic in a recent New York Times interview.   He says,”Many P. E. firms are hoping that daylight doesn’t shine on the corpses of their companies, so they are reluctant to restructure too quickly…Neither the banks nor P.E. want to come clean about mistakes.”  Hmm.

Natural resources–experts needed

More exotic assets, like direct ownership of natural resources (mining, oil and gas, timber…) present more complex valuation problems, and thus, much wider scope for a very wide range of expert opinion.  Also, unlike financial assets, they require specialized technical knowledge, which a finance MBA will probably need years to acquire.  They’re also typically very long-lived assets, creating still another dimension, the time value of money, for possible valuation differences.

Emerging markets, too

Emerging markets have their own issues of language, culture, legal systems and attitudes toward foreign investors.  Everyone involved in this area has numerous stories of people being bilked because hey didn’t understand the unwritten rules of doing business in a certain country.  But an equally serious issue, I think, is that the more “emerging” a market gets, the fewer experts on that market there are, and the greater the likelihood that the person who prices your investment is also somehow involved in managing that asset for you.  So investing in truly frontier emerging market areas becomes a lot like private equity, only with a greatly magnified level of risk.  Again, as in private equity, it’s hard to see who there is who doesn’t have a vested interest in providing a very optimistic assessment of your investment’s value.

Back to the endowments

Announcements of capital project postponements and other belt-tightening measures suggest that universities were caught by surprise by the downdraft in world financial markets over the past year.  More than that, they imply that income is less than expected, not just capital values.

The university endowments have no legal obligation to report their results to the world at large.  Further, assuming they have no outside clients, they would seem to face no legal sanctions for being excessively optimistic in their assessment of the value of their investments.  That alone would make me want to take the reported investment results with a grain of salt.

The bigger issue, though, is that the endowment managers probably don’t have the skills or experience in the narrowly specialized areas in which they appear to have invested to be able to second guess the reports they are getting from the managers they have hired.  In the cases of private equity and emerging markets hedge funds, the managers have no incentive at all, so far as I can see, to report conservative asset values.  And they have wide scope, given the high level of uncertainty with which they are dealing, to make excessively favorable (for them) estimates of future revenues and costs.

If I had to make a guess, for which I could give no justification other than intuition born of thirty years of investing experience (not necessarily the strongest justification), I’d say the weakest endowment results are in economic terms down 40%, not the down 30% reported.




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