“Valuing Illiquid Assets”
By Chester Spatt*
‘Board Oversight of Valuation Roundtable’
Center for Financial Policy, Smith School
and Mutual Fund Directors Forum
Reagan Center, Washington, D.C.
November 21, 2013
*Carnegie Mellon University and
former Chief Economist, U.S. SEC
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Valuation and Investors
• Challenging when markets are illiquid
• Implicit options are subtle, but important
• Fairness
– Buyers vs. sellers
– Among funds, products
• Avoid stale prices, look-back options and
dilution
– Costly to less sophisticated, uninformed investors
– Discourages desirable investors
• Fund valuations used for many purposes
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Why is Board Oversight Important?
• Articulate a process, understand it, follow it and
review it periodically
– Limits need for due diligence costs
– Crucial for common knowledge and expectations for
investors, fund staff to be able to rely on it.
• Board: Arbitrator that looks beyond private incentives
& disclosures of asset managers (Morgan Keegan)
– Crucial to satisfy fiduciary duties of board
– Boards scrutinized for ineffective oversight
– Monitor internal pricing; Approve and document overrides
• Even potential for fraud—reliance on the Business
Judgment Rule may not be a successful defense
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History
• Mutual fund market timing scandals
– Complexes didn’t follow or understand stated
procedures
– Unsophisticated investors victims in many ways
– Implicit “look-back options,” valuation relevant
• Money market mutual funds and valuation
• Financial crisis and illiquidity
– Mortgage tranche valuation
– Transparency
• Trade allocation conflicts
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Valuing a Property (House, Art)!
• Ultimate fragmented market—but offers valuable lens
– Highly differentiated products, unlike many financial assets
• Last transaction?
– Adjusting for staleness
– Adjusting for trade direction
• Mid-quote?
– Suppose I raise my asking price?
• Information from other “differentiated” transactions?
– Imperfect substitutes; ratings insufficient too for financials
– Regression methods
– Appraisal
• Focus upon repeat sales? (“Repeat Sale Indices”)
– The most liquid properties returns have different returns
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What’s Different about Financial
vs. Housing (Art) Markets?
• Quantities can influence valuation
– Houses, art objects are singular
• Competing sellers as well as buyers
– Allow greater opportunity and incentive to go
short, more access to critical feedback (ideally)
• Trading more frequent
– Still, many instruments offer quite infrequent
trading, so housing (art) provides a valuable lens
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Valuation and Fund Liquidity
• Providing liquidity to both buyers & sellers
• Valuation is cast as size independent
• Mutual funds face a tough challenge as they
offer daily liquidity without charge, even
though market liquidity is limited!
• Tax externalities and capital gains lock-in
– Diverse horizon, yet same valuation by share class
• Hedge fund approach
– Less frequent valuation and liquidity provision
• ETFs—immediacy, but priced via arbitrage
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Modeling and Illiquidity
• Non-trading (absence of trading)
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Inaction on valuation?
Stale prices (trading lags), trade infrequency
Substitute prices (analogy: ‘program trading’)
Trading halts; Asset illiquidity and valuation
• Patient buyers vs. sellers
– Meaning of transaction prices
– Mid-quotes; Are spreads symmetric?
• Position size (important facet of illiquidity)
• Securities lending frictions, “specialness”
– Examples: RJR bonds (1989-1991), Palm (2000)
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Refining the Valuation Context
• Clarity about uses of valuation, objectives
– What adjustments seem suitable?
• To what extent is your expert focusing on
valuation challenges?
– Subtle issues given the fund context (how
valuations used) and illiquidity of some assets
• Independence of expertise
• Choice of model inputs
• Is pricing transparent, fragmented?
– TRACE; Fragmented trading and diverse dealers
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