In private equity, private credit, and real estate fund administration, few concepts are as foundational as fair value. It’s the bedrock of financial reporting, investor transparency, and regulatory compliance. Yet, despite its centrality, fair value is often conflated with market price, cost basis, or even liquidation value.
This article breaks down the core principles behind fair value in the context of fund asset valuation, offering a practical, executive-level overview for professionals across finance, legal, and operations.
Fair Value: A Working Definition
At its core, fair value represents the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.
This definition, rooted in ASC 820 (FASB) and IFRS 13, emphasizes three key elements:
Orderly transaction: Not a fire sale or distressed exit.
Market participants: Not related parties or insiders.
Measurement date: Not a hypothetical future or past value.
Fair value is not what a fund hopes to get, nor what it paid. It’s what a well-informed, willing buyer would pay today, assuming normal market conditions.
Core Principles Behind Fair Value Measurement
1. Market-Based, Not Entity-Specific
Fair value is determined from the perspective of market participants, not the fund itself. This means internal models must reflect assumptions that others in the market would reasonably make, not just those unique to the fund’s strategy or structure.
2. Hierarchy of Inputs
ASC 820 introduces a three-level hierarchy to classify inputs used in valuation:
Level 1: Quoted prices in active markets for identical assets (e.g., publicly traded stocks).
Level 2: Observable inputs other than quoted prices (e.g., interest rates, yield curves).
Level 3: Unobservable inputs (e.g., projections, internal models).
Private equity and credit funds often rely heavily on Level 3 inputs, which require robust documentation and governance.
3. Unit of Account
Fair value applies to the specific asset or liability being measured, not necessarily the entire business or portfolio. For example, valuing a minority equity stake in a private company requires consideration of lack of control and marketability.
4. Highest and Best Use
For non-financial assets (e.g., real estate), fair value assumes the asset is used in a way that maximizes its value, even if the fund currently uses it differently.
Practical Implications for Fund Managers
Governance and Oversight
Valuation committees, third-party valuation agents, and independent reviews are increasingly standard. LPs and regulators expect clear documentation of methodologies, assumptions, and changes over time.
Audit and Reporting
Auditors scrutinize fair value estimates, especially for Level 3 assets. Funds must be prepared to defend their inputs, models, and conclusions with rigor.
Investor Communication
Fair value affects NAV, performance metrics, and fee calculations. Transparent communication around valuation practices builds trust and reduces friction during fundraising or exits.
Illustrative Examples
Example 1: Private Credit Loan Valuation
A fund holds a senior secured loan to a middle-market company. The loan was originated at par, but rising interest rates and sector-specific headwinds have impacted borrower performance. The fund uses a discounted cash flow model to estimate fair value, incorporating updated borrower projections and market spreads for similar credit risk.
Although the loan is still performing, the fair value is marked below par due to increased risk and market repricing, reflecting what a third-party buyer would pay today, not what the fund originally lent.
Example 2: Real Estate Asset Valuation
A fund owns a mixed-use property in a secondary market. The property is currently leased below market rates to a long-term tenant. For fair value purposes, the fund must consider the highest and best use, which may involve re-leasing at market rates or repositioning the asset.
The valuation reflects what a market participant would pay, factoring in the potential to unlock higher income, even if the fund has no immediate plans to change the lease structure.
Final Thoughts
Fair value is not a static number, it’s a dynamic, market-informed estimate that demands discipline, transparency, and judgment. For fund professionals, understanding its principles isn’t just a compliance exercise, it’s a strategic imperative. Whether you're preparing for audit, communicating with LPs, or evaluating exits, fair value sits at the intersection of finance, governance, and trust.