Fair Value: What Someone is Willing to Pay...Not What Someone Should Pay

I recently attended an accounting trade group lecture on the valuation of private equity portfolio investments. Market participants, media, and the public have recently begun to critically analyze the private equity sector and the Net Asset Value or Fair Value investment marks on their balance sheets. Such publicity is foreign to these private equity firms. And for many years, most have purposefully operated with low public footprints.

The call was somewhat mundane, which isn’t overly surprising considering it is, at its foundation, a technical accounting discussion. These topics tend to be jargon-dense, complex, and dull. But there were two questions asked, which were quite illustrative. A participant asked the question:

“[A] question just came in about what if the real-world transaction price just includes a lot of emotional value? They just want it. So they are overpaying because they want it.”

The response was brutally honest. And I think this is where investors and the general public misunderstand how valuations are calculated.

“GAAP doesn’t care. Fair value has nothing to do with what things are really worth. Fair value is defined as what people will pay. So a lot of people in the Financial Crisis; I know this is going back to ancient history for a lot of people now, but in the Financial Crisis a lot of people were saying ‘Well but these things are not nearly worth 100% of par. The option rate securities aren’t really worth 100% of par. And so, GAAP, FASB, you should have told us that the emperor has no clothes.’ But it couldn’t, we were transacting at 100% of par. Lots of people blowing the whistle saying, ‘No, no, no. This is silly’. But if they are transacting at 100% of par, that is fair value. We don’t get to think too hard about what it should be worth. We only get to say what it is.”

And that is true. FASB accounting standards define fair value as “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.” In other words, valuation is subordinate to the emotions of Mr. Market. Economic historian and Editor of Grant’s Interest Rate Observer, Jim Grant, has regularly compared Mr. Market to the equivalent of “going into business with a manic-depressive.” And rightfully so.

Financial history shows, time and time again, that irrational exuberance bleeds into the markets, including into valuation calculations. As the respondent said, it is ‘what people will pay’. It is not what people should pay. Should investors have bought interests in Puckle’s Machine Company during the South Sea Bubble? Puckle’s Machine Company sold square cannon balls and musket balls. Simple physics would have undermined Puckle’s products. Or in Tulips during the Tulip Bubble? Tulips have a finite life of one to two weeks in the ground, and up to a couple of years as bulbs.

Now, those are extreme examples, but at some point, those investments were considered attractive and fairly valued. Fair value is relative and not always rational, using a long-term lens.

The second interesting question and response from the call was:

“Another question came in saying, well, but, 92% of LBOs missed their projections [in year one].”

The response was:

“Yeah, markets price that in on Day 1. Your calibrated multiples, your calibrated discount rate, will all take that into account that those projections are not terribly reliable.”

I was not comforted by the response. They were obviously relying on the efficient market hypothesis. You cannot, contrary to that statement, account for an ‘unknown unknown’. So, there is a high probability that this was not accounted for in the fair value models. The fact that LBO projections missed 92% of the time indicates that there is a bias to overestimate financial projections. If valuations began pricing this into their models, you would see the accuracy of projections improve.

I understand why they took this position. As a valuation specialist, they cannot aggressively challenge their clients’ forecasts. But there is obviously an accuracy problem with fair value…starting potentially at the first mark. Market participants assume that these models are reliably accurate, but chances are they are not. Mr. Market is manic. You might unknowingly be exposed to higher markdown risks than you realize, especially when the cost of debt and equity, which impact the discount rate used in these valuation calculations, are steadily rising (see chart). The discount rate affects every business, public and private. This is not only a private markets issue.

History may only rhyme, but accounting doesn’t just rhyme; it repeats. It has to. It is rule-based. And knowing the technical accounting that goes into these fair value calculations is essential for prudent investors, because fair value is relative and reflective of sentiment, which is not always rational.