What ramifications will the Act have for holders of illiquid assets?
In its current form, the Act encourages that various derivative securities be traded through exchanges or clearinghouses. However, other forms of illiquid assets are not discussed in the Act. It does not discuss how valuation issues in private placement, private equity and venture capital fund transactions can be mitigated, though many investors, including corporate and public pension funds, endowments and insurance companies, hold these assets. Financial accounting standards have been implemented requiring these assets to be marked to market on a periodic basis; however, this is difficult and the Act provides no assistance. Valuation theory is premised on liquid markets and has significant difficulty dealing with illiquidity. The theory assumes an investor wishes to maximize return while minimizing risk over a single period. While this period could be lengthy, the key issue is that valuation theory assumes away liquidity risk, leaving an estimate of this quantity up to a valuation professional.
Overall, while increased transparency through more liquid trading is a laudable goal, it will be interesting to see what significant procedural changes occur.
Can you elaborate on the valuation issues you mentioned?
Assets are often valued through a market or income approach. In the market approach, an analyst might look at comparable transactions or at the trading multiples of public companies. This becomes difficult as the number of comparable transactions and comparable companies decreases. For instance, many venture capital funds struggle to find such comparable companies upon which to base a valuation — an idea may be so new and radical that nothing similar has preceded it.
With respect to the income approach, much of today’s valuation theory is based upon the principle that all investors hold an identical and diversified market, or ‘risky’ portfolio. This is not the case on either front, as investors each hold different portfolios. Moreover, when the values of different asset classes move in virtual lock step with one another, how can you be diversified?
Heuristic methods have developed over the years, modifying underlying valuation theory, but these were not originally a component of the theory. The valuation tools that we have developed over the past 50 years are invaluable, but they are also difficult to directly apply to some areas of modern markets and speak little to the assessment of systematic risks outside of the sensitivity of a particular asset to such risks.
How should companies and investors respond to today’s risky environment?
As we mentioned in last month’s article and complementary insert, risk management is a continuous, recurring process. Irrespective of the environment in which a company participates, risk managers should focus on four primary areas of risk: strategic, operational, process and compliance risks. The latter element was explicitly specified as a requirement in the Dodd-Frank Act. Risks pertaining to each of these areas must be frequently elaborated and analyzed by members from all levels of the organization. Companies should also focus on the risks associated with their illiquid asset holdings to ensure they are not overexposed to risks associated with these assets.
For more information on the specifics of risk management process implementation, visit www.cca-advisors.com/risk-assessment.html.
JIM MARTIN, CMA, CIA, CFE, is managing director for Cendrowski Corporate Advisors LLC. Reach him at [email protected] or (866) 717-1607, or visit the company’s website at www.cca-advisors.com.
