Level 3 communications

The Wall Street analyst community and financial media have a new bit of jargon to play with – “Level 3.”
For stock investors who demand transparency and reliable earnings, “Level 3” sounds ominous and like something that banks would not want to own. Private equity financial professionals will recognize this term as a designation that pretty much sums up the entire portfolio of most private equity firms.
According to FASB’s Statement of Financial Accounting Standards No. 157, Fair Value Measurements, firms should think about their assets as falling into roughly three valuation categories, or levels – Level 1 are assets with quoted prices for identical instruments in active markets; Level 2 assets have quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets.
Level 3 assets are the tough ones. These must be valued based on one or more significant inputs or significant value drivers that are unobservable.
The recent turmoil on Wall Street stems from the unknown risk posed to financial institutions from instruments for which there are few observable value inputs, such as collateralized loan obligations backed by subprime mortgages. A key reference point in discussing this risk has been the size of corporations’ respective exposures to Level 3 assets. Citi has been the most harshly criticized for its inventory of assets that require fair value “guesstimation” (see boxed items). Chuck Prince, the Citi CEO, lost his job in part because of a perceived obliviousness on his part to the risks of certain debt obligations.
As private equity increasingly becomes a tradable business, this harsh view of Level 3 assets should be cause for concern. Many of the portfolio items owned by private equity firms would be classified as Level 3. Public investors tend to sound the alarm over these hard-to-value assets during times of turbulence. During the tech meltdown of 2001 and 2002, several large financial institutions with private equity arms, notably JPMorgan, took beatings from investors critical of the fluctuations and estimations inherent to private-company accounting.
If listed companies are intermittently punished for having large Level 3 inventories, this calls into question private equity’s appropriateness as a listed business.