The mark-to-market fallacy

As the European Commission seeks to update AIFMD, Cyril Demaria of Wellershoff & Partners urges the sector to come up with counter-proposals for the sake of the industry and economic growth.

Cyril Demaria

It has been more than a decade since an update of accounting rules has required private market fund managers to determine the “fair market value” of their assets by essentially comparing them to their listed peers. Far from benefiting investors, this approach uselessly embeds volatility risk and ultimately prevents end-investors from reaping the rewards of long-term investing.

The rules adopted in 2007 require managers to mark private assets to listed market prices, supposedly to measure risks more precisely. By bringing private assets closer to the “reality” of listed markets, investors would get a more comprehensive view of their holdings in order to make better decisions. So went the theory.

As the European Commission has embarked on another round of regulation through an update to the Alternative Investment Fund Managers Directive (AIFMD II), I urge the sector to come up with a constructive set of counter-proposals for the sake of the industry and economic growth. It is time to break the silence surrounding the application of the fair market value – not just because it has not helped, but because it is potentially harmful. We should in fact reverse course.

Stable and conservative valuations are good

First, fund managers were and remain conservative in reporting. Investors are happy with this approach. They have long memories and do not easily forgive false hopes. Fund managers take this into account. They know that they must under-promise and over-deliver to smoothly raise their next fund. There is no need to change this status quo.

Valuations already reflected significant market adjustments

Second, assets already embed a certain amount of market sentiment every quarter. For example, in the case of venture capital, successive rounds of financing generate adjustments in the valuation of start-ups. These adjustments reflect the general evolution of stock exchanges. As long as this is done, the external advisors of fund managers, be it auditors or third-party valuators, can be put at ease. Their role is to acknowledge compliance. The output remains the fund manager’s assessment.

Avoiding unnecessary risk

Third, most investors abhor the volatility of listed markets and seek to reduce, not increase, its impact on their portfolio. Importing volatility artificially from listed to private market portfolios is counterproductive. The concern is the much-dreaded denominator effect, which occurs when listed stocks correct significantly and their private market assets get held up, uncovering a facial over-allocation. Forcing private assets to reflect the amplitude of the variation in listed ones is not a solution. In fact, investors should be allowed to value listed stocks as they do with bonds: if they invest to trade, the spot price can be the reference. If it is to buy and hold, the valuation should refer to fundamentals and hence be less volatile.

Adding some perspective

Why raise the issue of the fair market value now? Because at times like these, it matters. The consequences are potentially serious if listed markets become very volatile over an extended period of time. Regulators already sanction private market investments for lacking the immediate tradability of their listed counterparts. Marking private assets to market means that the volatility of listed assets is imported into private markets without the benefit of tradability. For fund managers, this amounts to running the asset allocation race with a ball and chain attached to each foot.

The next stock market crash will be a painful reckoning, unless we change the rules. The real losers are and will be end investors who could benefit from the performance of the asset class but cannot because of these measures. Instead of trying to “nudge” pensioners into expensive listed stocks, the sensible approach is to support their investments over the long term. The mark-to-market rule undermines this endeavor.

Cyril Demaria is head of private markets at Wellershoff & Partners with a focus on less liquid assets. He is the author of five books on private equity.