Valuation methodology for limited partnership interests

Chris Franzek and David Larsen of Duff & Phelps discuess the right way to value limited partnership interests. An excerpt from The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media

Limited partnership interests (LP interests) have historically been valued at the net asset value (NAV) provided to the limited partner (LP) by the general partner (GP). With the issuance of ASU 2009-12 in September 2009, FASB provided specific guidance to the LP community that allows the NAV provided by the GP to be used as the fair value of the LP interest. This can occur if the GP-reported NAV is as of the LP’s measurement date and if the NAV is derived using the fair value of underlying investments.
Ultimately the LP is responsible for determining the fair value in its own financial statements. The IASB has not provided any investment company specific guidance. The September 2009 update of the IPEV Guidelines provides a section outlining best practice for valuing LP interests.
Considerations that the LP should have in their determination of the fair value of their LP interests include: whether the GP has a robust valuation process for the underlying investments which are included in the NAV; differences in reporting dates – generally an LP receives the GP’s NAV after the GP’s measurement date and the LP then uses the GP’s NAV (for a prior date) as their NAV for a subsequent date; and the specific terms associated with their LP interest (for example, transferability of some LP interests is limited).
Ensuring that a fund has robust valuation policies and procedures before committing capital to the fund may be the easiest way for an LP to ensure that the NAV provided to them accurately reflects fair value. Once capital is committed, continued diligence and conversations with the GP to ensure a continued understanding of the GP’s fair value calculations is vital to ensuring that the LP knows and can document that the GP has a robust valuation process that is followed. If there are timing differences between the GP’s measurement date and the LP’s measurement date (typically the LPs will have the prior quarter’s NAV from the GP for their current fair value determination), the LP must make proper adjustments to the GP’s dated NAV in striking the LP’s NAV at the current measurement date.
Methods used to roll the GP’s NAV forward include J-Curve analyses (DCF analyses of the expected  capital calls and contributions associated with the LP interest); indexing to a meaningful index (for example, an LP interest in a private real estate fund may be indexed using one or more real estate investment trusts [REITs] that invest in similar assets or regions); and/or incorporate discussions with the GP about their expectations of changes in the fair values of the underlying companies or NAV as of the current measurement date.
Secondary market transaction data can be considered, but it is frequently discounted due to the fact that sellers may be distressed. As multiple LP interests are packaged, it may be difficult to determine the transaction price for a single interest. The secondary market may also lack adequate volume to reflect current market conditions (such as old trades) or prices may vary widely, which can reduce confidence around a fair value estimate.
This passage is excerpted from The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media. Primarily written by valuation experts Duff & Phelps LLC, this guide provides investors and fund managers with valuable tools and practical guides to fairly value nuances and scenarios, as well as case studies and best practices. Sample contents and more information on the book are available here.