LP fund interests: Pricing vs. NAV

Determining the fair value of limited partner interests for financial reporting purposes requires more thought and analysis than many sellers and buyers realise, according to the head of Duff & Phelps alternative asset advisory practice and managing director David Larsen who co-authored the PEI book Private Equity Valuation. 

When sellers and buyers price an LP fund interest, it’s often based on, or described as, a percentage of net asset value.

Larsen explains there are two types of LP fund interests sold – those where NAV is clearly based on the fair value of underlying assets and those where NAV is not necessarily reflective of the fair value of underlying assets. Likewise, there are also two types of LPs – those that fully understand NAV accounting rules and take steps to validate that NAV is based on the fair value of underlying assets and other LPs that blindly accept NAV.

“Sellers of LP interests have different levels of sophistication and what they’re selling has different levels of underlying robustness,” Larsen told Secondaries Investor.

The discrepancy between pricing and NAV is a result of timing, underlying asset quality, supply and demand and accounting nuances that sellers and buyers face when negotiating terms, Larsen added.

“With respect to LP interests, fair value for accounting purposes is not necessarily synonymous with the transaction price. Deal pricing is often separate and distinct from the financial reporting; while similar information is used, investors need to understand the appropriate context in which value is determined.”

The valuation of a LP fund interest should be partially based on reasons why the fund interest is being sold, such as levels of distress or an LP’s over allocation to the asset class, Larsen and his colleagues write in Private Equity Valuation.

The valuation should also take into account whether the fund interest was part of a larger portfolio sold at a discount to NAV. If so, it’s likely impossible to ascertain the appropriate value paid for each fund interest in the portfolio. Similarly, if the fund interest wasn’t sold as part of a portfolio but should have been, the NAV may not be based on sufficient information to allocate it to the purchase price.

Larsen said some of the thoughts included in the chapter came after accounting guidelines were modified in 2009 allowing NAV to be used to estimate fair value for financial reporting purposes. Not all LPs have fully understood and applied the revised guidance.