Recent and ongoing events in Ukraine and Russia are unprecedented. Economic reverberations are felt around the world and, like the economic impacts experienced from the response to the COVID-19 pandemic in 2020/2021 and the global financial crisis of 2008/2009, the full repercussions of Russia's war on Ukraine will take time to become fully evident.
Alternative asset managers (GPs) and their investors (LPs) have financial reporting requirements, internal management needs (asset allocation, incentive compensation, portfolio construction, etc.) and a fiduciary duty to measure and report investments at “fair value.” Fair value is defined as the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (FASB ASC Topic 820/IFRS 13).
While investors with investee companies located in Ukraine or Russia face specific challenges, more broadly all investment managers will be faced with challenges when estimating the “fair value” of underlying investments on March 31, 2022, and beyond. The application of informed judgement in estimating fair value can be difficult in the best of times. Now, with the current geopolitical and global macroeconomic situation, estimating fair value will require significantly more expertise and thought.
In addition to the crises of 2008 and 2020, global investors experienced the suspension of the A-share market in China in 2016 and the Greek debt crisis shortly after the financial crisis. All of these events highlight that when equity markets freeze, become more volatile or are not accessible, significant professional judgment and experience is required to estimate what a market participant will pay for an investment in an orderly transaction, i.e., fair value.
Fair value is fundamentally an orderly transaction view given current market conditions. Yet in an environment with greater uncertainty, greater volatility and greater risk, buyers will likely require an increased rate of return to compensate for these factors. The fact that there may be some market trades does not automatically mean that the underlying prices can be considered fair value. In periods of market upheaval and related liquidity crushes, the few trades that are observed often relate to distressed transactions rather than representative of fair value indications. Fair value is estimated based on the specific facts and circumstances impacting an investee company. Knowing that each situation must be addressed from an individual lens, the following considerations—to the extent they are applicable for a particular investment—are of key importance when estimating fair value in times such as these:
- Who are the potential buyers of the investment? Has the population of buyers changed?
- What is the principal or most advantageous market? Can the seller participate in this market?
- Is the investee company subject to commodity price risk? How is it addressing sourcing production inputs?
- Is the investee company subject to counter party risk? Do its customers have the ability to pay; do its suppliers have the ability to deliver?
- Do sanctions impact the ability to buy or sell as before? Can payments be made without violating such sanctions?
- Does the investee company have sufficient liquidity to withstand supply change disruptions, inflation and changes in customer demand?
- If the investee company experiences insured losses related to geopolitical events, will the insurance company be able to cover such losses?
- Is there a risk of expropriation when operating in certain countries and how should such risk be incorporated?
- Should the potential for central bank accommodation or governmental stimulus be incorporated in projections?
These are just some of the questions which must be addressed as fair value is estimated in the current environment and in the future. The impact on the fair value of directly affected investee companies and investments may be dramatic. The impact on fair value of investee companies indirectly affected by sanctions, inflation and uncertainty may be just as dramatic. Investors need fair value to be rigorously and robustly determined each time they or their investment managers report. The uncertainty associated with Russia's war on Ukraine increases the need for exercising experienced informed judgment in estimating fair value.