The world is wealthier now than it’s ever been — but only on paper. Much of this prosperity may prove illusory as a global shift toward less liquid investments undermines the basis of valuation.
Private equity, infrastructure and private credit have become a bigger share of investment portfolios, making mark-to-market values increasingly uncertain. The standard method of valuing assets assumes prices are available and that there is adequate trading liquidity to be able to sell at those levels. This may hold for traditional investments such as stocks and bonds. But assets such as private equity are rarely traded or not tradable at all, necessitating the use of models or proxies instead...
...Over recent years, trading volumes have declined for most asset classes due to a reduction in dealer numbers, regulations that make it more expensive to hold trading inventory, and central bank intervention. Meanwhile, prices for smaller-cap shares, as well as many corporate and structured bonds, emerging- and frontier-market securities, and distressed debt may not be consistently available. These factors combined with the growth of large funds and the size of holdings mean that the ability to sell at quoted prices is questionable.
...discounting future cash flows. These may be distorted by low rates and decreased risk premiums. The models typically require a residual value...
...Sometimes, known sales are used as proxies to establish or calibrate model values. These suffer from the problem of small sample sizes and a lack of exact correspondence to the asset being valued. Adjustments are necessarily subjective. ...
...Where the asset value secures borrowings, unrealized losses may trigger margin calls, creating a liquidity squeeze and forced sales that further depress prices.
...Performance-based compensation encourages aggressive valuations that increase assets under management and generate higher fees for managers....
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