Investment Company Notebook

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Interval Funds - Calibration in Valuation Models | BBD, LLP

As many portfolio managers look to launch alternative investment strategies, we have seen a growing interest in the interval fund structure.  An interval fund is a hybrid of an open-end mutual fund and a closed-end mutual fund.  Similar to an open-end fund, an interval fund accepts subscription dollars and issues shares at net asset value on a regular basis, often daily.  However, they generally only offer to repurchase shares at net asset value quarterly.  These infrequent repurchases allow interval funds to hold less liquid assets compared to traditional open-end mutual funds. 

Calibration resizedLess liquid assets present valuation challenges, as they are unlikely to have readily ascertainable market prices.  As these funds take subscriptions daily in many cases, they must strike net asset values daily, and therefore value their assets, including their illiquid assets, every day.

To value their illiquid assets daily, interval funds must incorporate valuation models into their daily valuation process.  There is no single valuation model that is appropriate for all types of illiquid assets.  Instead, interval funds must take into account the nature of the illiquid security and develop a model that is appropriate for the investment.  Examples of different types of valuation models are a discounted cash flow model or a comparative analysis to the liquid stocks of peer companies, just to name a couple.  One of the things that is challenging with valuation models is that they tend to be self-fulfilling prophecies.  If a discounted cash flow model is projecting a steady growth in cash flows for a company, then the value of that asset will steadily increase over time.  For this reason, it is essential to incorporate calibration into your valuation model.

What is calibration in a valuation model?  Calibration is a way of checking the accuracy of your valuation model and can come in several forms.  The most effective form of calibration would be a publicly available reference point of value.  An interval fund could model price a security because it trades with little frequency.  Calibration for a security such as this would be to compare the infrequent trades to the model price and to adjust the model price to the trade price on those days.  If the traded price is significantly different than the model price, the model should be revisited to see if it can be adjusted to produce prices more in line with actual traded prices.

Calibration can also be incorporated in the valuation models for securities that do not have any trading.  This form of calibration involves comparing estimated inputs in the model to actual data.  If the actual data differs from the estimate, the input and resulting price should be adjusted to match the actual data.  Additionally, future assumptions should be revisited in light of the actual results.  In the example above of a discounted cash flow model, let’s assume the model incorporated an annual growth in cash flows of 5%.  After a year, the financial statements for the company showed only a 3% growth in cash flows.  The model should be adjusted to reflect the actual cash flows.  Furthermore, projections of future growth in cash flows should also be revisited to determine if a 5% growth rate is still appropriate in light of actual results.

Strong valuation models are essential tools for interval funds investing in illiquid assets. Calibration is a necessary component of these models to ensure the results are accurate.  Absent calibration, valuation models are self-fulfilling prophecies subject to regulatory scrutiny. 

BBD has vast experience working with interval funds and valuation models.  Please contact us if you have questions about interval funds.