The Price Hasn’t Changed. Has the Risk?

PRIVATE ASSETS & MEASURING RISK

An old bond-market lesson

Consider a high-yield bond that rarely trades. Its last recorded price can remain unchanged while interest rates move, comparable bonds reprice or the borrower’s prospects deteriorate. The absence of a new price is not evidence that none of those things matters.

That creates a statistical problem: measured volatility can look low, and measured correlations with other investments can be distorted when prices update at different times. We can make numerical adjustments for stale pricing. But correcting a risk estimate is only part of the job.

Putting a number on smoothing

One simple model treats the reported return as a blend of the current economic return and the previous reported return:

r_t^reported = (1 − α)r_t^economic + αr_t−1^reported

Here α is the smoothing coefficient, with 0 ≤ α < 1. With independent, identically distributed underlying economic returns and a constant smoothing coefficient, the stationary model gives:

σ_economic = σ_reported × √[(1 + α) / (1 − α)]

Under these assumptions, α also equals the lag-one autocorrelation of reported returns.

Reported volatility 4% → adjusted volatility 6.9%

With α = 0.5: 4% × √[(1 + 0.5) / (1 − 0.5)] = 4% × √3 ≈ 6.9%. Both figures refer to the same measurement horizon.

The exposure has not become riskier because we changed the calculation. The model suggests that smoothing had concealed some of its variability.

Illustrative one-parameter smoothing model, not an estimate for a particular bond or fund. Serial correlation can have other causes, and this adjustment does not capture every source of risk. Related research: Getmansky, Lo and Makarov (2004), An Econometric Model of Serial Correlation and Illiquidity in Hedge-Fund Returns.

Private assets take the question further

A private loan, property or business may have no regularly executable market price. Its valuation can depend on expected cash flows, discount rates, comparable transactions and judgement. Those are legitimate tools. They also make the assumptions behind the number particularly important.

The modern discussion extends beyond the valuation technique to the structure around the asset: borrowing, refinancing dates, fund redemption terms and the interaction between investors who want to stay and those who need to leave.

In its April 2024 Global Financial Stability Report, the IMF identified valuation uncertainty, layers of leverage and liquidity vulnerabilities among the issues requiring attention in private credit. That is a dated sector assessment, not a judgement about every private investment.

The economy does not wait for the next valuation

An illustrative sequence for a leveraged private asset. Developments between reports can change the assessment of risk.

Valuation dateCash-flow forecasts, comparable transactions and financing assumptions support the reported value.A valuation is an estimate at a point in time

Financing becomes more expensiveA future refinancing may leave less cash for investors.

Operating conditions weakenBorrower earnings or property income may come under pressure.

New evidence reaches the valuationUpdated forecasts, appraisals or comparable deals may support a revised estimate—or the existing one.A review need not produce a markdown

A transaction tests the assumptionsA sale or refinancing provides new evidence about achievable prices and funding terms.

Conceptual illustration, not the history of a particular investment. Valuations may be updated between scheduled reports when material information emerges. There is no assumed hidden “true value” line, and a transaction price can also reflect its circumstances.

The risk can change before the number does

Take a property whose valuation is unchanged. If its debt is approaching maturity, the terms available at refinancing matter. Higher interest costs can reduce the cash left for investors even if the building remains fully occupied. A weaker tenant or a more cautious buyer can change the picture again.

These developments do not prove that the reported valuation is wrong. They do give us reasons to revisit the evidence supporting it. We should not wait for a visibly falling NAV before asking the questions.

A small move in the asset. A larger move in the equity.

A simplified leveraged investment, in arbitrary monetary units.

Starting position

Asset value: $100
Debt: $60

$40 equity

The investors own the residual after debt.

Asset value falls 10%

Asset value: $90
Debt, unchanged: $60

$30 equity

Equity value falls 25%: ($30 − $40) ÷ $40.

Hypothetical arithmetic, not a forecast or Fieldhouse holding. Assumes unchanged debt, no other assets or liabilities, and no income, interest, tax or transaction costs. Reporting frequency does not change this economic exposure; it changes when movements may become visible in reported values.

A smoother number can change our decisions

If an investment appears to have low volatility and little correlation with listed markets, a portfolio model may make room for more of it. If that apparent stability partly reflects the valuation process, we risk allocating on the strength of a measurement effect.

The underlying exposure might still share familiar risks with the rest of the portfolio: economic growth, interest rates, credit conditions or property demand. A different reporting rhythm does not necessarily provide a different source of return.

Less visible movement is not, by itself, evidence of less economic risk.

What happens when someone needs cash?

A valuation estimates what an investment is worth. It does not promise that the asset can be sold promptly at that price, or that a fund can meet every redemption request at once.

Where a fund offers redemptions while holding assets that take longer to sell, liquidity management matters. Cash reserves, liquid holdings, notice periods and other redemption provisions all shape the experience. Estimated values also matter to fairness between investors entering, leaving and remaining in the fund.

A long holding period can give a manager time to work through difficult conditions. That can be valuable. It does not remove the need to assess value, financing and the client’s own cash requirements.

Look through the NAV

For us, the useful questions begin beneath the headline number. What cash does the asset generate? How much borrowing sits ahead of the investor? When does that borrowing mature? Which assumptions have the greatest influence on the valuation, and what evidence would make us change them?

We also need to understand how the manager challenges valuations, how independent oversight works, and what happens if withdrawals rise while asset sales slow. Those answers help us judge the role and size of an exposure in the wider portfolio.

Private assets can have a useful place in a long-term portfolio. The discipline is to understand the risks we are accepting, rather than infer their absence from a stable reported number.

The question is not just whether the number moved.
It is what would make it move and whether we could transact near it.

Disclosures

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