Reliability and Relevance of Fair Values: Private Equity Investments and Investee Fundamentals

Abstract

We directly test the reliability and relevance of fair values reported by listed private equity firms (LPEs), where the unit of account for the fair value measurement (FVM) is an investment stake in an individual investee company. FVMs are observable for multiple investment stakes, fair values are economically important, and granular data on investee economic fundamentals that should underpin fair values are available in public disclosures. We find that valuations assessed by LPE fund managers reflect accounting-based fundamentals — equity book value and net income — in a manner consistent with the way in which stock prices reflect fundamentals of listed companies. Additionally, our findings are consistent with LPE fund managers’ fair value estimates reflecting the investee’s net income to a lesser extent when no direct market inputs are available. Thus, LPE fund managers appear to distinguish between Level 1 and Level 3 investments when valuing their investments. We also report evidence suggesting that investors perceive the judgments that LPE fund managers apply when determining investee valuations as reliable.