Level 3 Assets Unveiling Hardest to Value Financial Assets

Core Description

• Level 3 assets are financial instruments whose valuation relies primarily on unobservable inputs, subjective judgment, and complex models rather than market prices.
• The significant uncertainty, illiquidity, and model risk embedded in Level 3 assets require robust governance, careful disclosure, and rigorous valuation controls.
• Understanding Level 3 assets is important for investors and financial professionals to assess risk, interpret financial statements, and ensure transparent reporting.

Definition and Background

Level 3 assets represent the most complex and least transparent tier in the fair value measurement hierarchy established under ASC 820 (US GAAP) and IFRS 13. Unlike Level 1 assets, valued using quoted prices in active markets, and Level 2 assets, relying on observable market data for similar instruments, Level 3 valuations are based on unobservable inputs such as management assumptions, projections, and bespoke model outcomes.

Evolution of Level 3 Asset Classification

Before formal fair-value standards, illiquid and complex assets were often reported based on amortized cost or internal estimates, resulting in inconsistent and unclear reporting. The adoption of FAS 157 in 2006 and subsequent global alignment via IFRS 13 standardized fair value reporting and introduced the three-level hierarchy:

• Level 1: Quoted prices in active markets for identical assets.
• Level 2: Quoted prices for similar assets, observable inputs such as yield curves or broker quotes.
• Level 3: Significant reliance on unobservable inputs, subjective models, and management judgment.

Typical Level 3 Instruments

Common examples of Level 3 assets include:

• Private equity or venture capital investments.
• Illiquid corporate or distressed loans.
• Structured financial products (for example, equity tranches of collateralized debt obligations, residual tranches of mortgage-backed securities).
• Complex over-the-counter (OTC) derivatives with nonstandard features.
• Long-dated insurance liabilities or unique tangible assets (such as infrastructure rights or art).

Level 3 assets have become especially relevant in crisis periods. For example, during the 2008 financial crisis, a large number of mortgage-backed CDOs became Level 3 assets as trading liquidity declined.

Calculation Methods and Applications

Valuing Level 3 assets requires specialized models and techniques due to the lack of observable market inputs. The primary approaches include:

Income Approach: Discounted Cash Flow (DCF)

DCF involves projecting asset-specific cash flows under multiple scenarios and discounting them at a risk-adjusted rate, which incorporates illiquidity, credit risk, and optionality. Key unobservable inputs include:

• Projected cash flows and exit timing.
• Growth rates and churn.
• Discount rates and terminal value.

Analysts frequently calibrate models to the latest observable transaction and document the sensitivity of fair value to input assumptions.

Market Approach: Comparable Adjusted Transactions

This method compares Level 3 assets to comparable private transactions or secondary market data, with adjustments for differences in control, size, and risk. Typical adjustments include:

• Discounts for lack of marketability (DLOM) and control (DLOC).
• Industry multiples and transaction structures.

This approach is often used for private equity or venture capital stakes with at least some partially comparable market precedents.

Cost Approach

Used mainly for unique or non-revenue assets, this method estimates fair value based on the cost to replace an asset, less functional or economic obsolescence.

Advanced Modeling Techniques

• Option Pricing Models: Lattice, binomial, and Monte Carlo models are used for complex derivatives and instruments with embedded options. Inputs may include volatility, time to liquidity, and projected payouts.
• Probability-Weighted Expected Return Method (PWERM): This technique weighs discrete possible outcomes (such as IPO, sale, wind-down) by their probabilities, commonly used for venture capital assets under ASC 820.
• Valuation Adjustments: Fair value may also account for credit and counterparty risk (CVA, DVA), funding risk (FVA), and additional liquidity adjustments. Inputs include probability of default, recovery rates, and required returns for illiquidity.

Application in Practice

Financial institutions, insurance companies, asset managers, and pension funds apply these models with structured governance, validation from independent valuation agents, and periodic recalibration in response to new market evidence.

Comparison, Advantages, and Common Misconceptions

Differences from Level 1 and Level 2 Assets

Advantages

• Illiquidity and Complexity Premium: Investors may receive higher returns to compensate for holding assets that are difficult to sell or value.
• Tailored Risk Exposures: Level 3 instruments can be customized to target specific risk exposures unavailable in public markets, supporting portfolio diversification.
• Alpha Opportunity: Skilled managers may capture gains from inefficiencies or pricing differences.

Disadvantages

• Significant Valuation Uncertainty: Small changes in assumptions, such as discount rates or default probabilities, can materially impact valuations.
• Liquidity Constraints: Exiting positions is often challenging, especially during periods of market stress.
• Regulatory and Reporting Burden: Enhanced reporting, controls, and audit scrutiny are required to address potential management bias and model risk.

Common Misconceptions

• All Level 3 Assets are Problematic: Illiquidity or lack of market observability does not inherently signal poor quality; many private assets offer stable and meaningful cash flows.
• No Use of Market Data: Valuators maximize use of observable inputs where possible; fully subjective valuations are uncommon.
• Level 3 Transfers Indicate Manipulation: Movement between levels typically reflects changes in market evidence, such as changes in liquidity, rather than intent to misstate value.
• Day-One Gains Are Reliable: When initial fair value relies on unobservable inputs, many accounting frameworks restrict recognition of up-front profits until further validation.
• Reported NAV Equals Fair Value: For investment funds, NAVs may lag or omit certain risks. Adjustments for timing, illiquidity, and contingent fees are sometimes necessary.

Practical Guide

Setting Up a Robust Valuation Process

1. Define the Unit of Account: Clearly specify the asset, rights, and market context.
2. Choose Appropriate Methodologies: Select among DCF, comparables, or cost approaches based on the asset’s character.
3. Document Inputs and Assumptions: Prioritize observable inputs and explicitly record all estimates and rationale.
4. Calibrate and Backtest Models: Regularly calibrate to the most recent transaction, compare past estimates to actual outcomes, and document findings.
5. Governance and Controls: Segregate valuation duties, ensure independent oversight, maintain audit trails, and review regularly through valuation committees.

Sensitivity and Scenario Analysis

• Quantify the effect of key input changes (such as discount rate, volatility, default rate) on final fair value.
• Use scenario testing to capture a range of outcomes and adequately reflect uncertainty in disclosures.

Disclosure Best Practices

• Report Level 3 rollforwards (purchases, sales, transfers, gains/losses), key assumptions, sensitivity ranges, and governance measures.
• Explain any methodological changes or bases for significant input adjustments.

Illustrative Case Study (Hypothetical, Not Investment Advice)

Background:
An asset management firm holds a stake in a private late-stage technology company, for which there have been no recent trades.

Step 1. Income Approach (DCF):

• Project cash flows based on management’s latest operating plan (five-year forecast).
• Apply a discount rate reflecting industry risk, illiquidity, and market context.
• Set the terminal value using growth rates from similar public technology markets.

Step 2. Market Approach:

• Analyze recent M&A transactions of comparable companies. Adjust for control premiums and size.
• Apply discounts for the company’s lack of marketability and specific risk factors.

Step 3. Sensitivity Analysis:

• Prepare a table showing fair value changes if the discount rate or exit multiple is adjusted by +/- 1 percent.
• Disclose these ranges and justify key assumptions in investor filings.

Outcome:
The fair value estimate balances market precedent and asset-specific risk, applying sensitivity analysis for transparency. The asset is classified as Level 3 due to its lack of active trading and reliance on material unobservable inputs.

Resources for Learning and Improvement

• Accounting Standards:

  • ASC 820 (US GAAP) and IFRS 13 (IFRS): Authoritative texts defining fair value, input hierarchy, and disclosure requirements.

• Regulatory Guidance:

  • SEC, ESMA, and UK FRC publications on valuation governance and recommended practices.

• Audit and Valuation Frameworks:

  • PCAOB AS 2501 (Auditing Estimates) and AS 1105 (Audit Evidence).
  • AICPA’s “Valuation of Portfolio Company Investments” and IPEV Guidelines for private equity.

• Academic Literature:

  • Song, Thomas, and Yi (2010): Information risk and pricing for Level 3 assets.
  • Laux and Leuz (2009): Fair value’s impact during financial crises.

• Methodology Guides:

  • Big Four valuation white papers, IVSC perspectives, and Kroll Valuation Insights for complex credit and illiquid asset pricing.

• Data Sources and Tools:

  • Bloomberg BVAL, Refinitiv, S&P Capital IQ, PitchBook, Preqin for transaction and market data.
  • Kroll cost of capital tool.

• Professional Communities:

  • CFA Institute, ASA, CAIA for technical resources and industry updates.

FAQs

What exactly qualifies an asset as Level 3?

An asset is classified as Level 3 if its fair value is based mainly on unobservable inputs, meaning that neither quoted prices nor corroborated market data are available for key valuation factors.

Can Level 3 assets ever move to Level 2 or Level 1?

Yes, if significant observable market inputs become available, Level 3 assets can be reclassified as Level 2 or Level 1 as data and liquidity improve.

How does model risk affect Level 3 valuations?

Model risk arises from errors in methodologies, flawed assumptions, or potential management bias. Small changes in unobservable inputs can materially affect valuations, increasing estimation risk.

Are all Level 3 assets hard to sell?

Level 3 assets are characterized by limited or infrequent market activity, complicating rapid or large-scale liquidation, especially during volatile market periods.

Why are disclosures for Level 3 assets so detailed?

Detailed disclosures are necessary to address higher estimation uncertainty, allowing investors to understand input choices, assess risks, and evaluate reported values’ reliability.

Do auditors verify the precise value of Level 3 assets?

Auditors focus on model methodologies, input documentation, and appraisal governance processes rather than the exact number, since fair value is often a range.

What industries typically report high proportions of Level 3 assets?

Industries such as private equity, insurance, real estate, and specialty finance often hold significant proportions of Level 3 assets due to bespoke investments and complex long-term contracts.

How can investors protect themselves from Level 3 valuation risks?

Investors can review disclosures, evaluate sensitivity reports, study governance frameworks, and compare input assumptions to market benchmarks to assess valuation reliability.

Conclusion

Level 3 assets hold a specific place in modern financial reporting and portfolio management. While they may offer increased returns and portfolio diversification due to illiquidity and complexity premiums, they also introduce considerable valuation uncertainty, liquidity risk, and require robust governance. Effective valuation methods, transparent disclosures, and continual recalibration to available market evidence are essential for maintaining investor trust and regulatory compliance. For both investors and professionals, a clear understanding of Level 3 assets is not only a technical requirement but also a key to managing risk in complex investment environments.