Chapter 8: Valuation in Category III Alternative Investment Funds — Part 2: Valuation Techniques, Mark-to-Market (MTM), and Practical NAV Calculations

8.2 Valuation Techniques for Diverse Asset Classes

Under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, Category III AIFs are required to value their underlying portfolios in strict compliance with the Indian Accounting Standards (Ind AS). Because these funds hold a diverse mix of liquid, illiquid, public, and private assets, distinct valuation techniques must be systematically applied to each asset class to ensure that the fund's Net Asset Value (NAV) is fair and transparent.

1. Traded and Publicly Listed Securities

• Valuation Principle: Securities that are actively traded on a recognized stock exchange or other regulated markets are valued at the closing price quoted on the relevant exchange or market as on the specific Valuation Day.
• Primary Exchange Rule: If a security is listed on multiple stock exchanges, the fund must consistently use the closing price of the primary exchange where the maximum volume of the security is traded.

2. Unlisted Equity Securities

• Initial Valuation: Unlisted equity shares are initially recorded and valued at their historical acquisition cost.
• Subsequent Valuation: Thereafter, unlisted equities are valued at their Fair Market Value (FMV). This FMV must be determined by an independent registered valuer appointed by the Trustee or the Investment Manager of the AIF.

3. Unlisted Non-Equity Debt Securities

• With an Ascertainable Market: If there is an active over-the-counter (OTC) or parallel market for unlisted debt instruments, they are valued at the closing price dealt on that market on the relevant Valuation Day.
• Without an Ascertainable Market: If no active or ascertainable market exists, the debt instruments must be valued using the amortized cost method. The valuation is computed as the acquisition cost of the security plus any accrued interest or coupon income from the date of purchase up to the Valuation Day.

4. Mutual Fund Units and Other Investment Vehicles

• Valuation Principle: The value of units held in any mutual fund, unit trust, investment corporation, or other similar pooled investment vehicle is derived directly from the last net asset prices published by the managers of those funds as of the relevant Valuation Day.

5. Cash, Bank Holdings, and Receivables

• Valuation Principle: Cash in hand, bank deposits, bills, demand notes, accounts receivable, prepaid expenses, and interest accrued but not yet received must be valued at their full face value.
• Impairment Exception: The only exception to the full-value rule is when there is clear evidence that the amount is unlikely to be paid or received in full, in which case a suitable provision or markdown must be made.

6. Foreign Currency Denominated Assets

• Valuation Principle: Any investment, asset, or cash holding denominated in a currency other than the Indian Rupee (INR) must be converted into INR at the closing market exchange rate on the relevant Valuation Day.

7. Exchange-Traded and OTC Derivative Contracts

• Exchange-Traded Derivatives (Futures and Options): Valued based on the latest available settlement prices of these contracts on the stock exchange and market where the fund actively trades.
• OTC or Unregulated Derivatives: For futures or options contracts that are not listed or are traded on unregulated markets, the value is determined as the net realisable value calculated using a methodology approved by the independent registered valuer.

8.2.1 Portfolio of Liquid and Illiquid Securities

A significant operational challenge for Category III AIF managers is the fair valuation of illiquid securities. Liquid securities have a ready market with a large volume of daily transactions and a high number of buyers and sellers, meaning they can be exited instantly at their Fair Market Value (FMV). On the contrary, illiquid securities—such as stocks of Small and Medium Enterprises (SMEs) or thinly traded listed companies—have very small trading volumes.

The Market Impact and Liquidation Period

If an AIF holds a large block of shares in an illiquid company, the investment manager cannot sell all the holdings in a single trade without severely crashing the market price. This transaction bottleneck creates a "liquidation period" that must be factored into the valuation. To account for this risk, the investment manager must apply a discounting technique to the nominal market price based on the estimated time and price impact required to fully execute a sell order.

Workbook Example 3: Valuation of an Illiquid SME Security

Scenario Details:

• Total Shares Purchased by Fund: 2,00,000 shares (This represents a 2.00% holding in Company ASME)
• Total Outstanding Shares of Company ASME: 1,00,00,000 shares
• SME Exchange Market Price (on T-Day): Rs. 25.00 per share
• Average Daily Trading Volume of the Stock: 50,000 shares
• Daily Price Band Limit: +/- 2.00%
• Fund Opportunity Cost of Capital: 12.00% per annum (Assuming 250 trading days in a year, this equates to a daily opportunity cost of 0.048% per day).

Execution & Pricing Analysis: Because the daily trading volume is capped at 50,000 shares, it will take the fund at least 4 trading days to liquidate its entire position of 2,00,000 shares (200,000 / 50,000). Assuming the fund's large sell orders push the stock price down to its maximum lower daily limit of -2.00% on each subsequent day, the liquidation proceeds are calculated as follows:

• Total Present Value of Net Proceeds: Rs. 48,48,568
• Total Position Size: 2,00,000 shares
• Fair Value per Share of Company ASME: Total PV of Net Proceeds / Total Shares Held = Rs. 48,48,568 / 2,00,000 = Rs. 24.2428 per share.

Conclusion: Even though the closing market price on T-Day was Rs. 25.00, the illiquid nature of the holding forces the AIF to value the ASME position at Rs. 24.2428 per share for its NAV calculation. This realistic adjustment ensures the portfolio is not artificially inflated.

8.2.2 The Mark-to-Market (MTM) Valuation Process

Mark-to-Market (MTM) is the operational process of revaluing every security, asset, and liability in the AIF's portfolio to its current fair market value on a periodical basis.

Strategic Importance of MTM

• True-Worth Reflectivity: MTM ensures that the AIF's disclosed NAV reflects the true, realisable market value of the fund's net assets, rather than keeping them historical cost-basis.
• Fair Pricing for Transactions: Accurate MTM processes protect both incoming and exiting investors. It ensures that subscriptions and redemptions are executed at fair, up-to-date valuations.
• Accurate Incentive Fees: Performance-linked incentive fees payable to the Investment Manager must only be computed based on MTM valuations. This prevents the payout of fees on unrealised, paper gains that have not been validated by current market pricing.

8.3 Practical Case Study 1 — Valuation of Fund INC (As on June 30, 2023)

To illustrate the step-by-step calculation of Net Asset Value, consider the first closing of Fund INC.

Fund Background: On January 01, 2023, the Investment Manager raised Rs. 50 crore by issuing 5,00,000 units at an initial subscription price of Rs. 1,000 per unit. As of the Valuation Date (June 30, 2023), the portfolio holds the following positions:

1. Statement of Fund Assets (As of June 30, 2023)

• Listed Equities (valued at closing market prices):

  • Company ABC: 50,000 shares @ Rs. 840 = Rs. 4,20,00,000
  • Company XYZ: 1,00,000 shares @ Rs. 1190 = Rs. 11,90,00,000
  • Company PQC: 10,00,000 shares @ Rs. 150 = Rs. 15,00,00,000
  • Company LMN: 75,000 shares @ Rs. 2250 = Rs. 16,87,50,000

• Unlisted Equities (valued at Fair Market Value determined by independent valuer):

  • Company SME: 1,50,000 shares @ Rs. 110 = Rs. 1,65,00,000

• Unlisted Debt Investments (valued at Amortized Cost):

  • Corporate Bonds (RCE Ltd.): 1,000 bonds (Face Value Rs. 10,000, 9% Coupon) @ Rs. 105.00 rate per bond = Rs. 10,50,00,000

• Units in Equity-oriented Mutual Funds (valued at published NAV):

  • Equity Fund (EAMC): 10,00,000 units @ Rs. 23.75 = Rs. 2,37,50,000

• Gross Asset Value (Total Assets): Rs. 63,02,50,000

2. Statement of Fund Liabilities (As of June 30, 2023)

• Accrued Fees & Expenses:

  • Incentive Fees Payable to Manager: Rs. 1,02,00,000
  • Other Accrued Administrative Liabilities: Rs. 4,33,50,000

• Total Net Liabilities: Rs. 5,35,50,000

3. Step-by-Step NAV Calculation

The flat, single-line mathematical formula for Net Asset Value is:

NAV per Unit = (Total Assets - Total Liabilities) / Total Number of Units Issued

• Net Asset Pool: Rs. 63,02,50,000 - Rs. 5,35,50,000 = Rs. 57,67,00,000
• Total Units Issued: 5,00,000 units
• NAV per Unit: Rs. 57,67,00,000 / 5,00,000 = Rs. 1153.40 per unit

Analysis: Between January 01, 2023 and June 30, 2023, the NAV per unit of Fund INC successfully appreciated from Rs. 1,000 to Rs. 1,153.40. This represents a capital appreciation of 15.34% on a net basis.

8.4 Practical Case Study 2 — Mark-to-Market Revaluation of Fund INC (As on July 31, 2023)

To observe the continuous process of Mark-to-Market (MTM) and portfolio rebalancing, consider the status of Fund INC one month later, as of the next Valuation Day (July 31, 2023).

Portfolio Rebalancing Transactions during July 2023:

• Asset Disposals: The fund executed partial sales of its unlisted holdings in Company SME (reducing the position size from 1,50,000 to 75,000 shares) and its listed holdings in Company PQC (reducing the position size from 10,00,000 to 9,00,000 shares).
• Mutual Fund Switching: The fund liquidated a portion of its holding in Mutual Fund EAMC (retaining 5,00,000 units) and reinvested the cash proceeds to acquire 10,00,000 units in Mutual Fund MAMC.
• Liabilities Settled: The previously accrued liabilities, including management fees and outstanding tax provisions, were fully paid off using accumulated cash and dividend receivables.
• New Liabilities Accrued: Additional current liabilities, including GST on services, administrative expenses, capital gains tax provisions, and updated accrued incentive fees, have been accounted for.

1. Statement of Revalued Fund Assets (As of July 31, 2023)

• Listed Equities (MTM closing market prices):

  • Company ABC: 50,000 shares @ Rs. 950 = Rs. 4,75,00,000
  • Company XYZ: 1,00,000 shares @ Rs. 1340 = Rs. 13,40,00,000
  • Company PQC: 9,00,000 shares @ Rs. 165 = Rs. 14,85,00,000
  • Company LMN: 75,000 shares @ Rs. 2650 = Rs. 19,87,50,000

• Unlisted Equities (revalued FMV):

  • Company SME: 75,000 shares @ Rs. 165 = Rs. 1,23,75,000

• Unlisted Debt Investments (OTC valuation or Amortized Cost):

  • Corporate Bonds (RCE Ltd.): 1,000 bonds @ Rs. 105.20 = Rs. 10,52,00,000

• Units in Mutual Funds (updated published NAV):

  • Equity Fund (EAMC): 5,00,000 units @ Rs. 25.40 = Rs. 1,27,00,000
  • Equity Fund (MAMC): 10,00,000 units @ Rs. 13.20 = Rs. 1,32,00,000

• Liquid Cash Balance:

  • Cash-in-hand: Rs. 75,000

• Gross Asset Value (Total Assets): Rs. 67,23,00,000

2. Statement of Revalued Fund Liabilities (As of July 31, 2023)

• Annual Service Provider Charges Payable: Rs. 1,00,00,000

• GST Payable on Management Fees: Rs. 1,08,000

• Salaries and Administrative Expenses Payable: Rs. 1,00,00,000

• Provision for Capital Gains Tax: Rs. 15,00,000

• Incentive Fees Payable to Manager: Rs. 1,62,00,000

• Total Liabilities and Provisions: Rs. 3,78,08,000

3. Step-by-Step NAV Calculation

• Net Asset Pool: Rs. 67,23,00,000 - Rs. 3,78,08,000 = Rs. 63,44,92,000
• Total Units Issued: 5,00,000 units
• NAV per Unit: Rs. 63,44,92,000 / 5,00,000 = Rs. 1268.9840 per unit

Analysis: Due to strong market performance and revaluation gains on major stock holdings (such as ABC rising to Rs. 950 and XYZ rising to Rs. 1,340), the MTM NAV per unit of Fund INC has risen to Rs. 1,268.9840. This robust revaluation provides a clear, transparent base for the calculation of the updated incentive fee of Rs. 1.62 crore for the investment manager.

8.5 Key Takeaways for Examinations (NISM Series XIX-B)

• Closing Price Valuation: In accordance with Ind AS, listed securities must always be valued at their official closing prices on the Valuation Day.
• Role of Independent Valuers: Unlisted equities cannot be valued indefinitely at cost; they must be periodically valued at Fair Market Value by an independent registered valuer registered with the IBBI.
• Debt Amortization Rule: Unlisted debt securities that do not have an active parallel market are valued at their amortized cost (purchase cost plus accrued interest).
• Illiquidity Adjustments: Large blocks of illiquid securities (like SME stocks) require pricing adjustments to account for the market impact and liquidation time required to exit the position.
• MTM as a Safeguard: Periodic Mark-to-Market revaluation of both assets and liabilities is essential to prevent stale pricing and protect incoming/exiting unit holders.

8.6 Glossary of Key Terms in Part 2

• Fair Market Value (FMV): The unbiased estimated price of an asset, determined by a registered valuer using standard valuation methodologies, reflecting its realisable value under current market conditions.
• Amortized Cost: A valuation method for unlisted debt where the asset is valued at its initial cost plus the systematic accrual of earned interest or coupon payments up to the valuation day.
• SME Exchange: A dedicated stock exchange platform or segment of a recognized exchange established for trading the securities of Small and Medium Enterprises.
• Present Value (PV): The current worth of a future sum of money or stream of cash flows, calculated by discounting those cash flows at a specific opportunity cost of capital.
• Ind AS (Indian Accounting Standards): The set of accounting standards formulated to align Indian financial reporting practices with global standards, which govern the valuation of AIF portfolios.