Level 3 valuation of unquoted equity and fund investments in emerging markets

Most of a DFI's equity book consists of minority stakes in unlisted companies and commitments to private equity, infrastructure and SME funds in markets where there are few comparable transactions, thin or no public markets and material currency and country risk. These investments are measured at fair value through profit or loss, almost always within Level 3, so the valuation judgments go straight to profit and to the capital the DFI reports to its shareholder. Carrying investments at cost for years, accepting a fund manager's quarter-old net asset value without adjustment, or applying developed-market multiples without a country risk adjustment can overstate or understate the portfolio by a large margin, and unsupported valuations are a frequent audit finding.

Which valuation technique is used for each unquoted equity stake (earnings or revenue multiples, discounted cash flows, recent transaction price, net assets), and is it the technique a market participant would use for that type of business? Was the model calibrated to the transaction price at initial recognition, and are the calibrated inputs rolled forward rather than replaced each period? How is country risk captured (in the discount rate, in the cash flows or through an adjustment to multiples), and is it counted only once? Is the fund manager's NAV at the same date as the DFI's reporting date, prepared on a fair value basis consistent with IFRS 13, and adjusted for capital calls, distributions and market movements after the NAV date? Is cost still used as fair value for any investment, and if so is there evidence that it remains representative? Are the cash flows in USD discounted at a USD rate, or in local currency at a local rate, so that currency and inflation assumptions are internally consistent?

1. Confirm the unit of account for each investment (the equity stake, the fund interest including the obligation to meet future capital calls, and any shareholder loan as a separate financial asset, although a stake and loan that are managed and would be sold together are often valued on a combined basis and the value then allocated).
2. Select one or more valuation techniques appropriate to the investee's stage and sector, maximising observable inputs (listed peer multiples, observable interest rates, quoted sovereign spreads) and minimising unobservable ones.
3. At initial recognition, where the transaction price is fair value, calibrate the model to that price and document the implied inputs, such as the discount to peer multiples or the implied discount rate.
4. At each reporting date, roll the calibrated model forward with updated investee performance, market data and country risk, rather than relying on cost.
5. For fund interests, start from the manager's NAV and adjust for the time gap, capital calls, distributions, known market and currency movements, and any differences between the manager's valuation basis and IFRS
6. 6. Categorise the measurement within the hierarchy (usually Level 3) and recognise the change in fair value in profit or loss.
7. Document an independent review of significant valuations and back-test them against actual exit prices.

Fair value is the exit price a market participant would pay for the DFI's stake at the reporting date, not the DFI's view of developmental value. Common techniques are earnings multiples derived from listed peers and adjusted for size, growth, liquidity and country risk; discounted cash flows with a discount rate that includes a country risk premium consistent with the currency of the cash flows; and recent transaction prices, used only while they remain relevant. Cost may be an appropriate estimate of fair value only in limited cases (for example very shortly after acquisition with no significant change in the investee or market). Fund NAV is a starting point, not a practical expedient: it is used to the extent it is prepared on a fair value basis at or adjusted to the reporting date. Translate USD fair values into the reporting currency at the closing rate.

Disclose: (1) the fair value at the reporting date by class (direct equity, fund interests, other) and the hierarchy level; (2) the valuation techniques and the significant unobservable inputs with their ranges or weighted averages (multiples, discount rates, country risk premiums, NAV adjustments); (3) a reconciliation of Level 3 balances from opening to closing, showing gains and losses in profit or loss, purchases, capital calls, distributions, disposals and transfers; (4) unrealised gains and losses for the period on Level 3 investments still held; (5) the valuation process and governance, including the role of an independent valuation committee; (6) a narrative sensitivity analysis and the quantitative effect of reasonably possible alternative assumptions; (7) any restrictions on realising investments, such as foreign exchange controls.

• Holding investments at cost for several years on the ground that no reliable valuation is possible
• using a fund NAV that is three or six months old without rolling it forward
• applying listed developed-market multiples to a frontier-market company without adjusting for size, liquidity and country risk
• adding a country risk premium to the discount rate while also haircutting the cash flows for the same risk
• discounting local-currency cash flows at a USD rate
• failing to calibrate to the entry price and then recognising an unexplained day-one gain
• recognising a fair value uplift for developmental impact that a market participant would not pay for
• disclosing ranges of inputs without the sensitivity of fair value to them