Updated September 2019
“Marking to market” simply means updating the value of an asset or a portfolio of assets to reflect the latest available prices. This is easy to do when prices are readily available and assets are highly liquid (easy to buy and sell) and fungible (one is substitutable for another). For example, the value of a portfolio of FTSE 100 shares will be reliably up to date at virtually any point you look at it.
It’s harder when transactions are less frequent, and the asset involved is idiosyncractic – for example, you probably have a rough idea of what your house is worth, but you won’t know for sure until you actually come to sell it, and there may be several years between official valuations from estate agents or surveyors. The same goes for a private business, for example.
One problem in the 2008 crisis came when the market for subprime mortgage securities collapsed and banks had to mark their holdings to market. As a result, banks’ liabilities outweighed their assets, blowing a massive hole in their balance sheets and rendering them effectively bankrupt.
As Robin Wigglesworth points out in the Financial Times this week, in today’s financial markets, one key attraction of private equity and other unlisted assets in general for institutional investors, is the greater flexibility enjoyed in terms of “marking to market”. While the value of a portfolio of publicly-listed stocks is transparent and hard to fudge, “private capital funds enjoy more leeway on how to value their assets, making returns seem much smoother.”
This in turn can boost their appeal to investors (who still tend to equate price volatility – ups and downs – with risk), by making their “risk-adjusted” returns look healthier. Yet when investors are forced to face reality (Neil Woodford’s various dud bets on unlisted companies are a good example of this), they may, as Wigglesworth puts it, “come to rue their addiction to the phoney smoothness of private capital returns”.