One fund's Level 3 reconciliation taken apart line by line, from the exits and their opening marks to the transfer that stops it tying to the statement of operations.
A Level 3 roll-forward runs from opening to closing fair value through purchases, sales, realised gains, the change in unrealised gains and transfers between levels. Read it by splitting the unrealised line into the reversal of gains on what was sold and the marks on what is still held. In an illustrative fund, a change in unrealised of minus 31,600 is 22,700 of reversal on exits and only 8,900 of markdown on the remaining portfolio, minus 2.47 per cent, while the exits themselves came in 9.66 per cent above their opening marks.
Worked in full in How to Read a Private Fund's Financial Statements by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
IFRS 13 requires every reporter to reconcile the opening and closing balances of its Level 3 investments, those valued on unobservable inputs. Under US GAAP (ASC 820) the full reconciliation is required of public business entities; since ASU 2018-13 a private fund may disclose only purchases, issues and transfers into and out of Level 3, but many still present the full roll-forward because their investors expect it. In a private equity fund Level 3 is nearly the whole portfolio. The fund below is fictional; amounts are in USD thousands.
| Line | Amount |
|---|---|
| Opening fair value | 412,000 |
| Purchases | 58,000 |
| Sales and settlements (proceeds) | -96,500 |
| Net realised gains | 31,200 |
| Net change in unrealised gains | -31,600 |
| Transfers out of Level 3 | -22,000 |
| Closing fair value | 351,100 |
Read at face value, the year looks like a wash with a markdown in it: 31,200 of realised gains, 31,600 of unrealised losses, a net Level 3 result of minus 400, and a headline unrealised loss of 7.67 per cent of opening value. Both readings are wrong.
When a position is sold, the fund books its whole gain over cost as realised and reverses the unrealised gain it had been carrying. The notes or the schedule of investments give the two figures needed: the cost of the positions sold, 65,300, and their fair value at the opening, 88,000.
Realised gain = proceeds − cost = 96,500 − 65,300 = 31,200
Reversal of prior unrealised gain = −(opening fair value of positions sold − cost) = −(88,000 − 65,300) = −22,700
Unrealised change on positions still held = −31,600 − (−22,700) = −8,900
Exit gain over the opening mark = 96,500 − 88,000 = 8,500, or 9.66%
IFRS 13, and US GAAP for public business entities, also require the change in unrealised gains for the period on Level 3 assets still held at the reporting date; a private fund under US GAAP may omit it. When the note gives it, it should equal the minus 8,900 above; when it does not tie, the difference is a question for the manager.
The positions still held were worth 412,000 − 88,000 − 22,000 = 302,000 at the opening, and the fund invested 58,000 more. On that base of 360,000, the minus 8,900 is a markdown of 2.47 per cent. Check: 360,000 − 8,900 = 351,100, the closing balance.
So the year has two stories, both better told than the headline. The sales were made at 8,500 above where the fund had them marked a year earlier, evidence that the marks were not aggressive. The rest of the portfolio was marked down modestly.
A company that listed during the year left Level 3 at 22,000, its opening value under the fund's convention of recognising transfers at the beginning of the period. It closed the year at 25,400 as a Level 1 holding, so its 3,400 gain appears in the statement of operations but not in the roll-forward. The statement of operations therefore shows a net change in unrealised of minus 28,200, not minus 31,600, and the same realised gain of 31,200. A reader who tries to tie the two without the transfer finds a 3,400 difference and nothing in the roll-forward that explains it. Under an end-of-period convention, the same company would have left Level 3 at 25,400, and its gain would have sat inside the Level 3 unrealised line.
At the close, Level 3 investments of 351,100 are 92.39 per cent of net assets of 380,000: the valuation policy is the fund.
| Exit proceeds | Realised gain | Change in unrealised | Net Level 3 result | Gain over opening mark |
|---|---|---|---|---|
| 88,000 | 22,700 | -31,600 | -8,900 | 0 |
| 92,000 | 26,700 | -31,600 | -4,900 | 4,000 |
| 96,500 | 31,200 | -31,600 | -400 | 8,500 |
| 101,000 | 35,700 | -31,600 | 4,100 | 13,000 |
The reversal depends only on the opening mark and the cost, so the unrealised line is the same whatever price the exits achieve. Only the realised line responds to the exit price. That is why the realised gain alone says nothing about valuation quality: an exit at exactly the opening mark still books 22,700 of realised gain.
| Unrealised on positions held | Headline change in unrealised | Closing Level 3 |
|---|---|---|
| -20,000 | -42,700 | 340,000 |
| -8,900 | -31,600 | 351,100 |
| 0 | -22,700 | 360,000 |
| 12,000 | -10,700 | 372,000 |
Even a year in which the held portfolio rose by 12,000 would show a negative unrealised line, because the exits drag it down by 22,700.
The journal entries behind one exit are set out in how to calculate realised vs unrealised gain on a fund exit; the cash side of the same sales is read in how to read a private fund's statement of cash flows.
A complete fund reporting pack in which every reconciliation is a live formula is in the free workbooks for this book.
It is the reconciliation, required by IFRS 13 and by ASC 820 for public business entities (private funds under US GAAP may give a shorter disclosure but often present it), of the opening and closing fair value of investments valued on unobservable inputs: purchases, sales, realised gains, the change in unrealised gains and transfers in and out of Level 3. In a private equity fund it covers most of the portfolio, 92.39 per cent of net assets in the worked case.
Because a sale reverses the unrealised gain the fund had been carrying on the position and books the whole gain over cost as realised. Exits carried at 88,000 against a cost of 65,300 reverse 22,700, so even a portfolio whose remaining positions rose by 12,000 would show a negative unrealised line of minus 10,700.
Usually because of transfers between levels and gains on Level 1 or 2 positions. In the worked case a company that listed left Level 3 at 22,000 and gained 3,400 as a Level 1 holding, so operations show a change in unrealised of minus 28,200 against minus 31,600 in the roll-forward.
This article is one calculation from How to Read a Private Fund's Financial Statements. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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