How to Value Level 3 Assets During a Liquidity Crunch

Valuing Level 3 assets is challenging in the best of markets — and when liquidity dries up, the difficulty ramps up fast. These assets don’t have observable market prices, so firms must lean heavily on models, assumptions, and judgment. During a liquidity crunch, when trades slow to a crawl and pricing signals vanish, determining fair value can feel like navigating in the dark. Below is a practical, audit-ready guide for how to value Level 3 assets during a liquidity crunch, with techniques, controls, and documentation practices that help maintain accuracy and transparency even in turbulent markets.

Level 3 Assets Become So Hard to Value in a Liquidity Crunch

Level 3 assets are illiquid and model-based by nature, and they lack a reliable market price. Instead, they depend on complex valuation models that rely on unobservable inputs. When markets seize up and liquidity evaporates, those model assumptions become even harder to justify.

Market Data Disappears

During liquidity stress, you’ll see fewer (or no) recent transactions, bid-ask spreads widening dramatically, and stale or unreliable quote data. When markets disconnect, the usual price signals simply aren’t trustworthy. 

Valuations Become Extremely Sensitive

Small changes in discount rates, cash flow projections, or risk assumptions can swing values wildly. In volatile markets, these inputs become unstable, increasing the risk of incorrect pricing.

Regulatory and Audit Scrutiny Increases

Crises like that of 2008 showed how poorly supported Level 3 valuations can mask real losses. Auditors and regulators now expect firms to justify every key input and prove their methodology makes sense under current market conditions.

Robust Valuation Techniques for Illiquid Assets

1. Use Multiple Methods 

Relying on a single model is risky — especially in a crunch. Instead, triangulate value using:

• Discounted cash flow.
• Comparable transactions.
• Market multiples.
• Asset-based approaches.

Weigh the methods and reconcile the differences. Cross-checking reduces bias and provides a stronger audit defense.

2. Add Liquidity Risk Adjustments

In stressed markets, incorporate higher:

• Illiquidity discounts.
• Risk premiums.
• Discount rates.

These reflect what a real market participant would demand to transact in turbulent conditions.

3. Confirm That Price Inputs Come From “Orderly” Transactions

If you’re using quoted prices or recent trades, determine whether they were orderly or reflected distressed, forced, or fire sale activity. Distressed prices may not reflect fair value. Adjust or exclude them when necessary.

4. Calibrate to the Most Recent Reliable Data

When possible, anchor your valuation to the most recent: 

• Financing round.
• Transaction.
•  Appraisal.
• Third-party quote.

Then adjust based on changes in fundamentals, market shifts, or capital structure since that event.

5. Stress Test Your Assumptions

Run scenarios to test how sensitive the value is to:

• Revenue changes.
• Macro shifts.
• Discount rate adjustments.
• Liquidity assumptions.

If the test yields an extremely wide range, that’s a sign that inputs need tightening and assumptions should be more conservative.

Audit-Ready Documentation and Controls

Document every assumption clearly. Provide support for each input — why you chose it, how you calculated it, and what data backs it up. Tie revenue forecasts to client data or signed orders, justify chosen comparables, and explain why certain data points were excluded. Good documentation reduces audit friction significantly.

Maintain a Continuous Audit Trail

Don’t wait until year-end. Throughout the year, document valuation discussions, oversight committee meetings, model changes, and interim analyses. A year-round trail shows strong internal controls and preparedness.

Avoid Optimism Bias

Inflated projections won’t survive audit review, especially in stressed markets. Auditors will compare prior forecasts to actual results, so keep assumptions grounded and defensible.

Include Third-Party Evidence

External data strengthens credibility. Examples include independent appraisals, broker quotes, and recent comparable transactions. Supporting documentation reduces challenges during audit review. For highly complex or material Level 3 assets, bringing in an external expert often eases auditor concerns and pushback.

Valuation Policy and Governance Best Practices

Formalize your valuation policy. Your policy should spell out responsible parties, valuation methodologies, controls and approvals, and how to handle inactive or dislocated markets. Make sure the policy aligns with accounting standards and current regulatory guidance. Establish strong oversight. A valuation committee or oversight group adds governance and prevents single-person subjectivity. Include members from finance, risk, and — if possible — independent roles. Plan for illiquidity events. Your policy should specify what happens when assets become extremely illiquid. For funds, this may include side-pocket procedures, gating, and other investor-communication requirements. These steps must be consistent, documented, and clearly disclosed. Update the policy regularly. Incorporate lessons from recent volatility, new accounting guidance, and emerging best practices.For instance, standards emphasize using multiple valuation techniques and adding risk premiums when market activity decreases. Internal policies should evolve as markets do. Communicate transparently. If key assumptions or valuation methods will change because of market stress, notify auditors early. Communicate clearly with investors, when required, and ensure financial statement disclosures explain uncertainty and methodology. No one likes surprises — especially auditors.

What Successful Firms Do During a Liquidity Crunch

Prepare early. Establishing rigorous valuation processes and documentation before a liquidity crunch means you won’t be scrambling when stress impacts. Firms with strong valuation hygiene — clean models, thorough documentation, and consistent controls —  navigate crises much more smoothly. Use multiple data points. No single model is “the truth.” Cross-checking methods and using both qualitative judgement and quantitative techniques results in a more realistic fair value.Document everything. Transparency is your best defense. It builds credibility with auditors and investors and significantly reduces the likelihood of adjustments. A well-supported valuation is far less likely to be questioned or changed. Strengthen governance. Clear policies, engaged oversight committees, and defined emergency contingency plans ensure you can maintain fair, defensible valuations even when markets freeze. With the right processes, controls, and mindset, forms can value Level 3 assets credibly and consistently — even in the toughest liquidity environments.

Turn Liquidity Stress Into a Valuation Advantage

Liquidity crunches aren’t the time to improvise your Level 3 valuation process. They’re when weak models, thin documentation, and inconsistent governance get exposed — by auditors, regulators, and investors. Firms that treat valuation as a year-round discipline, not a once-a-year scramble, are the ones that protect credibility when markets seize up.Michael Coglianese CPA, P.C. helps alternative investment managers build and defend robust Level 3 valuation practices — from model selection and calibration to valuation committee governance, side-pocket and gating mechanics, and audit-ready documentation. Our team draws on 30+ years of experience in alternative investment audits and assurance and NFA regulatory compliance and consulting to help you explain your numbers clearly and withstand scrutiny from both investors and regulators. If you’d like an independent review of your current Level 3 valuation process, support ahead of your next audit, or help strengthening your valuation controls before markets tighten again, we’re here to help. Call us at (630) 351-4005, email info@cogcpa.com, or contact us through our website to discuss your needs.