How does ASC 820 guidance determine liquidity levels?
One of the primary purposes of ASC 820 guidance is to provide a framework for valuing assets according to their liquidity, so ASC 820 also includes regulations that describe how to determine the liquidity of any asset. There are three levels, ranging from 1 (liquid) to 3 (illiquid and incomparable).
A Level 1 asset is one for which direct market data is available. One example would be the common stock of a publicly traded company, where effectively an identical asset would be traded in an open and unrestricted market.
A Level 2 asset is one for which comparable assets, underlying assets, or comparable assets to underlying assets have available, direct market data. For a Level 2 asset, ASC 820 permits analysts to use data about these comparable assets in their justification for the valuation. An example of a Level 2 asset is an interest rate swap. With interest rate swaps, the value is determined based on observable inputs (such as interest rate and risk premiums), and the value of the derivative itself is calculated and thus derived from observable market data.
A Level 3 asset is one for which there are no observable market prices, and for which an analyst must use an internal model. These assets cannot (yet) be directly sold, are unique, and are not solely valuable for their underlying assets. So, a stake in a private company would usually be a Level 3 asset. ASC 820 provides ample guidelines (and requirements) for the methods, inputs, and models permissible in developing the internal model that provides the fair value of the stake, and for venture funds, these Level 3 assets comprise most of the portfolio—hence the work that analysts must do to provide a justifiable ASC 820 report.