Illiquid assets are believed to have stale prices and spurious return autocorrelation. An important question is what drives this autocorrelation. I provide evidence that the primary driver of this phenomenon is the difficulty in valuing these assets, and not managerial manipulation. Specifically, I find that autocorrelations, risk factor loadings, (β’s) and risk-adjusted returns (α’s), are statistically equivalent regardless of whether they are completed internally or externally. I do find, however, that loadings on lagged risk factors increase significantly when valuation estimates are completed externally. Consistent with this, I also find that external valuations have significantly larger valuation changes than internal valuations. However, both of these findings are primarily due to valuation effort and the types of properties being valued externally. External and internal valuations become economically equivalent after controlling for valuation effort and property characteristics. I also find that funds choose to have properties valued externally at those times, and for those properties, when valuation changes are expected to be the largest. Lastly, I find that managers exert the greatest effort on internal valuations at those times when valuation changes are expected to be the largest and the least amount of effort at those times when valuation changes are expected to be the smallest and slightly positive.
Spencer Couts, University of Southern California, Lusk Center of Real Estate