Wed, Mar 16, 2016

Valuation: A Hidden Risk for Managers and Investors

The importance of accurate valuation processes, particularly of hard-to-value assets, is critical.

Inaccurate valuations can result in financial losses being incurred by investors, either via the subscription/redemption processes for an open-ended fund vehicle or through secondary trades and misallocations of capital in a closed-ended vehicle. A failure to adhere to the basic principles of fair value NAV (Net Asset Value) may also constitute a breach by the manager of its fiduciary duty to act in the best interests of investors.

This risk has been highlighted recently for open-ended hedge funds trading in markets like Greece or China, where a number of equities have been delisted making accurate valuation somewhat challenging. In addition, a growing number of open-ended funds are adopting strategies that involve exposure to more esoteric and sometimes illiquid assets whereby valuation can be a highly subjective process. Mispricing a NAV through an inaccurate or conflicted valuation could result in litigation. This can be fatal for a manager’s business.

A number of regulators have begun taking breaches around valuation seriously. The Autorité des marché financiers (AMF), the French financial services regulator has levied a number of sanctions or reached settlement agreements with investment managers over recent months and years around shortcomings in valuation. Perhaps the best documented case is that of Société Générale Gestion (S2G), an asset manager established in 2010 following the merger between Société Générale Asset Management (SGAM) and Credit Agricole Asset Management (CAAM). Through the acquisition, S2G found itself managing a mutual fund with exposure to an equity tranche of a collateralized debt obligation (CDO), which was high risk and violated the liquidity provisions of the mutual fund. 
The AMF’s Sanctions Committee found S2G had significantly underestimated the value of the equity tranche of the CDO and had failed to properly inform investors of the valuation issues that had arisen. The AMF also criticized the fund house for failing to provide an accurate and independent valuation of the fund assets, the firm was fined €280,000 for these shortcomings.

Other firms who fell afoul of the regulator in France and elected to settle did so following regulatory scrutiny around the lack of clarity, formalization and independence of their internal valuation processes.  Just under half of these settlements in France around valuation concerned short-term money market instruments. A number of these instruments are often illiquid and sourcing prices from external data providers can be difficult. Absent any reliable external price sources, asset managers resort to determining their own internal pricing model, which could sometimes be construed as allowing the fund manager a degree of discretionary bias in price determination. This could then be used to pilot the NAV. It is also equally challenging to identify high-quality service providers to value these complex financial instruments.  In all events, regulators and investors insist that due care must be exercised when valuing these assets and in ensuring that valuation policies are properly documented and maintained.

The EU’s Alternative Investment Fund Managers Directive (AIFMD), which came into effect in July 2014, applies to all EU asset managers or non-EU managers utilizing national private placement regimes (NPPR) to operate within the EU who are not already authorized under the UCITS Directive. AIFMD subjects managers to a number of provisions including a requirement that they have procedures in place to ensure proper and independent valuation of fund assets at fair value. This is a service offered by Kroll.
Regulators across the EU will undoubtedly scrutinize AIFMs’ valuation processes, particularly those transacting in unlisted securities. Xavier Parain, Managing Director and head of the AMF’s asset management directorate recently reminded firms in France of the importance of having each new mechanism adopted under AIFMD formally documented, implemented and traceable[1]. Across Europe, harsher sanctions and financial penalties for non-compliance are now part of the regulators’ arsenal, so fund managers need to ensure they fully adhere to the rules.  The UK’s Financial

Conduct Authority (FCA) is currently scrutinizing valuation, findings on this matter are likely to be released later this year.  

A recurring criticism from the regulator is that individual fund managers have benefited from excessive discretion over valuation when pricing illiquid financial instruments. It is essential that the valuation function is independent from the fund management activities. If an internal employee is tasked with valuing financial instruments, they must solicit advice from multiple sources – both internally from the fund manager or deal team, or externally via independent price sources or a valuer acting in a consultancy capacity – before they reach a conclusion. Simply relying on internal fund managers or deal teams for pricing of illiquid, hard-to-value assets is ill advised.  Equally, internal valuation specialists must boast industry experience. They must be functionally and hierarchically independent from the investment management or deal teams. In addition, their compensation package needs to be calculated independently of any fund performance.  Adopting these best practices can help prevent deliberate or inadvertent conflicts emerging and potentially mitigate regulatory risk around valuation. 

The consequences of falling foul of regulators are not just financial. Failing to produce accurate valuations can result in significant operational risk, which can even threaten a business’ viability. The findings of regulatory investigations are often publicly available, and this can result in significant reputational risk. This will not bode well with institutional investors, particularly as capital raising has proven difficult of late for many fund managers. The importance of valuation is evident in a 2014 Deutsche Bank survey of operational due diligence executives overseeing roughly $2.72 trillion in assets. The survey identified valuation as one of the most frequently cited red flags by operational due diligence teams. The study found 100% of allocators would review a fund’s valuation policy during the operational due diligence process, and 78% added they would verify it on-site.

Managers need to take note and recognize that they need to implement valuation policies and procedures that adhere to regulatory and industry best practices. Capital raising in today’s environment is a challenging proposition for managers. Performance is not the only criteria investors will review. As such, getting the basics right around valuation is crucial in this risk-averse environment to attracting institutional money.

Kroll can work with managers to ensure their internal valuation procedures are in line with AIFMD requirements, which requires “proper and independent valuation.” In addition, we can provide independent valuation services to managers and offer assistance to firms around documenting their valuation processes. Kroll can provide substance and governance services through our own third party AIFM ManCo and offer regulatory consulting to assist in ensuring that compliance and risk controls are in place and formalized.

[1] AMF website, Interview given in September 2015


Valuation of businesses, assets and alternative investments for financial reporting, tax and other purposes.

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