ManCos and Valuation
The cost of compliance with the Alternative Investment Fund Managers Directive (AIFMD) is not insubstantial. For firms hoping to market their investment vehicles freely across the 28 member state bloc with the pan-EU AIFMD distribution passport, they must be fully AIFMD compliant. This entails establishing an onshore presence through bricks and mortar, which may be prohibitively expensive for some managers.
An alternative, cost-effective approach has been to appoint an AIFMD management company (“ManCo”). This type of solution is currently being offered by a number of service providers, particularly out of Ireland and Luxembourg. ManCos will provide “functionally and hierarchically” separate risk management as obliged under Article 15 of the AIFMD. Larger fund houses can simply appoint a senior individual to a management committee separate to the portfolio management division to oversee this risk management role. However, this is a luxury few small to mid-sized asset managers can afford. The ManCo model has proven popular among asset managers hoping to distribute into the EU. However, they do present challenges and fund managers and their investors must be cognizant of them.
AIFMD obliges each Alternative Investment Fund Manager (AIFM) to have in place “appropriate and consistent procedures so that a proper and independent valuation of the asset can be performed.” The regulation allows for this valuation process to be undertaken by an external valuer, which is independent to the AIFM and AIF. The AIFM is also allowed to carry out valuation internally provided it again is functionally independent from any portfolio management and remuneration policy. It is crucial that any individual performing valuation – either internally or externally – must have the prerequisite skillsets, experience and appropriate qualifications or credentials to undertake this role in accordance with industry and regulatory best practices and standards. It is equally important that such individuals possess sufficient gravitas to defend their valuations.
Valuers will need to receive and consider input from portfolio managers but not be implicitly bound by it, a point that the UK’s Financial Conduct Authority (FCA) made abundantly clear in its 2015 consultation paper.  Furthermore, any conflicts of interest must be carefully managed and certain employees need to be prevented from influencing the valuation process in any way. The majority of AIFMs (both internal AIFMs and third-party AIFM ManCos) are aware of these rules.
Fund managers which have elected to utilize the outsourced AIFMD ManCo model might simply assume that the third party AIFM is handling valuation. This may or may not be a safe assumption. While ManCos have a variety of capabilities, there are question marks over whether they have personnel or staff with the relevant experience, expertise, and gravitas to properly value complex Level 3 assets. The valuation of complex Level 3 assets often requires significant asset-specific expertise and always requires some degree of judgment.
Type of Asset
Level 1 Asset
An asset that has an easily observable price and straightforward fair market value – e.g. publicly listed stocks, bonds, funds and derivatives
Level 2 Asset
An asset that may not have readily available market pricing but value can be determined by using other market or data sources or inputs. Value is often calculated using a mark to model methodology – e.g. interest rate/currency swaps
Level 3 Asset
An asset that cannot typically be valued through easily observable prices or financial models. The assets are generally illiquid and require inputs that may be unobservable and subjective at times – e.g. complex or highly bespoke swap transactions
Failing to correctly value the assets of a fund – irrespective of their complexity – exposes AIFMs or ManCos to significant liability and risk. Regulators have made it no secret that they intend to scrutinize AIFMs’ policies and procedures around valuations. Where they suspect there are deficiencies, it could warrant regulatory investigations which could result in sanctions. The Autorité des marchés financiers (AMF), one of France’s financial services regulators, is one example of a proactive regulator in this space. Between 2013 and 2015, there have been a number of sanctions or settlement agreements between investment managers and the AMF around valuation shortcomings. Luxembourg’s Commission de Surveillance du Secteur Financier (CSSF) and the FCA have adopted tough standards for ManCos and any inadequacies in valuation processes could potentially result in further action. The importance of valuing assets of all types correctly should not be underestimated.
If an AIFM cannot demonstrate to all stakeholders that they have undertaken appropriate steps to value an asset, this could potentially expose them to significant liability. Any litigation or fine against an AIFMD ManCo could have an adverse impact on its operating model and reputation. Depending on the size of the fine, it could even put managers using these platforms at risk. It is critical that ManCos assess and are aware of the risks they are incurring when valuing any assets. They must be certain that they have the prerequisite skill-sets and competences to value those assets safely, particularly Level 3 hard to value instruments.
Running a third party AIFM is comparable to being captain of a ship. The captain cannot be expected to be expert in all areas so must hire the appropriate personnel to provide support. AIFMD ManCos are no different. If there is any hesitation or doubt, those ManCos should seek assistance from a valuation advisor that is well-versed in this area.
Irrespective of the regulators’ approaches towards ManCos, AIFMs must undertake thorough initial and on-going operational due diligence on external valuers. The AIFM is after all responsible for any valuation issues, so it is critical to demonstrate to regulators and investors that valuation practices are adherent with best practices. The reputational and financial risk of getting this wrong could be severe.
As a valuation adviser, Duff & Phelps can provide consultancy to AIFMs on valuation where the AIFMs may feel they do not have the correct expertise. Duff & Phelps also offers an array of services in addition to valuation. We provides substance and governance services through our own third party AIFM ManCo and regulatory consulting practice providing a one stop shop service for fund managers looking to market into the EU.