No Quick Fix on Valuation
This article was first published in Valuation Insights Q2 2016
In July 2013, two years after it hit the EU statute book, the Alternative Investment Fund Managers Directive was transposed into UK law. Designed to improve the administration, management and marketing of alternative investment funds throughout the EU’s 28 member states, the Directive’s investor protections present a series of potential compliance problems.
While those challenges are material, the slow pace of transposition at a national level may have lulled some managers into a false sense of security about the willingness of regulators to take enforcement action against funds yet to take steps to comply. This, however, could be a potentially very costly mistake, as regulators are beginning to bare their teeth.
Indeed, the consequences of making insufficient provision on valuation can be severe. Between 2013 and 2015, there were a number of sanctions or settlement agreements between investment managers and the French financial regulator, the Autorité de Marchés Financiers, around valuation shortcomings. Luxembourg’s Commission de Surveillance du Secteur Financier (CSSF) and the UK’s FCA have adopted tough standards for investment managers – particularly those who have appointed management companies (ManCos). Inadequacies in valuation processes could potentially result in further action, especially after the FCA publishes the final version of its consultation paper on valuation.
Valuation of assets poses a particular problem. The Directive mandates several layers of conditions for legal valuation and where legal complexity is great, the chances of being found liable are high. For example, the EU legislators have aimed to decrease conflicts of interests and increase transparency within funds. Consequently, the Directive mandates that those valuing assets must be functionally independent from portfolio management, while all policies for valuation have to be procedurally consistent, fully documented and tailored to each asset within the fund.
The question of who is best qualified and placed to value the assets within a fund is extensively addressed within the Directive. Regulators can deem fund managers themselves competent to value fund assets. However, according to strict rules separating the valuation from the investment function, putting in place sufficient governance around valuation is impractical for many managers. Because ManCos, however, are by definition separated from the investment function, establishing independence isn’t the problem. The problem for ManCos is in having the breadth and depth of professional expertise to value all of the different types of financial instruments and asset classes that their investment managers may venture into. When the assets held by a fund are illiquid or so called ‘hard-to-value’ level 3 assets, the problem is dramatically amplified. Hiring external valuers may be an option. This isn’t a quick fix, however, as the Directive is clear that these hired hands must be professionally registered and have strong valuation expertise. The underlying assumption throughout these regulations is that only the best asset valuers will do.
ManCos are often intricate vehicles that were growing in popularity even prior to the Directive, as they offered funds a platform for expansion into new territories without the requirement for large local capital investment. With the advent of the Directive, however, they have taken on a new purpose – compliance with Article 15, which requires the risk management functionaries to be separate from the people who actually put money to work.
While ManCos don’t interfere with the day-to-day running of a fund, they take a prominent role in corporate governance and often take responsibility for asset valuation. This frequently presents a potential compliance risk, as that valuation service is often not sophisticated enough for the purposes of the Directive. Furthermore, the responsibility for effective valuations remains with the fund, even if it has delegated that function to a ManCo. AIFMs can ill afford the reputational damage amongst investors that even the mildest regulator action can inflict. Consequently, putting unqualified ManCos in charge of valuation, with no accompanying transfer of responsibility, is a gamble not worth taking.
Those managing an alternative investment fund face both an opportunity and a threat from the Directive. The ability to market throughout Europe is an opportunity many funds will understandably wish to seize. But before they proceed, managers must ensure that they properly comply with the Directive’s regulations.
Thorough initial and ongoing operational due diligence when using external valuers is key, as is a deep understanding of the nature of their services. Acting on qualified advice, investment managers and ManCos must decide whether they are competent to undertake valuations themselves, with the support of an independent valuation opinion, or whether they are more suited to a conventional external valuation team. Whichever route they take, they must be able to demonstrate to both investors and regulators that they have taken the decision with compliance, rather than cost or convenience, in mind. The ramifications if they cannot could be grave.