Enforcement action against firms for improper valuation procedures and controls by the Autorité des Marché Financiers (AMF) is a sign of things to come – and not just in France.
Valuations are a core issue for all stakeholders in the alternative funds sector. Failure to properly report the fair value of the assets of a fund distorts decision-making, undermines credibility and increases risk, while improper valuation practices may expose investors to losses, through secondary trades or through misallocations of capital. Furthermore, improperly valuing fund assets violates fund formation agreements and may constitute a breach of the fiduciary duty to act in the best interests of investors.
Transparency is also a key challenge when it comes to valuation and funds must reassure investors that their policies and procedures are robust. This is particularly true for illiquid and complex assets, where regulators are increasingly becoming sophisticated in examining the valuation practices. Since 2014, the EU’s Alternative Investment Fund Managers Directive (AIFMD) has given legislative backing to the requirement for funds to have “appropriate and consistent procedures so that a proper and independent valuation of the assets can be performed.”
Not holding back
Recently, the Financial Markets Authority has proved willing to act against funds where it has found their valuation processes and controls insufficiently robust and independent. For example, the AMF Sanctions Committee fined an asset manager €280,000 in France for failures around the valuation of an equity tranche of a collateralized debt obligation (CDO). The fund significantly underestimated the value and failed to provide investors with valuation transparency. The fund manager also failed to provide accurate and independent valuations of the fund assets.
Another example is when the AMF imposed a fine of €300,000 against another asset manager running a venture capital and private equity fund. It was fined for deficiencies around its valuation process and controls with a range of valuation procedures deemed to be imprecise, incomplete and non-operational. What is striking about this action is that there was no evidence that investors actually lost money, but the deficiencies were enough that the regulator still took action as the asset manager’s actions infringed both EU and AMF regulations.
The AMF has recently announced the valuation of non-listed assets would be among its top priorities for on-site inspections during 2018, and audit firms must now put a clear emphasis on valuations as part of their audit process.
An international issue
The U.K.’s Financial Conduct Authority (FCA) changed its approach to follow up with supervisory oversight to check whether an alternative investment fund manager (AIFM), for example, is now following the provisions established by AIFMD Article 19. The regulator will take action if it sees that the fund manager is not acting in the best interests of investors. Regulatory interaction may start with product intervention and could progress to issuing a remediation plan. The impact on AIFMs can range from being relatively inexpensive in terms of costs and reputational damage, to extremely costly and with significant reputational damage. In cases where the FCA believes there is serious consumer detriment and is in the public interest, the regulator has the power to go straight to enforcement.
Although the U.S. has no equivalent to AIFMD, and no particular laws requiring independent valuations, the SEC is extremely vocal and proactive in this area. The SEC has been focused on several key valuation areas such as the relationship between valuation and the fees charged by fund managers, and whether fund managers are following their own valuation policy documents in good faith. The SEC is also beginning to question the use of broker-dealer quotes in the pricing of so-called “level 2” investments – a dubious but common practice across the alternative funds sector.
While many fund managers have observed the stance of regulators on valuation issues, some still fail to act as it is not always clear what specific actions they need to take.
Time to move
Investors will demand meaningful action as they become increasingly sophisticated in examining valuations. Over recent years, investor due diligence processes have grown stronger and stronger and is a theme set to continue.
Institutional investors will likely demand better controls and consistency across asset managers, and across jurisdictions – and many are doing so already. These expectations from managers in France are likely to follow through to managers in Europe and the U.S. Fund managers will also be expected to know what constitutes good practice. In the absence of regulatory guidance, others have stepped in. The Alternative Investment Management Association has published its Guide to Sound Practices for the Valuation of Investments since 2005 – before AIFMD came into force. The 2018 edition was published in March and a substantial portion covers governance, policy and transparency. As noted previously, the AICPA has also released a working draft of a new guide providing best practice with respect to valuing private investments. Refer to page 5 to read an article on the new guide.
Regulatory pressure will increasingly force funds to act in response to investor concerns. The AMF has not let the lack of guidance stop it from taking action against firms and other regulators seem likely to follow. Given the uncertainties that remain, they may give some latitude for different interpretations in firms’ efforts to meet the requirements of the AIFMD.
No quick fix
Managers should look more closely at their valuations; appropriate governance, processes, procedures and documentation will take time.
Most firms have neither the capacity nor the inclination to establish a fully robust valuation function in-house. And even if they were, the potential for conflicts of interest are difficult to overcome. In most jurisdictions, the use of external valuation experts is considered “best practice” and is insisted upon by investors – whether or not it is a requirement of local regulators.
Independent experts can validate valuations in one of two ways: either through a review of the fund’s valuations and written opinion to confirm that they are reasonable; or through performing an independent valuation, which can then be used to corroborate the value the fund reports as its Net Asset Value (NAV). In both cases, the outside valuation expert’s work serves to corroborate or support the internal work and the valuation process, not replace it.
While external valuation services can greatly improve governance, helping ensure the independence, consistency and credibility of the process cannot eliminate the work required to put in place robust valuation processes, procedures and documentation. There is plenty of work for funds to do and an increasingly urgent need to get it done.
For more information, contact Ryan McNelley, +44 207 089 4822; [email protected]