Basel issues new fair value guidance

On 15 April 2009, the Basel Committee on Banking Supervision, a committee of banking regulators from the world’s major financial markets, issued a final set of guidelines to help banks improve their valuation of complex financial instruments.  The guidelines, which the Committee circulated in draft form last November, aim to “provide guidance to banks and banking supervisors to help strengthen their assessment of banks’ valuation processes for financial instruments and promote improvements in banks’ risk management and control processes”. The guidance, however, applies to all financial instruments, and contains some valuable information applicable to private equity funds.

The guidelines do not set forth any new accounting requirements, but rather focus on promoting a strong governance process around valuation, the use of reliable inputs and diverse information sources, and the articulation and communication of valuation uncertainty both internally and to external stakeholders.

While most private equity firms have a written valuation policy that they share with LPs, the Basel guidelines call for a more in-depth, rigorous approach: recommending that written policies detail the range of acceptable practices, as well as thresholds for determining when there is a case to challenge the valuation model. In presenting valuation results, managers should be sure to include an explicit assessment of the valuations’ uncertainty.

Firms should also periodically review and test the performance of their valuation models, the guidelines say. They also add that firms need to make sure they’ve devoted adequate resources to the valuation process, even during “stressed market conditions”.

The guidelines also recommend adopting more rigor in assessing whether an input is “reliable and relevant”, suggesting that firms take into account the following factors:

• The frequency and availability of the prices/quotes and whether those prices represent actual regularly occurring transactions on an arm’s-length basis. Whether the price/quote is an indicative price or a binding offer.

• Whether the available prices are relatively consistent with available corroborating market information and if the prices vary significantly across market participants.

• Whether prices are transparent and generally available to market participants.

• The timeliness of the pricing data relative to the frequency of valuations, such that the pricing data can be relied upon. Recent pricing data will tend to be more reliable than stale data.

• The number of independent sources that produce the quotes/prices. It is also important to consider the dispersion of prices/quotes available. This will assist market participants in assessing the quality of the pricing data.

• The maturity of the market.

• The similarity between the financial instrument sold in a transaction and the instrument held by the institution.

• The nature of a transaction, especially in inactive markets, and whether it reflected a forced or distressed sale (which are not relevant) or otherwise involved a seller that needed to sell and one or very few buyers (which may require consideration of other information and management judgment in determining the implications for the estimate of fair value).