We’re now just a few months away from the day when hundreds of GPs will need to be able to show that they have complied with the various requirements of the Alternative Investment Fund Managers Directive (AIFMD), Europe’s grand project to harmonize and strengthen its regulation of private funds across all 28 member states.
Most compliance officers will tell you that this is a job riddled with complexity, particularly given all the confusion around depositary rules, delegation rights and the separation of risk management and portfolio management teams.
But fewer CCOs seem to think the directive’s requirements on valuation present the same level of challenge. And in some cases, that could be a mistake.
On valuation, the directive requires fund managers to do one of two things: either prove that the partners who stand to benefit from generous valuation marks can’t actually control the valuation process, or hire a third-party service provider to oversee said valuation process for them.
Large fund managers with plenty of resources are likely to pursue the first of those two options. In fact, most have already assembled independent valuation committees and/or processes that exclude those optimistic dealmakers who just know their pet companies are worth more than the bare numbers suggest.
But smaller fund managers that don’t have the same resources tend not to have the same controls in place. When valuing portfolio companies, many smaller firms rely on their deal teams to oversee the process, and that are ultimately accountable for any mistakes made. At these firms, the finance team – if a dedicated finance team exists – is simply relaying valuation reports to investors and other stakeholders. Clearly these types of firms do not satisfy the first option offered by the directive on valuation. Problem is, pursuing the second of those options isn’t exactly simple.
Valuation service providers tell us the directive is too ambiguous for them to feel comfortable about taking on the liability that comes with AIFMD-approved valuation work. Under the directive, third-party providers are liable for any losses suffered by the fund manager as a result of their negligence or intentional failure to perform the job. This could potentially prove very costly if a buyer (say) proves that it overpaid for an asset: for instance, a real estate advisory business owned by Big Four accounting firm Deloitte was recently forced to pay a £18 million ($30 million; €22 million) court fine after its business overvalued a sold asset.
Valuation service providers always take on a certain level of liability risk when valuing private equity assets (which are especially hard to price). But pre-AIFMD, at least liability costs were usually capped at a certain multiple of the fee. Post-AIFMD, liabilities can be as high as the level of damages arising from a negligently mispriced asset. And some valuation specialists say it’s not worth their while to take the risk.
PROVING INDEPENDENCE
So what options do smaller fund managers have? Not many, is the short answer. ‘Lending’ staff from the deal team to an independent internal valuation function is unlikely to work; market sources reckon that approach is likely to be challenged by regulators.
Instead, smaller GPs are being told to ask their outside advisors for guidance on how the firm can restructure internally to meet AIFMD valuation requirements; after all, third-parties should have a good vantage point on how firms of a similar size and makeup are approaching the challenge. One option being recommended – at least for those firms who have some wiggle room in the budget – is to hire a full-time back office employee who could chair an independent valuation committee.
Other advice being offered is to give the chief financial officer final authority over all valuation estimates. In fact regulators see this as a best practice, according to multiple CFOs speaking with PE Manager, who are currently in the process of becoming AIFMD authorized. UK-based mid-market firm ECI is one GP that’s pursued this option.
“I’m responsible now, because as finance director, I’m not directly involved in portfolio management. That is quite a significant change,” says ECI finance director Philip Shuttleworth.
However, providing the CFO final say on valuation numbers is not an easy option for all organizations.
As mentioned before, the directive requires those responsible for valuation to be independent from portfolio management teams, but the valuation professionals must also have the equivalent knowledge, experience and level in management hierarchy as deal teams. Accordingly, GPs must appoint a finance professional that is not only in the firm’s upper echelons but fully separate from the investment decision-making process. And it’s a requirement that a lot of private equity firms are struggling with, says Heleen Rietdijk, global leader of KPMG’s AIFMD task force in the UK.
Shuttleworth says he is able to take on this responsibility because, as one of the firm’s board directors, he has enough sway at ECI to challenge the deal team on their input.
VALUATION BY VOTE
Creating a valuation committee is another best practice GPs are being encouraged to adopt. Valuation specialists say a committee with multiple members demonstrates to regulators that no one voice can dominate (and potentially abuse) the valuation process.
Many GPs have already established a valuation committee (see graph), but for some, legal experts say regulators are looking for something more formal. And rebranding current processes and procedures may not be sufficient.
“Before we just had a list of agreed valuations after a meeting, but now we record proper minutes, track changes from initial valuations and create an assessable audit trail,” says one UK-based CFO.
“You need proper voting and not someone railroading through a process,” adds Doug McPhee, the global head of valuation services at audit and accounting firm KPMG and a member of the International Valuation Standards Council’s Professional Board. “You need to be clear on governance, frequency of meeting, voting structures and reporting lines.”
As before, smaller GPs are going to find this more difficult than firms who have more senior staff on hand to sit on a committee. After all, it’s harder to show independence when your board only consists of a handful of people. But one way to work around this problem is providing the limited partner advisory committee (LPAC) a voice in the process, sources advise, adding that the LPAC can act as an oversight body for the valuation process.
And while it may seem more of a procedural issue, the types of valuation models and methods used during the valuation process is another affordable way to demonstrate independence on valuation processes. For instance, valuation service providers note that GPs who use public market comparables have less ability to cherry-pick data that suits their own conclusions.
“If you have a UK-based manufacturer your first stop needs to be companies in the UK. You shouldn’t start at the bottom with companies you happen to know are similar and automatically benchmark against them,” advises one industry valuations specialist.
Another strategy is writing a robust valuation policy, which regulators will be sure to examine during the AIFMD application process and see that it is regularly reviewed if authorization is granted.
Under the directive, the policy should at a minimum disclose: the fund’s investment strategy and assets it may invest in; the valuation methodologies and selection process for each methodology; the obligations, roles and responsibilities of everyone in the valuation process (including any external advisor); details of the competence and independence of those doing the valuations; and also what controls are in place for the selection of valuation inputs, models and market data sources.
SL Capital chief operating officer Ian Harris, one of the first GPs to undergo the authorization process, noted that regulators asked for follow-up details on how certain activities (including valuation and risk management) were undertaken to ensure effective independence from the portfolio management function.
“There is a lot more paperwork; and some firms are probably not putting in sufficient detail on their valuation policies and procedures,” adds Tamasin Little, regulatory lawyer at King & Wood Mallesons SJ Berwin.
So with time running out for a majority of firms – recent research from BNY Mellon found 81 percent of GPs have yet to formally submit their AIFMD applications to local regulators – the last thing GPs will want to hear is that meeting the new valuation requirements is likely to take a lot more time than they expected.
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