The AIFMD challenge

To be fair, regulators weren’t given a great starting point. When the first draft of the Alternative Investment Fund Managers Directive (AIFMD) was written in 2009, EU legislators wanted valuation to be completely outside of GPs’ control. Better to have an independent third party specialist measure the worth of these shadow funds, managing hundreds of billions in institutional capital, instead of allowing GPs to pin whatever value they wanted on them. Or at least that was the post-crisis thinking.

Following extensive lobbying from industry representatives, and something of an education campaign, the final draft of the directive recognized the necessity of in-house valuation but preserved the concept of an “independent” valuation function as a middle-ground.

Still, it’s a concept CFOs struggle with. GPs have the option of appointing an external valuer, a quick though arguably expensive way of demonstrating independence, but tell pfm that they prefer retaining control over the process. Firms would have to stand behind whatever marks an outside valuation provider reaches, which seems fine when all parties agree, but an impossible conundrum when disagreements arise (GPs would be breaking their fiduciary duty to investors if they signed off on a valuation report they didn’t ultimately agree with).

Add in the fact that third-party valuation providers take on a scary amount of liability when measuring private fund assets – and the amount of time and effort it takes to familiarize themselves with companies that deal partners already know intimately – and “it’s not surprising that many GPs haven’t gone down the external valuer route,” says Kinetic Partners director Andrew Lowin, who is responsible for helping GPs reach AIFMD compliance.

So what can be done? That’s precisely the challenge being taken on by the Financial Conduct Authority (FCA), the regulator responsible for AIFMD oversight in private equity’s biggest EU market, the UK. As of press time, the FCA was still digesting responses to a consultation it opened in March on Article 19 of the directive, the section on valuation. It is understood that regulators with similar responsibilities across the EU are closely monitoring the FCA’s progress here in the hopes of copycatting solutions reached by the FCA, meaning the work will likely have a pan-EU effect.

The problem so far

If external valuers aren’t a practical solution, the only other alternative so far is for GPs to figure things out in-house. What the FCA must do then is “create practical guidance” that GPs can use to review their internal processes and ensure that they meet the regulator’s test or “explain exactly what an independent valuation function should look like,” says David Larsen, managing director at financial advisory and investment banking firm Duff & Phelps. As the FCA is discovering, that’s easier said than done.

Deal partners, who know the portfolio companies best, are often involved in the valuation process. In its consultation paper, the FCA says this is allowable so long as they don’t have final say on the marks, but it’s not quite clear how much influence portfolio managers are allowed: is a portfolio manager sitting on the valuation committee acceptable? What if he or she didn’t have voting power?

Things get even stickier: to stop senior deal partners from strong-arming the valuation process, it appears the FCA also wants the CFO to be outside senior management’s sphere of influence. Put differently: the FCA appreciates the need for deal partners to speak with the CFO during the valuation process. But at the same time the CFO can’t be “directly supervised” by anyone responsible for evaluating the deal team’s performance, such as the CEO. The result is the CFO not only has to be “functionally independent” from portfolio management, but “hierarchically independent” too, as the British Private Equity and Venture Capital Association (BVCA) put it in a consultation submission.

For smaller firms especially, it would be a tall order to hire a senior non-executive (capable of handling the valuation function) who is one step removed from the CEO’s oversight. The alternative, of course, would be to delegate the valuation task to more junior members of the back-office, who report directly to the CFO instead of the CEO, but that creates for an unsuitable and awkward chain of command.

What to do now

Leaving these lingering technical questions aside, advisors are urging GPs subject to the directive to review their valuation policies and procedures. It’s clear portfolio managers will continue advising the valuation process in some capacity, but more necessary than ever are clear policies that the CFO isn’t “duty-bound to accept deal folks’ opinion,” advises Lowin.

Larsen agrees, but looks at it from the other way round: the valuation policy should also include a mechanism to cope with situations where a portfolio manager doesn’t agree with the CFO. “How do you deal with that? Because portfolio managers may have information that wasn’t fully comprehended by the valuation team, and you don’t want a scenario where the valuation people can blindly trump what the deal partners say,” he notes. “One way to solve the functional independence conundrum is enhancing the valuation process by engaging an independent valuation adviser to validate the GPs fair value conclusions.”

It remains to be seen how the FCA will supervise Article 19 of the directive, but rumors are forming that the UK regulator is assembling a special team of inspectors to visit a sample of AIFMD-authorized managers in order to test their valuation policies and procedures, and better yet, see how this “functional independence” riddle might be solved. The FCA denies the rumor, but at one point or another will have to formulate a response to its consultation. We can only wish them luck.