Coming from America

The US regulator has been coming down hard on private equity firms on valuations over the last couple of years. In one case, it fined an undisclosed firm for failing to justify the output of its third-party valuation model. Private funds managers must ensure they are documenting their process and that their model aligns with what they promised investors.

“Six years ago the Securities and Exchange Commission wasn’t sophisticated enough to interrogate methodologies. That’s changed now; they have significantly improved their staff capabilities and can assess whether the method is appropriate,” says Ryan McNelley, managing director at Duff & Phelps, a global corporate finance and valuations advisor.

Independence in the valuations process is a recurring theme when chief compliance officers talk about regulation.

“Fund managers are extremely good at what they do. But they don’t necessarily have the training to know what investors, regulators and other stakeholders require with respect to establishing a truly objective and independent valuation framework. Whilst there may be a GP who understands the valuation method, implementation may be shaky. Despite their good intent, they can fall into traps,” McNelley says.

As third-party valuations become accepted in the US, it is possible that best practice ‘requirements’ might spread eastwards.

“Typically, what happens in the US then follows in Europe. The rules around business combinations and fair-valuing intangibles are good examples in this regard. US-based funds are launching more European funds and strategies. Their limited partners have come to expect the US standard,” says Tomas Freyman, managing director in the valuations & opinions group at Lincoln International, a global investment bank.

“Valuation services are not regulated in the US per se; however the SEC does expect to see certain standards. It is that ‘best practice’ expectation which has become a loose regulation of sorts,” Freyman adds.

Some managers already believe third-party valuation best fulfills the Alternative Investment Fund Managers Directive requirements.

“With regards to the AIFMD, there are two routes funds typically take: the first is they engage a valuer in an advisory role, and then the fund takes the ultimate decision. The second is they totally outsource the valuation in a formal ‘External Valuer’ role. A lot of new funds are coming to market and trying to stay as lean as possible and focus on making deals. Hence, fund managers and LPs seem to be driving the increasing popularity of the External Valuer role,” says Freyman.

European gateway
Valuation in Europe is currently governed by a series of industry guidelines, but is the European Securities and Markets Authority considering a more detailed oversight structure?

The regulator says it has no plans to enforce stricter rules than already exist in the AIFMD and International Private Equity Valuation guidelines. However, it has continued market consultation on valuations oversight, updated its AIFMD explainer document and opened applications for interested parties to be advisors to its Investment Management Standing Committee, which covers fund valuations.

But not everyone in the European market is convinced US-style oversight is necessary.
“The AIFMD provisions, which came in three and a half years ago, require the valuation process to be done externally or else independently of the portfolio manager. It also requires there to be an independent depositary overseeing the calculation of the net asset value of the fund, which is dependent on the valuation process. Therefore, some funds will have both an external valuer and a depositary overseeing,” says Julie Patterson, head of investment management at KPMG, a global professional services firm.
Despite these reservations, some in the sector believe stricter oversight in Europe could be positive.

“Unless the European regulator puts some pressure on the industry, the standards will vary from manager to manager,” comments Monique Melis, managing director at Duff & Phelps. “Regulatory pressure and oversight is really the only way to give a hard push on enforcing valuation or any standards. This is a common discussion point among due diligence professionals globally,” she adds.

McNelley notes managers are understandably wary of third-party valuation becoming mandatory.

“There is a need to strike a balance in achieving independence in funds valuations, but also use people who are close to the instrument itself. The valuation professional is inevitably going to miss something because they don’t have access to the deal person,” says McNelley.

Mandating third-party valuations also comes with cost considerations, lessening their appeal. “The value of a private equity fund’s portfolio securities does not often increase so rapidly that, after the first or second deal in the fundraising period, there’s a premium at which remaining interests in the fund are to be sold. So not having a separate valuation done is not going to make that much of a difference during that period,” says Julia Corelli, partner at Pepper Hamilton, a US law firm.

There are also some psychological traps to watch for. “Outsourcing valuations can mislead by thinking that third parties are the standard for valuations practices. This is certainly something of the past and not helpful in terms of prevailing standards of oversight and control,” Melis says.

But setting a single standard can be unhelpful, Freyman argues. ESMA may change its enforcement approach, as the SEC has done, but should steer clear of handing down gospel. “If you try and ‘regulate’ valuations too much, the fair-value answer may be quite different from where it should be in reality. The right approach may have required more creativity, which could be lost if you apply prescriptive standards that lack that level of interpretation required. Valuation is much more of an art than a science,” Freyman adds. ?