We’re now just six 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. And 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 it 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 many valuation specialists say it’s not worth their while to take the risk.
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. Another possibility – 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.
But either way: with only six months left until AIFMD comes into force, 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.