While it hasn’t been given the same level of media attention as some other (more controversial) provisions within the Alternative Investment Fund Managers Directive (AIFMD), Article 19 provides an important and detailed valuation framework that should be given ample attention.
Article 19 includes requirements for detailed valuation policy and procedures to be applied consistently across all alternative investment funds (AIFs) and requirements for competence and independence of personnel performing valuation functions. This is an area that requires close scrutiny by Alternative Investment Fund Managers (AIFMs).
There are a number of challenges that an AIFM needs to face in order to satisfy the directive on valuation, each of which carry practical challenges. Here we focus on some of the more pressing areas that will impact private equity fund managers; the requirement for independent valuation, formal valuation policies and procedures documentation and the use of valuation models.
AIFMs are required to ensure that the valuation function pertaining to the investments they manage on behalf of outside investors is carried out impartially and with skill, care and diligence, either by an independent external valuer or by the AIFM itself.
The requirement for independence brings challenges for AIFMs. For instance, if an AIFM chooses to value these holdings or investments internally, then the directive requires that those responsible for valuation be independent from portfolio management teams, yet have equivalent knowledge, experience and level in management hierarchy as those in portfolio management in order to appropriately challenge on key matters pertaining to price and value.
This relates to those overseeing the valuation function and those undertaking valuation analyses. As such, “lending” staff from portfolio management to any independent internal valuation function will most likely be challenged by regulators. For private equity fund managers, which have illiquid investments with individual characteristics, building an independent valuation function with the requisite knowledge of the underlying investments will, we think, be challenging. This will be increasingly challenging for AIFMs that do not readily have a larger pool of sufficiently experienced resource.
Private equity fund managers should also note that regulators may require an external valuer to verify the independence of the internal valuation function, when they feel there are questions around the independence and valuation processes and procedures set up by the AIFM. Indeed an AIFM may wish to include such confirmations in its regulatory submissions.
An AIFM could alternatively appoint an external valuer (which has no link to the portfolio management function of the AIFM or the AIF, and is not appointed by the portfolio managers) to undertake the valuation function. Whilst the appointment of an external valuer will not affect its liability to an AIF, the external valuer will be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer’s negligence or intentional failure to perform its tasks.
VALUATION POLICIES AND PROCEDURES
For each AIF it manages, an AIFM must establish, maintain, implement and review Valuation Policies and Procedures (VP&Ps) that ensure a sound, transparent, comprehensive and appropriately documented valuation process.
The contents of VP&Ps should include the following:
• The AIF’s investment strategy and assets it may invest in;
• The valuation methodologies used for each type of asset and the selection process for each methodology;
• Details of sources and controls over the selection of valuation inputs, models and market data sources;
• Obligations, roles and responsibilities of all parties in the valuation process (including senior management and external valuers);
• Details of the competence and independence of those doing the valuations; and
• Escalation channels for resolving issues in asset values.
VP&Ps should be reviewed at least annually and, in any event, before an AIF engages in a new investment strategy or new asset type. An AIF may not invest in a particular asset type before a valuation methodology for that asset type has been included in the VP&Ps.
The AIFM’s risk management function should review the VP&Ps and senior management should review and approve all VP&P changes.
To this extent, AIFMs will need to ensure that their VP&Ps have sufficient detail to be AIFMD compliant and also ensure there is sufficient governance to ensure that there is no disconnect between the documentation and implementation of the VP&Ps.
USE OF VALUATION MODELS
The directive requires that the main features of all models used to value assets or investments of an AIF be documented in the VP&Ps (including the reason for choice of model and underlying data and assumptions used in the model).
Additionally, before being applied a model must be validated by a competent and experienced person who has not been involved in building the model and be approved by senior AIFM management. Again, the regulator may require an independent audit on the used models.
This presents potential challenges for private equity fund managers, particularly where complex models are developed that evolve over time. AIFMs will need to ensure there is sufficient governance around its model validation, update procedures, version controls and documentation.
QUESTIONS GPs SHOULD BE ASKING
If you have not already done so, there are a number of valuation-related questions that private equity fund managers should be considering now:
• What will the organization need to do to comply with the directive?
• If performing valuations internally:
– Do we have sufficient qualified individuals that are separate to the portfolio management teams in order to deliver impartial valuations?
– Is there sufficient governance in place to support the delivery of objective valuations?
• If performing valuations through an external valuer:
– Have we performed the necessary diligence on external valuers to be satisfied of their competence?
– Are there requisite information transfer and governance processes in place to ensure an efficient process?
– Have we ensured that the external valuer does not delegate any of the valuation work to a third party?
• Do we have sufficient governance structures around proprietary valuation models and, in particular, governance around model validation, version control and processes around model updates?
• Do our VP&Ps contain the requisite detail to be AIFMD compliant?
• Are we comfortable that we are putting into practice our VP&Ps?
WHAT TO DO NEXT
Those firms that have not already conducted an in-depth impact analysis of the AIFMD for their business would be well advised to do so without delay, as the business implications are significant, the amount of work to be done is substantial and the timelines for preparation are becoming increasingly short.
By undertaking AIFMD impact and readiness assessments today, providers will be able to get a better sense of the implications, potential strategies and the scope of the work that needs to be done in order to not only achieve compliance under the directive, but to maintain long-term profitability under these new rules.
Doug McPhee is the global head of valuation services at audit and accounting firm KPMG and is a member of the International Valuation Standards Council’s Professional Board. Matthew Warren, is a director and AIFMD subject matter expert for valuations at KPMG.