Scrutiny on hard-to-value assets is hotting up
November 09, 2017
Financial Conduct Authority scrutiny combined with an increasing investor concern over unrealised valuations and the oversight process around them, means the valuations of level 2 and 3 assets (i.e. where prices cannot be directly observed in an active market) are more under the spotlight than ever.
We expect continued and increasing scrutiny on hard-to-value assets, such as private equity and early stage investments. Failure to comply with good practice could lead to regulator action in addition to an impact on continued investor appetite.
The FCA is increasingly focusing on fund managers’ governance, controls and process. In particular, their attention has recently been on Alternative Investment Fund Managers Directive (AIFMD) compliance, with scrutiny on what 'functional independence' in valuations means in practice.
We are seeing several themes emerging from firms when we consider what 'good' looks like for the industry, which include:
Conflict of interest
Conflict of interest is typically at the core of any scrutiny by the regulator and – crucially – covers perceived as well as actual conflicts. Moreover, these apply to not just open-ended funds, where managers are directly remunerated on net asset value ( NAV), but is also true for closed-ended funds given investors (e.g. pension fund investors) are making their decisions partly on the basis of reported, unrealised NAV. Are you able to demonstrate to the FCA that the front office do not control the valuation process or outcomes?
Robustness of challenge
A key aspect of the fair value process centres on the expertise of the second line. Do the individuals involved have the expertise and seniority to challenge the front line specialists? Do the minutes of meetings show valuations are routinely challenged so that you are able to demonstrate it takes place?
Reaction to market shocks
When an unexpected market event happens (e.g. Brexit), is effective governance and controlled decision making process still in place? Are fair value / risk committees in the habit of discussing the impact of potential market risk factors at their meetings before such events take place, so that quick and effective action can be taken if they do?
Is it clear what the purpose of the valuation is? Is the business trying to fit one value to a number of different requirements that may actually require different bases of valuation (e.g. fund reporting, PruVal reporting, commercial decisions)? Is it clear to everyone involved in the fund reporting process what the potential uses of their analysis are?
Consistency and portfolio coverage
An effective fair value process will ensure consistency between assets and asset classes where applicable. This can be done through a mix of proactive review and backtesting (comparing actual, realised valuation received on exit against its recent fair value estimate). Is it clear that your valuation oversight sufficiently covers over the entire portfolio (e.g. through good management information) rather than just looking at valuations on an asset by asset basis by exception?
Asset managers should expect hard-to-value assets to be a 'hot area' going forward and be ready to demonstrate how their valuation processes measure against good practice in the sector.
We hope you enjoy reading the perspectives and insights shared.