Determining fair value comes under attack

What are the issues around valuations?

With a plethora of illiquid vehicles continuing to cause problems for funds and increasingly exotic and complex instruments being used, the need for accurate valuation of a fund’s assets has become even more important as well as difficult. With volatile and unpredictable markets, a changing regulatory landscape and different views and advice being issued from numerous official and unofficial bodies, accountants are struggling to find a fair value process for the valuation of a fund’s assets.

The KPMG team agrees there are many issues around valuations. While the difficulties of completing valuations in an illiquid or a volatile market are well known, there are also the underlying structural issues due to the potential for conflict of interest.

The debate, they believe, has moved on and now centres on whether it is necessary to have an independent valuator as proposed by the EU’s draft alternative investments fund managers directive. Their collective view is that this is a logical proposal but difficult territory which the industry needs to engage with to come up with a practical solution.
In Malta at KPMG, Anthony Pace and Noel Mizzi believe determining fair value is rarely a straightforward affair in today’s current economic environment. Getting to a reliable fair value of an asset, quoted in an active market or otherwise, is often a “sticky process” they say. 

Defining, for example, what is an active market or trying to assess whether a market is really inactive can be subjective, depending on the point of view taken. Assessing the reliability of certain models and their inputs can be subjective when fair value cannot be ascertained directly through level one inputs – defined by the International Accounting Standards Board (IASB) as quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date.

Apart from needing knowledge about the market, valuations also require a good knowledge about the fund itself and the specific environment in which it operates. The best price in an active market might not be the best price the fund itself might be able to obtain through its brokers.

Meanwhile, Barry Winters and Garrett O’Neill at KPMG in Dublin believe valuation issues have gripped the investment management industry over the last year and are unlikely to become less important as time goes on.
Under present accounting standards, if the market for a financial instrument is not active, accounting standards require the use of a valuation technique. Valuation techniques should be calibrated against observable current market transactions or any observable market data.

Even if a market is not considered active, then observable transactions in that market are considered inputs which cannot be ignored when determining fair value. For model-based valuations, it is unlikely that no market-based information will be available at all, they note.

Transparency relating to valuation assumptions is paramount and, says Winters and O’Neill, it is imperative that assumptions are seen to take full account of market information. Ensuring appropriate procedures are put in place to address valuation issues is equally important.

Valuation is a significant operational risk and oversight of the valuation process is important. It is also a prerequisite that there is adequate segregation of duties between staff in the asset management process and those involved in the approval process for the adoption of the valuation.

A valuation committee should validate, interrogate the robustness of valuations and consider valuation policies and processes, say the pair. Market volatility increases the importance of the frequency of the valuation of illiquid assets.
Workable pricing practices, procedures and controls should be enshrined in a valuation policy document and approved by the board of directors, and should be reviewed on a regular basis.

Taking advice
Significant recent guidance has been issued by industry bodies on the subject of valuation. This supplements existing guidance and includes a number of IASB and Financial Accounting Standards Board pronouncements as well as recent guidance aimed at harmonising and defining best practice for hedge fund managers issued by the Alternative Investment Management Association (AIMA), the Hedge Fund Standards Board, Iosco, the Managed Funds Association in the US and the Asset Managers’ Committee of the US President’s Working Group.

At Ernst & Young in London, Julian Young says the inherent risks associated with valuing investments have evolved as products have become more complex. “This was intensified as the financial crisis developed and markets became distressed and illiquid. It seems likely that insufficient notice was taken by markets and participants of credit and liquidity risk in certain investments,” he says.

Until recently, according to Young, few would have reasonably expected funds to suffer from liquidity problems to the extent they could no longer meet their dis-investment obligations.

“The role of mark-to-market accounting has been the subject of much populist debate. There have been a number of amendments and clarifications to the accounting standards over the last 18 months as standard setters have sought to react to the changing market conditions,” notes Young.

While accounting standards have forced preparers and auditors to be more sceptical in the acceptance of broker marks and model valuations, this has forced a greater emphasis on the valuation process, concludes Young.

“While investment valuation will often have judgemental elements, this can be mitigated with robust oversight and governance,” he says. For example, the responsibility for the final net asset value (NAV) rests with the board of directors. This includes a comprehensive investment valuation policy setting out how typical investments are to be valued, a properly constituted independent investment committee with powers to take advice from the investment manager and a process to resolve disputes, explains Young.

Colin Hanson at PricewaterhouseCoopers in the Cayman Islands believes valuation depends on the level of observable versus unobservable data used to perform valuation. He says valuations based on observable inputs are generally more straightforward.

“Valuations that use some or many significant unobservable inputs are more subjective, whereby significant management estimates and judgements are likely required,” notes Hanson.

“A significant input into valuation of non-exchange traded securities is liquidity risk, which can be very difficult to quantify,” he adds.

Looking at funds of hedge funds, Hanson says valuation can be contentious, depending, for example, on whether the underlying NAV requires adjustment for negative liquidity events.

“Valuations impact NAV, which impact prices used for subscriptions and redemptions,” Hanson says. “Valuations need to be done real time for sub/red purposes, yet GAAP [generally accepted accounting priniciples] requires consideration of subsequent events,” Hanson concludes.

“In the current market there are several issues around valuations,” believes Stuart McLaren at Deloitte. These, he says, include the independence of who values the security and the governance around the valuation process.

“In illiquid markets, more valuations are based on estimates and judgements rather than visible market transactions and this adds a significant level of complexity to calculating a NAV and issuing financial statements,” he says. “Similarly, funds of hedge funds are marking their positions in funds with suspended NAVs based on information they can receive from the underlying manager.”