Enforcement action against firms for improper valuation procedures and controls by the Autorité des Marché Financiers (AMF) is a sign of things to come – and not just in France.

Valuations are a massive issue for everyone involved in the alternative funds sector. Any failure to report the fair value of the assets of a fund properly distorts the decision-making process, undermines the credibility of firms and makes their lives more dangerous. Improper valuation practices may cause losses for investors, whether at subscription or redemption, through secondary trades or through misallocations of capital. These mishaps, in turn, can result in significant liability for any fund manager that is caught in the middle. The improper valuation of a fund's assets violates the agreement on which the fund was formed and may constitute a breach of its fiduciary duty to act in the best interests of investors.

The problems surrounding valuation are most obvious when it comes to illiquid and complex assets. Even if a firm believes its internal teams to be good at valuing such assets, it still must reassure investors that its policies and procedures work reliably in this area and are open to their scrutiny. The valuation process must be seen to contain a minimum of bias.

Regulators are becoming more and more sophisticated in the way they examine the valuation practices of fund firms when it comes to illiquid and complex assets. Since 2014, the EU’s Alternative Investment Fund Managers Directive (AIFMD) has obliged funds to have “appropriate and consistent procedures so that a proper and independent valuation of the assets can be performed.” Evidence is growing that regulators are paying more attention to their efforts to fulfil this obligation.

Not holding back

A clear example of this increase in regulatory scrutiny comes from a case initiated by the AMF's sanctions committee in France. Over the last few years, the Financial Markets Authority, to give it its English title, has proved ready and willing to act against firms whose valuation processes and controls it finds insufficiently reliable and/or independent of executive interference. It fined an asset manager €280,000 (£246,200) for failures to do with the valuation of an equity tranche of a collateralised debt obligation. The fund was found to have significantly underestimated the value of the tranche and failed to provide investors with so-called 'valuation transparency.' The regulator also criticized the fund manager for failing to provide accurate and independent valuations of the fund assets.  The case was the most high-profile at the time, and just one of a number the regulator has been taking ever since.

At the start of this year, the AMF announced that it had imposed a further fine of €300,000 (£264,160) against another asset management firm that ran a venture capital and private equity fund with approximately €600 million (£528 million) in AuM. The regulator found many faults with the firm's valuation process and controls. According to the AMF, valuation procedures for certain holdings were, to translate from the French, “imprecise, incomplete and non-operational” while the firm's valuation methods were also “imprecise, unreliable and likely to be arbitrary.”

Two things are striking about the sanctions committee’s action. First, the AMF presented no evidence that investors actually lost money as a result of the problems it found with the firm's valuation procedures. It was enough simply that the firm's procedures, valuation methods and controls infringed both EU regulations and the AMF's regulations. The regulator, quite apparently, is not willing to wait until investors are directly harmed before acting.

The second point to note is that the failures cited by the AMF are subjective. As a result, many alternative investment fund managers could find themselves accused of similar failures, to a greater or lesser extent, as soon as they attract the regulator’s attention. It should also be noted that the AMF is now saying that the valuation of non-listed assets is to be among its top priorities during site visits this year and is asking audit firms to put a clear emphasis on valuations when going about their business.

At the very least, we should view the AMF’s stance as a harbinger of things to come – not just in France, but perhaps across the alternative funds sector if other regulators follow suit.

An international issue

Regulatory concern over valuations is certainly not limited to the AMF. The UK’s Financial Conduct Authority issued a discussion paper in March 2015 that went some way towards the provision of much-needed guidance on the subject – or would have done so had the regulator completed its consultative process and published a response. Unfortunately it did not, presumably out of a desire to avoid poaching on the European Securities and Markets Authority's preserves.

The regulator did, however, issue a piece of “themed supervisory work” which culminated in a statement on video from Nick Miller, its head of asset management. The regulator is now keen to find out whether alternative investment fund managers (AIFM) and other fund firms are obeying article 19 of the AIFMD. If it finds that a firm is not acting in the best interests of investors, it intends to take an escalating series of actions until it is satisfied that the firm is acting properly. These actions might start a use of the FCA's so-called product intervention powers, progressing to the imposition of a remediation plan. If the FCA is still not satisfied that the AIFM (or other firm) has shown it that it has obeyed the plan, the regulator could then ask the firm to appoint a “skilled person” to sort things out. Depending on circumstances, this might be relatively inexpensive in terms of costs and reputational damage for the firm, but might also be the opposite. In cases where the FCA believes that consumers have suffered serious harm, the regulator might take enforcement action straight away as long as it thinks that it is in the public interest to do so.  

The US Government, meanwhile, has not enacted anything similar to the AIFMD or any particular laws that require independent valuations. Despite this, the Securities and Exchange Commission has been more vocal and proactive than most European regulators in investigating the ways in which firms value products and in looking for problems. “Valuation is one of the core issues,” as the regulator’s enforcement director Andrew Ceresney has put it in the past. The SEC, for its part, has been concentrating on several key areas – both technical and governance oriented – in relation to valuation of late. These are the relationship between valuation and the fees that fund managers charge and the extent to which fund managers are following their own valuation policy documents in good faith. In addition, the SEC is beginning to question the use of broker-dealer quotes in the pricing of so-called “level 2” investments – a dubious but common practice throughout the alternative funds sector.

Although many fund managers know the stance of regulators on valuation issues only too well, there is a reason why some are still failing to act: it is not always clear what they should do. The AIFMD, in article 19, clearly obliges them to put independent valuation functions in place, perhaps by establishing 'independence' internally or by appointing external valuers. It is, however, maddeningly vague.

Time to move

This, of course, cannot become an excuse for inaction. The most important reason to act is that investors will demand it. Investors are becoming increasingly sophisticated in examining valuations. Their processes for checking the veracity of fund firm's claims are becoming more detailed. Few are now naïve enough not to know that investment managers with high concentrations of illiquid assets can "control the story" about their interim performance as they express it through net asset value figures. As a result, those investors are demanding better governance in respect of valuations.

Institutional investors will go on demanding better and better controls and more consistency between asset managers and jurisdictions. If they expect reliable valuations and information of high quality from their managers in France, they are unlikely to demand less from their managers in the UK, the US or anywhere else.

Nor will it do for fund managers to say that they do not know what constitutes good practice. In the absence of regulatory guidance, others have stepped in. The Alternative Investment Management Association published the first version of its Guide to Sound Practices for the Valuation of Investments in 2013 – even before AIFMD came into force. This year's edition was published in March and a substantial portion covers governance, policy and transparency.  

If funds do not act in response to investors' concerns, they will find themselves increasingly forced to do so by regulatory pressure. The AMF may allow firms some latitude in their interpretation of the AIFMD. It is likely to have less patience, however, with firms that have failed to deal with the issue entirely.

No quick fix

Managers should start looking more closely at their valuations now, because it will take them time to come up with appropriate rules, processes, procedures and documents. Most of them ought to look both outside and in when doing so. There is always a strong case for external valuation. Many, if not most, firms have neither the capacity nor the inclination to establish a reliable, valuation function in-house and make it resistant to interference from their executives. Even those that can do so also face the problem of conflicts of interest. It is true that no regulators anywhere in the world insist on the use of external valuation experts. It is equally true that, in almost every jurisdiction, enough managers are using external valuation services for it to be thought of as best practice.

People often think of the choice between internal and external valuation as binary one; they are in error. Independent experts can validate valuations in one of two ways: either through a review of the relevant firm’s valuations and written opinion to confirm that they are reasonable (as long they are, of course); or by performing an valuation that is free from interference from the firm's executives, which the experts can then use to corroborate the value that the firm intends to declare as its net asset value or NAV. In both cases, the external valuer’s work supplements the firm's own work in the valuation process, instead of replacing it.

* Ryan McNelley can be reached on +44 20 7089 4822 or at ryan.mcnelley@duffandphelps.com

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