As seen in Institutional Investor Fund Director Intelligence
Recent Securities and Exchange Commission scrutiny of the policies and procedures around fair value pricing for all investment funds has highlighted the fact that mishandling valuation responsibilities can lead to material misstatements and leave investors misinformed. This, in turn, can lead to serious consequences for the fund and ultimately expose the fund’s directors to material risks.
Most recently, the SEC in June settled an enforcement action against eight directors of several Morgan Keegan funds that it said had failed to satisfy their fair value pricing responsibilities during the financial crisis. Specifically, the agency said the directors “delegated their fair valuation responsibility to a valuation committee without providing adequate substantive guidance on how fair valuation determinations should be made.” ln addition, the SEC stated, the directors made no meaningful effort to learn how fair values were being determined, received only limited information about the factors involved with the funds’ fair value determinations, and obtained almost no information explaining why particular fair values were assigned to portfolio securities.
Mutual fund–and indeed all investment fund–boards should be discussing their fair valuation obligations. And, they should be looking at ways they can provide guidance and oversight to the funds whose investors they represent, thereby preventing a situation where regulatory and legal problems arise from valuation issues.
Directors’ responsibilities with respect to fair valuation are substantial and far-reaching. They have a fiduciary duty to provide guidance and governance around the policies and practices in place, and they must maintain continual oversight over those policies. The board’s own policies should stipulate that valuation reports–whether created internally or prepared by external valuation specialists–be provided to them on a regular and timely basis. The reports should be sufficiently robust and informative for directors to determine if the valuations presented are reasonable and fair.
Given the many important roles and responsibilities of fund directors, it is understood and generally accepted that they often delegate day-to-day operational responsibility for determining fair value to a valuation committee, although it should be stated that the ultimate responsibility for fair value determination resides with the board. When delegation occurs, it is incumbent upon the board to provide critical oversight over the valuation committee to ensure a smooth valuation process.
Well thought-out, sensible and consistently applied valuation policies and procedures help to ensure a fund’s fiduciary duties to its investors are met. Comprehensive policies should be meaningful and applicable and documented in clear and precise language, and these policies should address the selection and use of methodologies and inputs and describe how conclusions would be derived. Established internal valuation and reporting processes should be reviewed frequently to ensure robust reporting remains part of the ordinary course of business with the appropriate level of oversight from those charged with financial reporting.
As a matter of quality assurance, a fund must maintain a strong system of compliance and internal controls over processes using these disciplined procedures. Extra scrutiny may be required from directors if:
- prices are unjustifiably carried at cost;
- stale market or quote prices are used, especially in a volatile market environment; or
- there is a material positive or negative event with any of the securities.
As a best practice to strengthen and supplement internal valuation processes, directors often engage an independent third-party valuation specialist. When specialized knowledge and skill sets are required to provide consultation and support, engaging external specialists could add considerable value and may provide an elevated level of comfort to directors and the investors they represent. In the instance where the board may outsource directly to an outside valuation specialist, the directors should be guided to endorse a valuation firm that is independent and without conflicts of interest. It is imperative to note, however, that the board’s oversight responsibilities still exist, whether internally and/or externally provided marks are used as an input into the board’s valuation process.
When a fund engages a valuation specialist, the following should be addressed:
- type of assets to be valued
- scope of valuation procedures and opinions
- valuation process
- timing of deliverables
- ongoing recurrence of valuations
The last element–price–is always an important consideration. A low price, however, virtually guarantees insufficient review time and analysis. Quality should outweigh price due to potential legal ramifications of erroneous reporting; engaging an inexperienced valuation team without a dedicated practice is inadvisable.
Valuations by an external specialist may be in the form of “negative” or “positive” assurance. A negative assurance premise avows that values reviewed are “not unreasonable.” A positive assurance valuation, on the other hand, provides an independent opinion of value that naturally should provide higher comfort to the board. The resulting opinion may be a point estimate conclusion, but a tight range of values is preferable as it provides more latitude over the final determination. Finally, a specialist’s report should summarize capital markets information, fundamental and technical trends, valuation procedures, inputs, methodologies and conclusions.
Under U.S. generally accepted accounting principles, the valuation of securities is governed by the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) Topic 820 (formerly SFAS 157). The fair valuation of assets reflects “hypothetical exit prices” that would occur in an orderly market, incorporates market inputs and market participant valuation methodologies, and provides sufficient documentation of valuation procedures, inputs and results. The standard provides for a fair value hierarchy of Levels 1, 2 and 3 assets, where Level 3 assets are considered highly illiquid. Further, Accounting Standards Update (ASU) 2011-04 outlines additional disclosure requirements and specifies that valuation sensitivities to significant “unobservable” inputs must be disclosed and discussed both quantitatively, and qualitatively, if relevant. Valuations of hard-to-value Level 3 illiquid assets can be time consuming and complex and require highly specialized knowledge and training.
The guiding principle of fair value is that it always must be approached from a “market participant” perspective. The pertinent question a valuation specialist should ask is: “Is the chosen valuation methodology, along with the associated supportable inputs and the necessary qualitative assumptions, reflective of how an independent market participant in an orderly market would approach a given valuation from an exit price valuation perspective?”
Valuation specialists must be prepared to defend the choice of valuation methodology, assumptions and judgments to those who depend on the valuations. The methodologies used must be based in appropriate financial economic theory and must be capable of capturing the specific characteristics of the investment. Parties relying on the valuations want to see a valuation that can be understood and supported, even if a high degree of technical understanding is required. The Table below is an illustration of typical private equity and private debt investments, the relevant valuation techniques that may be employed, along with unobservable inputs, and a sample of the possible ranges of those inputs. The main point of the table is to demonstrate the importance of sensitivity analysis and the enhanced documentation required around value sensitivity analyses.
Valuation specialists must identify carefully all pertinent security features that could materially affect the resulting valuation conclusion, and significant judgment is crucial when choosing essential model inputs. For example, complex instruments with option features may call for a quantitative volatility/time-based model, but some model specifics and input estimation are left to qualitative judgments. Issues such as volatility, the choice of valuation methodology and early exercise of options require qualitative judgment that should be documented and supported.
It is not only important to choose a valid and proven valuation methodology and associated model, but also to understand a model’s limitations in order to better comprehend potential underlying risks and effectuate proper judgment. Valuations cannot be conducted within a “black box.” Typically, a non-traditional instrument has one or more features that alter its economic character, such as a feature that alters future cash flows and the resulting payoff distribution. At times, a simplistic Black-Scholes option pricing model may be inappropriate. These types of rigid models require inputs into an equation and, when the inputs cannot be measured and applied in a consistent manner the model fails due to its rigidity.
Ultimately, a reasonable valuation must be derived through a logical process that acknowledges all the economic features of a given instrument and uses supportable market inputs and informed qualitative judgments. Once all of these factors are considered and in place, it is often possible to reach an informed consensus on fair value.
The rise of sophisticated, illiquid and non-traded financial investments–many of which contain idiosyncratic and often esoteric features–has created significant risk for those funds that invest in these types of securities. It is the duty of directors to conduct their fair value asset pricing responsibilities seriously to ensure appropriate guidance and governance of the fund and reasonably accurate investor reporting. By doing so, the directors can avoid potential legal issues and regulatory action.