Inside the GP: Best practices in valuation

The argument for valuing investments at cost in favour of fair value has long run its course and has been debunked. The ‘new’ fair value standard is no longer new. What once passed as aspirational goals for greater transparency are now a baseline requirement for any alternative investment manager.

If any doubt remains about the importance of valuation in the alternative investment community, look no further than the US SEC’s record number of enforcement actions against investment advisers – with valuation among the main issues pursued – or to the EU’s Alternative Investment Fund Managers Directive and the emphasis on valuation and role of independence in the valuation process. It is now incumbent more than ever on fund managers to demonstrate that valuation is a core competency of their firm. A fund’s valuation policies and procedures are a road map to that end.

While the investment landscape changes rapidly, a number of key attributes remain constant as the hallmark of top-tier valuation policies and procedures:

• First, the valuation process must be openly and visibly embraced and enforced by senior management
• The valuation process must be transparent with appropriate measures to ensure both rigour and independence
• The valuation policy is well-documented and consistently followed. It is also regularly reviewed and updated to reflect changes in regulatory, accounting and industry guidance, as well as changes in the underlying investments
• The inputs to the valuation process are the same inputs used by investment professionals to determine what price to pay for an investment upon acquisition, monitor the performance of the investment while it is owned by the manager, and determine the appropriate selling price
• The valuation policy specifically includes:
– The basis for the requirement to determine fair value (for example, the fund’s governing document) and the standard of value that will be followed (for example, fair value in accordance with US GAAP/IFRS)
– Clearly defined roles and responsibilities for both internal and external parties including auditors and third-party valuation advisers
– Specific guidance on how to value the various classes of securities that may be held in the portfolio
• The use of independent third-party valuation advisers

The first and arguably most significant attribute of a sound valuation policy is that it is a priority of the fund’s management. This is evident from the level of management that is charged with the responsibility of executing the valuation process.

Whether a fund is large enough to justify a dedicated valuation team or if the responsibility is assigned to existing finance staff, the professionals executing the valuation process should have the attention of senior management and the fund’s advisory committee, as well as the participation of the investment managers that must be relied on to support the valuation process. Delegating the process to junior staff and treating it simply as a back office compliance function typically results in an ineffective process that does not withstand scrutiny. Assigning responsibility for the process to a senior-level officer will help ensure that the investment managers dedicate the appropriate amount of time and effort to the process, and that valuation issues and concerns will be given the appropriate amount of attention by those ultimately charged with assessing the value of the portfolio.