The Alternative Investment Fund Managers Directive, Europe’s answer to Dodd-Frank, contains extensive regulation that touches on all aspects of private funds and market structure. One of the notable inclusions for private equity funds and investors is the option to use an “external valuer” to provide independent valuations of assets like a potential portfolio company.
In essence, for private funds that want to be compliant with the law, they have two options. They can either have a fully capable, independent and accountable in-house team to produce valuations reviewed by an “external valuation advisor” and exercise strict governance over the individuals providing this services so as to ensure a measure of objectivity in their assessments, or they can outsource to an “external valuation adviser”. A handful of external valuation providers already exist. Historically, the Big Four accounting and advisory firms have played a role here, and also the investment banks. More recently, dedicated firms have emerged with the sole purpose of valuing assets.
On the surface, the fact that these service providers are on hand to step in would make it seem as though implementation of the Directive is going as planned. However, now that we are out of the first year transition period (AIFMD became effective in July 2013), fund managers and service providers are realising that compliance even with this seemingly straightforward aspect of the Directive is more difficult than previously thought.
At issue is the potential liability to the providers of these valuations. Accounting practice assigns a level to assets based on the difficulty of pricing them. Levels 1 & 2 most commonly include things like public equities, or other regularly traded assets that have an existing market and generally accepted norms when it comes to pricing. Level 3 assets are illiquid assets such as private equity portfolio companies, i.e. assets that require expert valuations.
When a private equity firm needs to place a value on a Level 3 asset and doesn’t have an in-house team that passes the governance and expertise test, then according to the law they must opt for an external valuer. In practise, however, and thanks entirely to AIFMD, GPs are finding it difficult to find valuation specialists who want their business because the rules impose unlimited liability on the external valuer. In practice this means that if an asset gets valued at $10 million, but only sells for $9 million, if a firm finds cause they can sue the provider of the valuation.
“We’ve interpreted that as the party bringing the suit is going to have to find gross negligence on our part, but it could still happen,” John Czapla, senior partner and managing director of Valuation Research Corporation’s US portfolio securities valuation practice tells Private Equity International. “I do think people are keeping an eye on this issue because the regulator hasn’t been clear on the bounds of that liability. You could see fees for this type of work go up considerably.”
Czapla’s viewpoint is strongly echoed by Dr. Cindy Ma, a managing director and global head of portfolio valuation of Houlihan Lokey, and a board member of the International Valuation Standards Council: “The fee we would have to charge for something like this could be very high – if we were to take on this liability. GPs have been surprised to learn about this issue, but we started telling people about it once we realised the potential liability. We had to start examining whether it was worth continuing to provide the service and what incremental E&O insurance cover would cost. I think GPs will have to consider whether they should pay for this or just hire an in-house team with an independent third-party valuation firm providing review and advice on the valuation process (the external valuation advisor). I think that’s going to be an unintended consequence of the provision.”
What’s more, unlimited liability for the valuer could have further unintended consequences when it comes to the quality of the work produced. “Once you see fees go up, smaller GPs may be forced to go to a lower-tier provider because they are still willing to do the work. That reality doesn’t really provide the full protection intended with the provisions in the Directive,” Ma adds.
The European Securities and Markets Authority (ESMA) has plans for review of the Directive as implementation moves forward, but hasn’t provided much in the way of additional guidance around the liability laid out in the law. Legal sources say that many practitioners are now in wait-and-see mode. Czapla adds that it is important for service providers to set clear and consistent terms with GPs.
In the US, the SEC has already zeroed in on valuations as a key area for its examination of private equity funds, and enforcement actions have already moved forward. This year both Lincolnshire Management and Clean Energy Capital have seen charges and fines. The SEC also filed a complaint against GLG Partners for overvaluation of assets in December 2013. That case saw a GLG pay $9 million settlement.
If Europe’s regulators take a page from the SEC as they have on other regulations already, GPs active there could see similar legal action before long.