A Better Alternative?
Over two years have passed since the Alternative Investment Fund Managers Directive (AIFMD) became operational across much of the EU. One small, but problematic, aspect of the Directive has been in relation to the valuation provisions, tucked away in Article 19. There may be an opportunity to fix this, but valuation professionals need to get themselves organised.
An “Alternative Investment Fund” (AIF) is defined as any collective investment undertaking that is not a unit trust or similar mutual fund invested in traded securities. AIFs include hedge funds, private equity funds, investment companies and real estate funds, among others. A wide range of assets may be held in an AIF, some of them relatively illiquid, and therefore the valuation process takes on a greater significance than it does for a mutual fund holding listed securities. This did not escape the attention of the EU when drafting the directive.
Since the primary objective of the AIFMD is to increase investor information and protection, it is not surprising that it requires fund managers to establish appropriate and consistent procedures for the proper and independent valuation of the assets held in an AIF. So far, so good. The Directive goes on to provide that the valuations may be undertaken by an external valuer or by the fund itself. In case anyone is worried that a valuation undertaken by the fund itself cannot be “independent”, the artful draughtsmen made this subject to the proviso that the valuation task should be functionally independent from management of the portfolio and that remuneration and other policies should be designed to mitigate any conflict of interest.
Given the complexities of deciding what represents a threat to independence and whether it can be effectively mitigated across all the different types of funds and assets covered by the Directive, it is probably a good thing that the EU has restrained itself from prescribing more detail about either identifying such threats or actions to avoid them where a fund undertakes its own valuations. However, not so clever was the prescription that was put around the external valuer, which has in many cases rendered this option unavailable. This has meant that fund managers often have little option but to use the internal option, even if this involves the use of smoke and mirrors to create an illusion of independence.
So why is the external valuation option often unavailable? The problem is caused by two provisions in the Directive which have meant that either no qualifying external valuer exists, or where they do they are often unwilling to accept the work. Article 19 requires the external valuer to be subject to “mandatory professional registration recognised by law or to legal or regulatory provisions or rules of professional conduct.” The first problem arises because in many jurisdictions, including the largest financial market in the EU, there is no system of mandatory regulation or registration of valuers recognised by law or regulation. The other option is to find a valuer who is subject to rules of professional conduct, ie a member of a recognised professional body. While it is not uncommon in Europe to find professional bodies for valuers, these are mainly operating in the real estate sector. Professional bodies for valuers of unlisted businesses and business interests are only found in a few EU countries, and there are virtually no such bodies for those who specialise in the valuation of products such as options and derivatives. As a result, the EU has effectively excluded many with the very expertise required to provide an independent external valuation of the types of financial asset that were causing most concern when the Directive was being formulated.
The second problem arises from the prohibition on the external valuer contracting out of liability for any losses suffered by the AIF as a result of negligence or neglect. While no reputable external valuer would expect to absolve themselves of any liability for their opinion, the reality is that very few can afford not to place a contractual cap on this liability. Indeed, in some cases such a cap is a condition imposed by professional indemnity insurers. The few that can and are prepared to take the risk of uncapped liability will expect to be compensated by higher fees. These higher fees clearly make the use of an external valuer less attractive to fund managers, another factor driving them towards the internal option, in spite of inherent problems of avoiding conflict, or just as importantly, the perception of conflict.
So what is happening in practice? it appears that very few external valuers within the definition of the Directive are being appointed. Even where fund managers have traditionally used external valuers, for example in real estate funds, those valuers now have a redefined role acting as advisors to the internal valuation team. This work around complies with the letter of the Directive but still involves the AIF in the expense of establishing a credible internal valuation operation which is functionally independent from its other operations. Arguably, it also deprives investors of the transparency and increased confidence that comes with an identified external valuer reporting the values.
Where funds are invested in assets for which there is a limited pool of specialists that are able and willing to meet the external valuer criteria in the Directive, even this construct is not available. This inevitably means that only the internal option can be considered. An illustration can be found in the world of private equity, where it appears that the majority of general partners are still undertaking valuations in house. In a poll conducted this year by Private Equity International*, 87% of respondents indicated that they undertook all valuation internally and furthermore the majority still have significant input from the deal teams. To say the least , this makes establishing "functional independence" a challenge. While this sample included many funds domiciled outside the EU, a significant number of these will be caught by the Directive because they are marketing their funds within the EU. It does appear that aspects of Article 19 are honoured more in the breach than in the observance.
Responsibility for enforcing compliance with the Directive falls on the regulators under the laws that implement it in each country of the EU. There is currently little evidence they are actively examining internal valuation processes to see if they are “functionally independent” from the management of the fund, perhaps because other aspects of the Directive are more worthy of headlines or are seen as more significant for investor protection.
As is often the case it appears that valuation is given little attention until something goes wrong. The currently regulatory insouciance about the problems of complying with the valuation provisions in the AFIMD means that investors are not necessarily getting valuation information that is demonstrably independent and objective.
It is also fair to point out that few professional investors are applying pressure on AIFs over valuation. Some go further and dismiss the idea of external valuation experts being necessary. Recently, one asset manager told Private Equity International “When we select fund managers we pay particular attention to their experience, knowledge and ethical approach to company selection and ongoing valuation. We require annual audit(ed) accounts by a reputable firm, but we do not expect external third-party valuation experts”**. Some might question the reliance on auditors to root out inappropriate valuations when the global audit regulators have repeatedly found that inadequate scrutiny of management’s fair value estimates has been the leading cause of audit deficiencies around the world over the past four years***.
There is little doubt that those drafting the Directive understood little about the practical aspects of valuation and the extent to which the profession is organised or regulated in different EU countries. The result is a Directive that cannot deliver one aspect of its stated objective. Fortunately, there may be an opportunity to influence an improvement. On 22 July 2017 the European Commission is scheduled to begin the process of reviewing the AIFMD. The Directive as a whole has not been well received for many reasons other than the valuation issue highlighted here, so there is likely to be much clamour for changes in this review.
Those who are concerned that the current valuation requirements are unworkable should mark this date in their diaries. The current Directive crept up on the valuation profession while it was distracted by a plethora of other issues arising from the 2008 crisis. This time it needs to organise itself to make sure that it speaks with one voice to the EU and lobbies for an improved regime for valuation that provides useful information and proper protection for investors. I would suggest that removing the prescription around the external valuer and basing any safeguards deemed to be necessary on existing professional standards in the sector would be a sound point from which to start.
* Private Funds Management 29 January 2016 -report on PEI CFO’s and COO’s Forum January 2016
** Private Funds Management – 18 August 2016
*** IFIAR Global Survey of Inspection Findings 2015