There are challenges facing alternative investment fund managers with the introduction of the AIFMD. Doug McPhee and Matthew Warren from KPMG focus on the pressing issues that will affect them the most.
When the European Commission introduced the Alternative Investment Fund Managers Directive (AIFMD), it drafted one of the most ambitious and complex regulatory reform agendas ever introduced into the asset management industry.
Among many reforms, the directive provides a detailed valuation framework, including requirements for detailed valuation policy and procedures to be applied consistently across all alternative investment funds (AIFs) and requirements for competence and independence of personnel performing valuation functions. This requires close attention by alternative investment fund managers (AIFMs).
There are a number of challenges AIFMs face in order to satisfy the directive on valuation. Here we focus on some of the more pressing areas that will impact AIFMs.
AIFMs are required to ensure that the valuation function pertaining to the investments they manage on behalf of investors is carried out impartially and with skill, care and diligence, either by an independent external valuer or by the AIFM itself.
The requirement for impartiality brings challenges for AIFMs. For instance, for AIFMs undertaking valuations internally, the directive requires that those responsible for valuation be independent from portfolio management teams, yet have equivalent knowledge, experience and level in management hierarchy as those in portfolio management in order to appropriately challenge key valuation matters.
This relates to those overseeing the valuation function and undertaking valuation analyses. As such, “lending” staff from portfolio management to an internal valuation function will most likely be challenged by regulators. For many AIFMs, building an independent valuation function with the requisite knowledge of the underlying investments will be challenging. This will be increasingly challenging for AIFMs that do not readily have a larger pool of sufficiently experienced resource.
Regulators may also require an external valuer verify the independence of the internal valuation function and an AIFM may wish to include confirmations in its submissions.
An AIFM could alternatively appoint an external valuer (which has no link to the portfolio management function of the AIFM or the AIF, and is not appointed by the portfolio managers) to undertake the valuation function. While the appointment of an external valuer will not affect an AIFMs liability to an AIF, the external valuer will be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer’s negligence or intentional failure to perform its tasks.
VALUATION POLICIES AND PROCEDURES
For each fund it manages, an AIFM must establish, maintain, implement and review valuation policies and procedures that ensure sound, transparent, comprehensive and appropriately documented valuation processes. Policies and procedures should include:
- The AIF’s investment strategy and assets it may invest in.
- The valuation methodologies used for each asset type and the selection process for each methodology.
- Obligations, roles and responsibilities of all parties in the valuation process (including external valuers).
- Details of the competence and independence of those doing the valuations; and
- Escalation channels for resolving issues in asset values.
Valuation policies and procedures should be reviewed at least annually and, in any event, before an AIF engages in a new asset type. An AIF may not invest in a particular asset type before a valuation methodology for that asset type has been included in the valuation policies and procedures.
The AIFM’s risk management function should review the valuation policies and procedures and senior management should review and approve all changes.
AIFMs also need to implement sufficient governance to ensure that there is no disconnect between the documentation and implementation of the valuation policies and procedures.
Use of valuation modelsAIFMD requires that the main features of all valuation models be documented in the valuation policies and procedures. Before being applied, a model must be validated by a competent and experienced person who has not been involved in building the model and be approved by senior AIFM management. Again, the regulator may require an independent audit on applied models.
This presents potential challenges for AIFMs, particularly when investing in more illiquid assets where bespoke and complex models are developed that evolve over time. As such, AIFMs will need to ensure
there is sufficient governance around model validation, update procedures, version controls and documentation.
WHAT QUESTIONS SHOULD AIFMS BE ASKING?
If a firm has not already done so, there are a number of valuation-related questions that AIFMs should be considering now.
If performing valuations internally:
- Are there sufficient qualified individuals that are separate to portfolio management in order to deliver impartial valuations?
- Is there sufficient governance to support the delivery of objective valuations?
If using an external valuer:
- Has the necessary diligence been performed on external valuers to be satisfied of their competence?
- Are there sufficient information transfer and governance processes in place to ensure an efficient process?
- Is it certain that the external valuer does not delegate any of the valuation work to a third party?
- Are there sufficient governance structures around proprietary valuation models (particularly model validation, version control and model updates)?
- Do the valuation policies and procedures contain sufficient detail and are we putting them into practice?
WHAT TO DO NEXT
AIFMs that have not already conducted an in-depth AIFM impact and readiness assessment should do so without delay. The timelines to compliance are increasingly short and by undertaking such an assessment, AIFMs will get a better sense of the implications and the scope of the work that needs to be done in order to not only comply with the directive, but to maintain long-term profitability under these new rules.
Doug McPhee is global head of valuation services at KPMG and a member of the International Valuation Standards Council’s Professional Board.
Matthew Warren is director and AIFMD subject matter expert for valuations at KPMG
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