SEC’s New Fund Fair Value Rule: Ops and Fintech Solutions

FinOps Report’s editor Chris Kentouris recently spoke with Robert Proctor, head of product management and NAV solutions for Milestone Group, about just how fund managers and boards of directors should prepare for the new Rule 2a-5  Milestone Group is well-known for its pControl platform allowing fund managers to oversee the process for striking net asset values and creating contingency net asset values in case of a glitch at their fund administrators. Milestone Group also recently signed an agreement with mega custodian and fund administrator BNY Mellon to use its pControl platform to create an independent NAV agent service for fund managers regardless of whether they use BNY Mellon as their fund administrator.

The focus of the new rule is not specific to the valuation of non-exchange traded assets or those without an observable price. It is much broader and incorporates adjustments to observed prices as well. Therefore, the question is not so much about the valuation methodologies used to price a security without a readily available market quotation. It is about what the definition is for “readily available market quotation” and the protocols which a fair value determination must follow.

The new rule requires registered investment companies to follow a clear set of guidelines. The requirement is more prescriptive than past SEC guidance.  Some of the flexibility once allowed in valuation policies and procedures must now fit within the new framework. Some of the key requirements of the new rule for making fair value determinations are: assessing and managing material risks; selecting, applying and testing fair value methodologies; overseeing and evaluating pricing services used;permitting the board to designate the valuation responsibility to certain parties provided adequate oversight determined by the board; and defining recordkeeping requirements. The requirements of the rule are based on perceived best practices and will affect some firms more than others depending on their current practices. In summary, it is a more holistic approach to valuation and clarifies key definitions and responsibilities providing a higher level of consistency and certainty of SEC expectations for fund managers.

Assets classified as Level 2 or Level 3 assets under ASC 820 fall under the fair value rule and Level 3 assets should concern fund managers the most.  Under Section 2(a)(41) of the Investment Company Act of 1940 if a market quotation is readily available for a portfolio security it must be valued at the market value. Rule 2a-5 defines “a readily available market quotation” as when the quotation is a quoted price (unadjusted) in active markets for identical instruments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable.” This definition means that any adjustment to a market price, such as the application of vendor-provided fair value factors for foreign entities, will require a fair value determination. Currently, fund boards may treat some securities with Level 2 inputs, as having readily available market quotations, so this practice will no longer be allowed.

Level 2 assets are assets that do not have readily available market price, but can be given a fair value based upon observable inputs, such as interest rates and yield curves. Interest rate swaps fall under Level 2.  Level 3 assets also do not have a readily available market price. In addition, they don’t have any readily available market information, so they are fair-valued using models and observable inputs. Asset-backed securities or distressed debt instruments can fall under Level 3 assets. Level 3 assets will be not only the most difficult to value, but also to maintain appropriate documentation as required under Rule 31a-4 which was adopted with Rule 2a-5.

Rule 31a-4 requires funds, or their advisors, to keep the right documentation to support fair value determinations. The SEC believes that the requirement to obtain appropriate documentation to support fair value determinations should include documentation that would be sufficient for a third-party, such as the SEC’s staff not involved in the preparation of the fair value to verify, but not fully recreate the fair value determination. Although it is not clear to me what the SEC means by “sufficient to verify, but not fully recreate,”  I still believe this will be one of the most onerous parts of the new regulation to follow given the nature of Level 3 assets, which have unobservable pricing inputs.  Although there will be a higher number of Level 2 than Level 3 assets, Level 3 assets will need the most attention as they are the least liquid and contain unobservable inputs in their prices.

The changes depend on their current policies and procedures. As the SEC was drafting Rule 2a-5 it inquired about current market practice and used bits and piece of what firms are doing now to craft the final regulation. Therefore, the changes are not really cut and dry given that each firm has a different baseline starting point. For some firms it is going to be quite onerous to comply with Rule 2a-5, while for others it will be straightforward.  There will be a formalization of recordkeeping and reporting in relation to the valuation process, particularly in the area of delegated authority, oversight, operational tracking and reporting required to make the whole process transparent and easily auditable.  One of the considerations of valuation committees will be what level of automation will be required to allow them to prove compliance with the various elements of Rule 2a-5, particularly in terms of transparency and auditability.

When the fund manager is the board of directors’ designee, the fund manager will need to meet the requirements of Rule 2a-5. There are a number of areas that will affect organizations differently depending on their current practices. Those areas include the segregation of portfolio management from the fair value determination activities due to a potential conflict of interest.; mechanisms to provide periodic reporting — quarterly and annual; and prompt reporting within five business days for material issues. There will also be the need to perform price challenges; the need to do stale price analysis, testing and back-testing of fair value methodologies; the need to maintain appropriate documentation to support fair value determinations; the need to retain those documents for six years with readily available access for the first two years; and the need for appropriate staff and technology to manage these activities.

The key challenging areas appear to be the application and auditing of revised policies and procedures; verification that the processes are working; and verification of the oversight of any delegated authority. Tying all of these requirements will be difficult, because the function of valuation has been a low profile area for the securities industry. The industry has relied on spreadsheets and manual processes dependent on key people.  As is the case with other processes that have undergone a transition, the question will arise as to what the right level of automation is to achieve compliance and resilience in valuation.

Given that the rule that fair value determination must be done by either the board or a valuation designee, it is tempting to say that administrators are not really involved. They are integral to the fair value process that must be undertaken by the board or its designee. Subadvisors, pricing vendors, and fund administrators are not allowed to make fair value determinations under the rule. However, the board or valuation designee can obtain assistance from others in fulfilling its duties. The assistance can take several forms, including services such as performing back testing as specified by the valuation designee and performing calculations required by the valuation method selected by the board or valuation designee.  Therefore, fund administrators along with pricing services could be asked to provide much of this assistance.  Ultimately it is up to each fund manager to determine the level of assistance, which parties they want to provide the assistance; and the level of oversight required to ensure these activities are performed properly.

I think that as a result of the rule we will see  higher due diligence and oversight over pricing agencies as the rule requires the board or designee to establish a process for the approval, monitoring, and evaluation of each pricing service used.  The rule provides guidance on what to consider when selecting a pricing service which includes its qualifications, experience, and history; its valuation methods or techniques; inputs and assumptions used for different classes of holdings; and how the inputs and assumptions are affected. if at all, as market conditions change. In addition, the quality of the pricing information provided by the service and the extent to which the service determines its pricing information as close as possible to the time as of which the fund calculates its net asset value must be considered.  Other important factors are the pricing service’s process for considering pricing challenges, including how the pricing service incorporates information received from price challenges into its pricing information; the pricing service’s actual and potential conflicts of interest; the steps the pricing service takes to mitigate such conflicts; and the testing processes used.

The fund’s board or valuation designee, as applicable, should consider the appropriateness of using pricing information from a pricing service.  In addition to the initial review of the pricing service, fund managers should be performing ongoing reviews of the accuracy of the service through techniques such as vendor comparisons or comparisons to actual trade prices.  Funds or valuation designees, as applicable, must establish a process for pricing challenges. For most firms, the process of selecting a pricing vendor will not be a major change from their current practice.

As little as possible. I’m saying this tongue and cheek. What I mean by this is we would expect supporting technology to provide the primary audit trail of the formulation of the fair value and the approval process. The guidance did make specific reference to not overwhelming fund boards with more than they require to perform the oversight function.  As I previously said, Rule 2a-5 comes along with new recordkeeping Rule 31a-4, which requires that fund managers maintain appropriate documentation to support fair value determination for six years with the first two in easily accessible mode.

The SEC goes on to define what it believes as “appropriate documentation” to be documentation that is sufficient for a third party, such as the SEC, to verify the fair value determination.  The SEC gives the example of internally developed valuation models along with any inputs and assumptions used.  In addition, the fund manager must provide periodic reports to the board with adequate information needed for the board to adequately perform its oversight. The periodic reports are to be provided at least quarterly and annually.

The quarterly reports must include information requested by the board related to the fair value; a summary of material fair value matters that occurred in the prior quarter including material changes in valuation risks; fair value methodologies or changes to the valuation process.  The annual reports must include an assessment of the adequacy, effectiveness and resources of the valuation designee’s process; a summary of the results of the testing of fair value methodologies applied; and any material changes to the roles or functions of the people responsible for determining fair value.  Prompt verification reports to the board are also required when a material matter affects the fair value of a security.  This notification can be no later than five business days after the material matter is discovered. The specific format and content of those reports are purposely not defined so the fund’s board is left to determine the amount of information and its format that will allow the board to perform is oversight.  As is the case with any regulated process there is a lot of information and a lot of detail.  Therefore, I would expect the vast majority of recordkeeping and audit trails would be captured in the system supporting the fair value process itself.

I think that many of the items in the guidance of Rule 2a-5 are already on the radar of boards of directors, but key things that come to mind in terms of policy are: defining the appropriate level of information that is required to perform the active oversight; segregating portfolio management responsibilities from pricing; approval of fair value methodologies; defining, timing, and monitoring of material matters; notifications; required testing and back-testing of fair-value methodologies; and frequency of testing. Fund managers and their boards should also consider which valuation risks to monitor, such as potential conflicts of interest; investment types held; sensitivity to potential market or sector shocks; the extent to which each fair value methodology uses unobservable inputs; the proportion of the fund’s investments that are fair-valued and their contribution to the fund’s returns; and reliance on service providers that have more limited expertise in relevant asset classes.

In general boards should be familiar with the designee’s fair value processes. In particular, they should periodically review the financial resources, technology, staff and expertise of the valuation designee, and the reasonableness of the valuation designee’s reliance on other fund service providers. Doing so, will help the board understand how the designee supports the fund’s fair value processes.

I don’t believe the new rule will have a major impact on the way NAVs are calculated overall, but it will change and strengthen practices and policies related on how to fair value securities.  It would be hard to disagree with the SEC that the standards included in this regulation will lead to more accurate and consistent valuations; more consistency of prices across funds and fund families; and improved transparency and confidence in the price of a fund.  Valuation is an area that has probably needed attention for some time and we now see a focus in the opportunity for it to be industrialized in the same way as other key areas of the NAV production process have been.

Current technology is not sufficient. Milestone Group is talking to industry participants and being told that fund managers are either not happy with their current practices, or they are happy but realize that Rule 2a-5 is the trigger for upgrading their valuation infrastructure to meet the more stringent guidelines.  Obviously, when a key function is performed using an array of systems, spreadsheets and manual processing, you typically have poor auditability and transparency when you try to apply the same kind of principles embedded in the new rule.

In a fair valuation pricing survey of around 100 fund managers conducted by Deloitte in 2020, eighty three percent of survey participants indicated they use Excel-based tool in their valuation process. Given the extended period of working from home Deloitte thought here may be an increased focus on workflow management tools in facilitating and securing approvals. About 85 percent of the fair valuation survey’s participants indicated that they do not have workflow tools that cover the full end-to-end valuation process. One half of the survey’s participants indicated they are exploring new valuation-related technology solutions.

The results of the survey corroborate Milestone’s experience in the market where there is a lot of interest in how to take advantage of more specific process management solutions.  I am referring to solutions that are more tailored to the fair valuation process and can help firms to fully satisfy the higher standards, particularly transparency and auditability demanded by the new rule. We believe the use of new tailored solutions can be a a win-win,  because there is an opportunity to also benefit from significant improvements in efficiency by joining the various stakeholders in the end-to-end process via a common automated platform.

I think this would take the form of a process review that approaches the various aspects of the rule such as responsibilities, controls, transparency, and auditability that need to be satisfied.  This process review would take the form of a compliance/risk review or GAP analysis to determine how close their current practices align with the requirements in the regulations and where adjustments may be required.  Firms are looking at automation to play a key role in ensuring that once gaps are identified they are addressed in a reliable and permanent way.  Fund managers need to know that the process will remain resilient and efficient while providing evidence that the rule has been implemented correctly and the process can be  independently inspected by auditors and regulators.

There are multiple tasks fund managers need to be thinking about if they are not part of their existing routines. Fund managers should discuss and determine whether the fund’s board or manager will be responsible for the valuation; determine which investment types, if any, will be relegated to the fund manager; perform an assessment of the fund manager’s expertise, experience, process, technology and tools, staffing and conflicts of interest. Fund managers must specify the responsibilities, functions and titles of the people responsible for performing the fair value; perform a risk assessment of the fund;  identify applicable valuation rules and how to manage them; and define the content and format of the periodic and prompt notification reports needed to perform adequate oversight. Fund managers must also update their policies and procedures to align with regulatory requirements; evaluate current and future pricing services; establish processes for ongoing monitoring of pricing services; define the process for price challenges; establish fair valuation methodologies; and perform a technology review to determine if better tools and processes are available or should be developed to comply.

Obviously, most firms will be doing these tasks at some level, but there will be a number of areas fund managers need to think about. The SEC thinks that the cost to comply with the rule will come to US$100,000 to US$600,000 per fund but these figures could be lower when a fund manager is looking after a large number of funds and at least some of the costs can be shared. The US$100,000 to US$600,000 represents only the initial costs for compliance. There will be ongoing costs which depend on how closely aligned the fund’s current practices are with the requirements in the regulations and will vary by fund.  Some firms we have spoken to have indicated that their ongoing costs will not be materially different from their current costs. Others said the costs will be significant. In any case the SEC notes that the additional costs will be outweighed by the benefits that come along with the regulation in terms of improvements in fund governance and appropriateness of fair valuations.

I think complying with Rule 2a-5 will be another example of an industry change where all funds can benefit from coming up with a more standardized approach to valuation and perhaps share experiences around approaches and solutions that might work.  Having been involved in delivering a tailored fair value end-to-end solution, I don’t think every organization needs to go on a journey of solving the challenges from scratch.  Talking to peer groups is a good way to understand how others have been approaching this issue.  I see Rule 2a-5 as being similar to previous regulatory-driven market issues such as oversight, backup, and contingent net asset values where firms were able to come together and share industry standard outcomes.  I certainly think that technology will play a role in streamlining and industrializing processes in a way that will provide the right levels of control, participation and oversight in the fair value process.

Valuation has long been an area needing efficiency because of different practices across firms. Rule 2a-5 provides the framework to allow the funds industry to modernize and standardize the process of leveraging technology to reduce costs, increase efficiency and ensure accuracy, thereby protecting the investor.

We embarked on a journey two years ago which has led us to have a dedicated solution in this space called Fair Value Control.  We were approached by a large fund manager that wanted to move its valuation practices off of a series of proprietary databases and spreadsheets onto our pControl platform because of its end-to-end process management and automation capabilities.

As we are focused on product solutions rather than bespoke developments we wanted to test whether this was an area that had been solved so we spent a few months doing our own research. We found this was a neglected area across the market in terms of meaningful automation for operational teams and  pricing committees. Our new solution is purpose-built for teams responsible for the administration of the fair value process and for ensuring that the fund’s securities are correctly valued. Although not specifically designed with the new regulation in mind, Fair Value Control is aligned to meet its requirements and will evolve as other future global regulations come about.