Registered investment advisers might find it operationally a lot harder and a lot more expensive to value hard-to-price assets held by mutual funds if the US Securities and Exchange Commission’s proposed modernization of fund valuation practices is adopted. Appointing a chief valuation officer could become necessary to handle the laundry list of new requirements.
The SEC’s plan to revamp its antiquated hodge-podge set of rules and guidance dating back to the 1970’s calls for a fund adviser’s board of directors to either do the valuation of the fund’s exotic assets itself or assign the task to the fund’s investment adviser or fund manager. While that approach is common practice, the US regulatory agency has now codified the concept by setting in motion a prescriptive multi-step approach for a fund’s board of directors to use when overseeing the valuation process. “The SEC aptly realizes that boards of directors should not be burdened with addressing the day-to-day responsibilities of valuation,” says Richard Marshall, a partner in the financial markets and funds practice at the law firm of Katten Muchin Rosenman in New York. “The SEC’s stance on valuation is consistent with other recent decisions to have board members delegate other responsibilities to investment advisers, such as compliance.”
However, what’s good news for board of directors may not be ideal for fund management firms. If they haven’t done so already, the now have to come up with a rigorous documented process for a laundry list of hows: how they measure the valuation risk to their portfolios, how they will value each asset, how they will use third-party pricing experts, how they will test the accuracy of their results, how they will prevent any material conflicts of interest; and how they will report to their fund’s boards of directors about any “material events” that will effect the fair value of the assets in question. Those assets include over-the-counter derivatives, mortgage-backed and agency-backed securities, which are commonly used in fixed-income portfolios. Valuing these assets incorrectly can ultimately harm investors, because the fund’s performance results and its net asset value could be skewed.
“Complying with the SEC’s valuation requirements, if adopted, might not be that difficult for the largest mutual fund managers which have standing qualified valuation committees dedicated to pricing securities,” says Gwen Williamson, a partner in the investment management practice of the law firm of Perkins Coie in Washington DC. “However, smaller fund management firms with fewer resources will have some challenges and may need to hire valuation experts and use third-party valuation firms.” She recommends that all fund management firms analyze just how much their current valuation practices deviate from the SEC’s proposed rule.
Marshall points to the SEC’s 2019 settlement with Deer Park Road Management as an example of what can go wrong when fund managers don’t have the right valuation process in place. “Although the case involved a private investment adviser, the lessons are applicable to mutual fund advisers,” he says. The SEC’s description of Deer Park Road Management’s wrongdoing, which cost it a whopping US$5 million fine, also sheds some light into the SEC’s thought process behind its new proposed Rule 2(a)5. Traders at the Steamboat Springs, Colorado-based hedge fund management firm, says the regulatory agency, were allowed to improperly value residential mortgage-backed securities in its flagship fund STS Partners from October 2012 to December 2015. In their valuation spreadsheets, traders acknowledged that they intentionally undervalued the high-yielding mortgage-backed securities so they could gradually mark them up to sell at a profit.
The SEC criticizes that methodology for violating generally accepted accounting principles, because traders used pricing models that were not calibrated to include recent observable data such as transaction prices. In some cases the marks were 10 percent lower than the prices of recent trades. In its proposed rule, the SEC says investment advisers must rely on ASC Topic 820– commonly called the fair value rule — as the way to value assets when there are no readily available quotes. That fair value rule must apply not only for current asset classes, but also any time a new asset class is onboarded for trading. The SEC wants fund management firms to know exactly how they will value any new asset type in their portfolios before they execute orders. While that sounds like a logical idea, it is not always applied. Too often trading desks make valuations an afterthought when they are eager to start doing business in new asset classes quickly to generate higher investment returns.
ASC Topic 820 defines fair value as the price at which an asset can be sold, otherwise known as the exit price. That is not the same price at which the asset was purchased or the last price at which it was sold as subsequent market conditions may have affected interest rates, cash flows and ultimately liquidity. ASC Topic 820 categorizes the inputs used to value financial instruments in three classes. Level one assets typically encompass exchange-traded instruments which have readily observable prices. Level two assets are those where the fund management firm can rely on prices of similar assets to come up with its valuation. By contrast, Level three assets are those where fund management firms must be a lot more subjective in their analysis, because there are no observable inputs or market prices.
The SEC’s decision to dictate a definitive metric for valuation is a sound idea to eliminate any confusion and reduce in-house squabbles. Accountants and finance directors at fund management firms could easily disagree with each other on how to value the same asset because accountants typically rely on historical cost-basis analysis while finance experts favor the capitalization of future cash flows approach. Even adopting the accounting standard for valuations won’t make the fund management shop’s job worry-free. “Valuation is ultimately a complex combination of art and science,” says George Haloulakos, president of Spartan Research, a San Diego-based firm specializing in valuations. “The science reflects commonly accepted pricing models and methodologies while the art reflects differing interpretations of the models and methodologies.” As a rule of thumb, the more illiquid the asset the harder the valuation process becomes and the larger the discrepancy in pricing among valuation experts.
Based on their interpretation of the SEC’s proposed rule, some valuation experts caution that the fund management firm will be compelled to follow ASC Topic 820 even if the fund has little valuation risk because only a handful of assets must be fair-valued. In explaining how fund management firms should determine valuation risk, the SEC says they should include the types of investment the fund holds or intends to hold, the proportion of a fund’s investments that are fair-valued and reliance on third party service providers with limited experience in the relevant asset classes.
Addressing the SEC’s requirement to ensure an independent valuation with no conflicts of interest could be the most problematic aspect of its proposed rule, worry warn some regulatory compliance experts. For complex OTC derivatives in particular even the most experienced valuation managers often rely on input from traders and portfolio managers who spend plenty of time observing price fluctuations in the same asset or asset class. “The SEC presumes portfolio managers and traders have a vested interest in inflating the price of an asset because their compensation depends on investment performance,” says Joanna Fields, managing principal of regulatory compliance consultancy Aplomb Strategies in New York. “However, they may also have the most experience in understanding market impacts on pricing for a portfolio of transactions, so eliminating them entirely from the valuation process isn’t a sound idea.”
Simply relying on a valuation committee comprised of multiple representatives from the fund management firm may not be enough to qualm the SEC’s concerns over conflicts of interest. Deer Park Road Management had a valuation committee, yet none of its members knew how to value bonds and there were serious conflicts of interest. The compliance director on the valuation committee, says the SEC, was a geophysicist and the portfolio manager’s brother-in-law; the chief financial officer was a former bookkeeper and tax accountant at a small accounting firm. Deer Park Road Management’s chief investment officer Scott Burg was in charge of the valuation process.
In its proposed rule, the SEC suggests independent reporting chains, oversight arrangements or separate monitoring systems and personnel as a possible means of segregating the valuation process from the portfolio management process. Compliance managers at a handful of fund management firms who spoke with FinOps Report gripe that the SEC’s description of the segregation of duties won’t be easy to follow and could be a bigger problem if a fund manager relies on affiliated firms to do the valuation work.
Two other requirements outlined in the SEC’s proposed rule could also cause fund management firms some angst. One of those is that the fund management firm must tell the board of directors about any material circumstances which require a change in the valuation of an asset. The SEC uses as examples a significant deficiency or material weakness in the design of the valuation procedures or material changes in the fund’s valuation risks or a significant increase in price challenges that would reflect a material change to the fund’s valuation risks. The SEC does not explain whether changes in valuation risks due to any other factors would be considered material and who at the fund management firm would determine what materiality means. Acknowledging the difficulty in defining materiality, the SEC seeks feedback to a series of questions posed.
Fund management firms will also have some stress devising a valid test to prove that their methodologies and inputs to the valuation process are accurate. “Just who will do that testing is the question fund managers will now have to address,” says David Larsen, managing director of New York-based Duff & Phelps, a New York-headquartered valuation service provider. “The fund manager will have to decide whether to have internal departments conduct the testing or whether to hire a third- party expert to avoid the perception of a conflict of interest.” Depending on the number of assets involved, third-party experts could end up charging over US$100,000 a year, according to some fund management firms.
Given that the SEC now wants a formalized plan for determining fair value and quarterly communication with a board of directors, fund managers may likely have to tap a dedicated chief valuation officer to own the process. The chief investment officer, chief portfolio manager or any front-office executives are out of the running due to potential conflicts of interest. That leaves fund accountants and chief financial officers, neither of whom is an ideal choice. Fund accountants responsible for striking net asset valuations won’t fit the bill if their experience is limited to exchange-traded instruments. Neither will chief financial officers who are unfamiliar with ASC Topic 820 which was not implemented until 2006.
“Given a choice between chief financial officers and fund accountants, the chief financial officer is the most likely candidate,” says Haloulakos, who teaches valuation theory at the University of California at San Diego (Extension). “He or she he already has a relationship with the fund’s board of directors and can communicate effectively on the process and any changes.” The CFO will then have to fill in the knowledge gaps where necessary. “CFOs may need to outsource parts of the valuation process such as the actual calculations,” says Duff & Phelps’ Larsen. “However, doing so means another process must be established for oversight of the third-parties.” The oversight will mean a lot of additional work in understanding their pricing methodologies, measuring their valuation risk, testing their results and establishing a process to resolve a pricing dispute.
Third-party valuation firms, which include the likes of Duff & Phelps, S&P Capital IQ, Houlihan Lockey, Thomson Reuters and Bloomberg, shouldn’t be hired or retained lightly. Larsen recommends that the CFO or anyone else appointed to the role of chief valuation officer review with existing or prospective third-party valuation firms their experience with similar assets, whether their results will match up with ASC Topic 820, what valuation approaches and inputs will be used and why, and what they will do if transactions dry up. Just as critical is knowing the level of the expert firm’s transparency. The more open the firm is about how it came up with its valuation the more confident the fund management firm can be about its result and the easier it will be be to resolve any disputes.
Whether the title of chief valuation officer gives the CFO or anyone else assuming that role personal liability in the event of a flawed asset valuation is unclear based on the current text of the SEC’s proposal. However, legal experts believe that could be the case as shown in the SEC’s settlement with Deer Park Road Management. The firm’s CIO, Scott Burg, was fined US$250,000 for his poor judgment in allowing traders to value mortgage-backed securities without incorporating all available market data.
Fund management firms have until July 21 to comment on the SEC’s proposed rule and another year to comply after it is adopted. With so many procedures potentially required, they might want to start thinking about how they will tweak their existing workflow and budgets. In its proposed rule the SEC doesn’t project how much it will cost a fund management firm to implement its new requirements, but if some fund management firms’ estimates are accurate it could easily come to over US$1 million annually. “The SEC has the right idea in wanting to ensure correct valuations, but fund management firms won’t be able to systematize its requirements in a cost-effective way without further guidance,” says Fields.