Valuation Disputes: Process for Everyday Crisis

Internal analysis at a fund management shop sets the price of a non-exchange traded security at $US80 — the most recent trade price that could be found.

However, the third party evaluations provider used by the fund manager says it’s worth no more than US$60 based on projected future cash flows and taking into account the illiquid market.

What’s the “fair” value? More importantly, perhaps, how is the disagreement resolved among two or possibly even more sets of experts?

Incorrect valuations are nothing new. Neither is the need for fund managers to establish a clearcut process for resolving potential disputes. “What is new is the apparent increase in regulatory oversight and a tough economic market where they need to monitor market risk more closely,” explains Steve Engdahl, director of strategy for enterprise data management specialist GoldenSource in New York.

Pricing financial instruments is a pretty straightforward task when it comes to exchange-traded securities. They have a universally agreed-upon price which is typically based on end-of-day exchange prices.

Not so for assets which are often traded over-the-counter or ones that are traded too rarely to establish a consensus valuation. In these cases, financial firms are legally required under US  and global “fair value” accounting rules to turn to combinations of pricing models and inputs, which are vulnerable to interpretation and potential miscalculation.

Regs on Top of Regs

The US Securities and Exchange Commission has been quick to penalize asset managers for erroneous net asset values (NAVs) caused by poor valuations of specific financial instruments or holdings. The SEC has made no secret of the fact that it will be vigorously scrutinizing the valuations process. The UK’s Financial Conduct Authority hasn’t focused on valuations per se, but has called fund managers to the carpet for insufficient oversight of outsourcing contracts. Relying on a third-party for valuations falls into that category. New US accounting rules, effective in July, will also require governmental agencies to pay closer attention to the independent inputs and methodologies used by fund managers to value securities .

The regulators aren’t the only ones concerned about pricing methodology. “For asset owners, such as pension plans, endowments and foundations, the need to understand how a fund manager prices non-exchange traded securities, and how the fund manager demonstrates an independent process, is critical to their decision on whether to allocate a percentage of their assets with the fund manager,” explains David Larsen, managing director of valuation service provider Duff & Phelps in San Francisco. The reason: the asset owners have a fiduciary obligation to their constituencies to ensure their monies are handled correctly.

Of course, the word “independent” is subject to interpretation. Some fund managers keep the process entirely in-house. They rely on their own traders, portfolio managers, operations specialists and risk managers. Their process is designed to ensure that their trading desks do not have the final say, because the traders have a vested interest in valuing an asset in a particular way.

Yet other fund managers — a growing number — engage one or more of the handful of third-party pricing vendors or valuation service providers that specialize in pricing non-exchange traded securities. Fund managers want to prove to investors and regulators that the valuation has been vetted with a third-party that doesn’t benefit from its decision.

Multiple Experts

But relying on internal staff or just one third-party provider might not be enough any more. For their valuations to hold up to investor or regulator scrutiny fund managers may need a combination of several internal and several external sources; in fact, the more the better. “Too often, fund managers rely on a single pricing provider when it would be in their best interest to diversify and rely on more than one,” says Engdahl. “The word independent should be synonymous with multiple.”

Just who are those “independent” experts? They could range from an internal expert to specialists at broker-dealers, prime-brokers, fund administrators and custodians, as well as evaluation consultants such as S&P Capital IQ, Duff & Phelps, Houlihan Lokey, Thomson Reuters, Interactive Data, and Bloomberg. Fund administrators and custodians have historically rubber-stamped prices struck by fund managers and often rely on the same evaluated pricing providers as the fund managers they service. Only a few have developed their own complex pricing process. Hence, the chances for a discrepancy with the fund management firm are slim, two pricing operations specialists at US fund management shops tell FinOps Report.

Not so with third-party valuation specialists who are dedicated to coming up with the correct pricing models and inputs. The more “complex” the security or asset holding, the more likely there will be a difference of opinion between the fund management firm and the evaluations experts. And the more a fund manager attempts to establish a blame-proof independent valuation process with multiple external experts, the more differing opinions may have to be resolved.

No one contacted by FinOps wanted to provide specific cases of discrepancies or a percentage of price variances other than to say that they were common with investments in early-stage companies, alternative investments, private equity and some types of mortgage-backed and asset backed securities. Pricing analysts say that typical valuation metrics such as a multiple of earnings before interest, depreciation and amortization or discounted cash flows are hard, if not impossible, to apply to early-stage investments. Alternative investments are also difficult to value because their underlying holdings are primarily in non-traded debt and equity instruments.

It stands to reason that the higher the percentage of exotic semi-liquid or illiquid instruments held, the more likely a fund management firm will want to verify its own judgement using a third-party provider. The higher the percentage of variance between the fund manager’s price and the third-party provider’s price the more likely a price dispute or “challenge” will arise. A smaller discrepancy might also trigger a challenge if the holding were a sizable part of the fund manager’s portfolio.

Getting the Bad News

How is a fund management firm made aware of valuation discrepancies or variances? A back-office operations manager, or pricing specialist, will typically find out either by manually by comparing the prices given or through an alert from an automated system.

GoldenSource’s Engdahl says that his firm’s enterprise data management platform applies tolerance checks, vendor source hierarchies, consensus rules and other logic to come up with a final price.  “Any discrepancies are brought to the attention of the fund manager’s pricing staff as suspect prices to be further investigated, and if necessary for a price challenge to be raised with the originating price source,” he explains.

As in the case with any relationship, just how smoothly the disagreement is handled can determine how efficiently the correct price is struck, or at the very least result in an outcome in which the fund management firm and evaluations provider agree to disagree. “It is important for fund managers to set up a streamlined process for how they will generate a price internally and how they will resolve any price challenges,” says Larsen.

In fact, he  urges fund managers to try to reduce the potential for pricing discrepancies with some tough discussions with pricing service providers about what methodologies and data inputs which will be used for every asset class valued. Even so, he acknowledges there will be differences of opinion which require careful and prompt attention. The two most common reasons for such discrepancies: differences in data inputs and assumptions.

“Fund managers need to be able to ask their pricing provider how it came up with a particular price, if the price doesn’t fall within a range or if they are unsure about how a provider came up with its figure,” says Frank Dos Santos, vice president in charge of evaluated pricing services for S&P Capital IQ in New York.

Just how should that discussion take place? Lengthy face-to-face meetings might be time-prohibitive. On top of that, there is a need to document just what was disputed, the reasons why and how it was resolved. In the case of S&P Capital IQ, says Dos Santos, such communications take place through a dedicated email address for inquiries about price challenges or by phone. The interaction may include a discussion of how each side came up with its decision on a final price.

The typical result: either the fund manager will agree that the evaluated provider is correct or, even if the fund manager doesn’t agree, the provider will insist that its price is the right one. Occasionally, the evaluated provider may agree with the fund manager and go so as far as to change the data inputs it uses in the future or even its pricing models, if necessary. However, as one fund manager pricing operations director at a US investment fund tells FinOps, “more likely than not the evaluated service provider will stick to its guns and not change anything.”

Then what? “We agree to disagree and move on,” says the same pricing operations director. “Phone calls are rare and usually take place only if we are unhappy about the level of service we are receiving.” That service refers to the speed of response to the pricing challenge and the amount of information provided by the pricing analyst as to how the evaluation decision was made.

Of course, it is always best for both sides to be prepared with enough evidence to justify their respective stances. It is not in the best interest of either the fund management firm or the evaluated pricing provider to resort to fingerpointing as to who is right and who is wrong, agree fund management pricing specialists and evaluated pricing providers. The process for coming up with the answer is far too complicated and recognized as somewhat subjective.

Who should be involved on the fund management shop’s side? At most of the largest fund management firms and even hedge fund managers, the so-called valuation committees may include chief operating officers, chief financial officers, portfolio managers, trading desk specialists, and risk managers, who often sit down with product control specialists and internal price verification specialists.

Time Critical

Time is critical in some cases. A hedge fund might have several weeks to resolve a pricing challenge, but a US registered investment fund — aka a mutual fund — would only have an hour or two at most depending on when it received a price from the evaluated provider and the time it has to strike an NAV or correct an NAV before the price is published. The good news: as most mutual funds invest in exchange-traded securities or frequently traded securities, they are seldom faced with time-critical pricing challenges. Those which invest in non-exchange traded securities will need an automated decision-support system to calculate which price should be selected, explains Larsen.

Regardless of how long a fund management firm has to price a particular asset,  the longer the dispute or challenge drags on between the fund manager and the evaluated pricing provider, the more difficult the resolution may become. “There could be an unforeseen market event or external change which would also affect the price in the meantime,” explains Dos Santos, who adds that his firm updates its evaluated prices daily, whether or not a price challenge takes place.

Time management aside, documentation is critical. Fund management firms must be able to prove to regulators and investors alike that they communicated their concerns, disagreements or approvals with a third-party generated price. That requires case management, investigations workflow management and an audit trail, says Endahl. Such a process lends itself to an automated system, which in the case of GoldenSource’s software includes links to ticket numbers logged with pricing sources, emails and additional commentary. The optimal approach also incorporates analytics to detect patterns over time, enabling fund managers to have constructive discussions with pricing providers over quality levels.

Fund management firms may choose to end their relationships with evaluated pricing providers that won’t clarify their pricing methodologies and inputs, or that won’t entertain disagreements. In some cases, cost could also play a role. Likewise pricing providers may decide to “fire” a client which doesn’t pay its bills or care enough about valuations to support a rigorous process.

Coming  up with a defensible valuation for non-exchange traded and rarely traded securities is difficult by definition. The need for well-defined process doesn’t stop with the selection of pricing methodology, especially now when increased scrutiny is leading to increased likelihood of valuation disputes. Planning for everyday crisis in valuations may be a necessity that fund managers have to face.