Fund Middle Office 2021: Year of Fair Valuation

Middle-office accounting managers at US fund management firms will likely be talking a lot more in 2021 with C-level management,  third party valuation agents, and boards of directors to figure out  just what the terms fair and material mean when it comes to pricing non-exchange traded assets in their portfolios following the Securities and Exchange Commission’s new fair valuation requirements.

Although the idea of fair valuation has been around since the Investment Company Act of 1940, the SEC relied on valuation guidance dating back to 1969 and 1970 to explain how boards should determine fair value in good faith while carrying the legal onus. The new fair valuation rule, which scraps previous recommendations, now allows those boards to designate someone — likely the registered investment adviser– to do the valuation work on the condition it meets strict provisions for oversight.  The SEC’s final version of Rule 2(a)5 becomes effective 60 days after being published in the Federal Register and differs little from the original proposal issued for industry feedback earlier this year, as previously reported by FinOps Report (May 21, 2020: Fair or Not: Fund Managers Face SEC’s New Valuation Rule). Comments were due by July 2. Fund managers have eighteen months to comply with Rule 2(a)5 and given the potential extra work involved they and their boards of directors will likely need to spend all of 2021 getting ready.

Valuing assets is one of the core operational functions of a fund manager. Without those valuations, the fund manager’s middle office cannot strike a net asset value which determines the price at which shares are purchased or sold by investors. Fixed-income securities, over-the-counter derivatives, venture capital, and private placements will likely fall under the fair value rule which defines fair value as the price at which an asset can be sold in an orderly transaction. Fund accounting managers typically sit on valuation committees designed to find a consensus on how exotic non-exchange traded financial instruments should be priced.  Although those committees typically communicate with boards of directors about valuations on an annual basis, the SEC’s more rigorous guidelines on oversight from fund boards will force fund management firms to discuss valuations more frequently and to supply specific written reports on a quarterly and annual basis clearly articulating valuation procedures, methodologies, material changes, and results of testing. Much of the operational burden of explaining valuation procedures and monitoring testing will likely fall on the middle office with the internal audit, IT departments and third-party pricing vendors helping out.

“Most fund managers with rigorous valuation processes might not have to make too many changes to current practice but those who haven’t developed the right procedures may have a steep compliance curve,” says David Larsen, managing director of Duff & Phelps, a New York headquartered valuation service provider. Compliance managers at several US fund management firms tell FinOps Report they are planning to meet with board members early next year to review existing processes which will likely require either “minor” changes or major ones of “more than we would like to admit.” When pressed to elaborate, all executives would say is they will need more detailed documentation and more testing. “We need to convince the SEC we are following the new rule which always means writing more granular details and verification,” says one compliance manager at a US fund management shop.

Overruling some industry opposition previously reported by FinOps Report, the SEC remains adamant that fund managers should use the rules of Financial Accounting Standards Board’s ASC Topic 820 as the litmus test for fair valuation even though the provisions might not be perfect for every asset. (August 8, 2020: SEC’s Fair Value Rule: Don’t Drop Old Guidance, Say Critics). In defining fair value, ASC Topic 820 says the price is not the same as the price at which an asset was bought or the final price at which it traded. Assets must be categorized as either Level One, Level Two or Level Three, with Level One assets being the easiest to price and Level Three being the hardest. For any asset without a readily available market price, such as that traded on an exchange, Level Two or Level Three methodologies apply. Level Two assets are those for which the fund manager has to extrapolate the value based on similar assets, while assets assigned to Level Three don’t allow for any comparative analysis leaving the asset manager to make a tough subjective call. Equities typically fall under Level One, while mortgage-backed an asset-backed securities and over-the-counter derivatives fall under Levels Two or Three. Therefore, managers of some fixed-income portfolios or those investing in venture capital firms and private placements will likely have the hardest time fulfilling the SEC’s requirements. Compliance managers at some management firms who spoke with FinOps Report say that they already typically rely on Topic ASC 820 for most assets, with a few exceptions. They would not elaborate on which ones or how many were involved, but note that making alterations for even a few assets would be cumbersome.

Although fund management firms typically document their valuation methodologies, they will likely need to be more detailed and expand their procedures for assets which are valued using Level Two and Level Three inputs. The historic practice of using broker quotes or pricing services may not be sufficient without more extensive testing, support and transparency. “The fund manager might need to explain why it selected a particular pricing vendor, how it monitors the pricing vendor, and its process for challenging the valuations the vendor makes,” says Rachael Schwartz, an attorney specializing in investment management firms with Sullivan & Worcester in New York. The valuation designee– typically the fund manager — will also have to tap a point person on valuation to help draft the annual summary of the methodologies and inputs used as well as quarterly reports outlining any material changes to methodologies and inputs. Any mistakes in valuation will need to be reported to the board within five days, instead of the initially proposed three. The SEC never specifies just who the fund manager should select as the point person for valuation, but does suggest that it can’t be the portfolio manager due to a potential conflict of interest. The valuation of assets ultimately affects performance results, which can make or break a portfolio manager’s compensation. The fund management firm will likely pick someone from the fund accounting department who has the most experience with valuations and the most interactions with board members.

The chief valuation officer or anyone else designated with owning the valuation process will ultimately have to figure out the extent of testing that needs to be done and help define what constitutes a material change with the board of directors. “Both the board of directors and the investment adviser are likely to require third party assistance in testing their fair value process and conclusions to ensure independence,” says Larsen whose firm is one of a handful of valuation service providers; others include Houlihan & Lockey, Thomson Reuters, and S&P Capital IQ. The cost could range anywhere from a few thousand dollars to hundreds of thousands of dollars annually depending on the amount of work the third party has to do which relates to the number of assets that must be tested and their complexity. Dozens of similar assets won’t be that hard to tackle, but a few widely different ones will. “The testing can range from simply confirming that the valuation conclusions of the investment adviser are reasonable all the way to repricing the assets to determine how far off the third-party price the investment adviser is,” says Larsen. The more extensive the testing the less likely the SEC is to find fault with the fund management firm, according to compliance experts.

As ultimately responsible for fair value conclusions, boards of directors will need to create a process to deal with valuations when they disagree with the decisions of investment advisers or third party valuation  firms. As a rule of thumb, the more illiquid an asset the larger the discrepancy between a fund manager’s valuation and a third party valuation firm because of possible differences in methodologies and inputs. “In the vast majority of cases, consensus can be reached when common facts are understood and applied,” says Larsen. “The frequency and extent of testing will be a judgement call reached with the board.” Market volatility, as experienced during the COVID-19 pandemic could play a role. “Depending on the type of asset and market conditions, there could be more testing,” says Schwartz. She adds that during the height of the pandemic in the spring, many of her fund management clients likely did more testing as liquidity dried and prices became more sporadic for some asset classes.

 

The importance of a strong oversight process for overseeing third-party pricing vendors became evident as soon as the ink was dry on the SEC’s new fair value rule. As FinOps Report went to press, the SEC said it had fined ICE Data Pricing & Reference Data LLC, a subsidiary of Interactive Data Corp. US$8 million for relying on single broker quotes in valuing complex fixed-income securities from at least 2015 until September 2020. The SEC says that the firm, a registered investment adviser, never determined whether the quotes it used actually reflected the true prices and continued to report stale prices without  looking into quotes from other sources. “As large pricing services have become an oligopoly and industry utility they should be held to commensurate level of accountability,” writes Todd Cipperman, managing principal of Cipperman Compliance Services, a Wayne, Pennsyvania-based regulatory compliance consultancy specializing in investment management firms. “If you [as fund managers] don’t use a pricing service, consider the SEC’s allegations in this case as guidance for how to create a valuation process,” he adds in a recent blog.

 

Chief valuation officers or other assigned fund management officials will have to discuss with boards of directors how far the third-party prices deviate from the fund managers’ own processes, whether  any changes in methodology have to be made and whether those changes ae significant enough to be reported.  Much to the dismay of some fund managers, the SEC never defines the term material, instead suggesting that fund management firms will know what is material when they see it. “Changes in pricing vendors or oversight of pricing vendors, changes in personnel responsible for valuations, and changes in methodologies after testing will likely fall under the category of material,” says Schwartz. So will errors in valuations that had to be corrected. Every other instance is subject to interpretation which could turn into a heated difference of opinion between boards of directors and fund management firms. Boards of directors might want more tighter parameters to protect themselves from liability while fund management firms might ask for more leeway to reduce the amount and frequency of reporting.

 

For boards of directors, the SEC’s new fair valuation rule could bring a sigh of relief in reducing liability when following the new oversight procedures. However, for registered investment advisers, the term fair could become a four-letter word if they aren’t sufficiently prepared. The SEC will likely want more information on the methodologies and proof they are effective, based on more frequent and extensive testing. The costs of the extra work, which could either come out of the pockets of fund managers or investors, could reach $600,000 at most per fund, by the SEC’s estimate. However, that amount is an initial expense and doesn’t take into account ongoing costs related to continual testing and administrative work. “There could be higher compliance costs related to more detailed documentation and frequent reporting,” says Schwartz.  Whether all of the costs and stress pay off remains to be seen. The consensus among middle office operations executives at fund management firms who spoke with FinOps Report is that the new rule is a big win for board of directors at their expense.