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News May 4, 2015 Issue

Valuation: What Examiners Want to Know

Examiners follow the money.

Valuation is where the money starts. After all, valuation "impacts performance, which impacts marketing, which impacts how assets under management grow, which impacts fees," said Mayer Brown partner Rory Cohen. In short, it involves issues of investor fairness and conflicts of interest – both major red flags to SEC examiners.

Private funds in particular need to be concerned about examiner inquiries into valuation, said Zaccaro Morgan partner Nicolas Morgan. Hedge fund managers, for instance, have part of their compensation tied to the value of their portfolio. Private equity fund managers may want the NAV of their funds to be as high as possible when raising additional capital.

The agency’s Asset Management Unit in the Division of Enforcement focuses on hedge fund activities, with its Aberrational Performance Inquiry zeroing in on improbable returns from hedge funds. The unit has brought a number of cases in recent years. Improper valuation may be a contributing factor when it finds such returns, said Morgan.

Expect examiners to ask these questions:

  • Does your firm have an independent process designed to derive a fair value? "Your firm should consider having a formal process for valuation," said Morgan, and it should be spelled out in your firm’s policies and procedures. Valuation of particular securities may change over a quarter because of market circumstances or other reasons. Your firm should revaluate at least often enough to match a private fund’s publication of its performance results with the timing of subscriptions and withdrawals, which often will mean monthly.
  • Does your firm’s actual valuation process follow its policies and procedures? This goes to the heart of examiners determining if what your firm says it is doing is, in fact, what it is doing, said Cohen. You don’t want your firm’s policies and procedures stating that it is following methodology A when, in practice, it is following methodology B. Morgan suggested that a two-column chart comparing and contrasting how your firm is matching its policies and procedures in this regard would be helpful, with one column showing the particulars of your firm’s stated valuation methodology and the other showing the actual practice.
  • Are there any conflicts of interest that may impede fair valuation? These typically involve compensation or performance issues, said Cohen. For instance, a conflict of interest would exist if a portfolio manager participated or otherwise had influence on the valuation committee, because he or she has a direct interest in the valuation. The existence of such conflicts of interest may warrant disclosure to the full committee, investors and potential investors, Morgan said. It can be mitigated by making sure there are enough other committee members who would not so benefit, thereby ensuring that committee members with the conflict could not, by themselves, make a final valuation decision.
  • How does your firm valuate illiquid assets? Assets that are not liquid, such as mortgage backed securities or collateralized debt obligations, are particularly difficult to value because, Morgan said, unlike liquid securities, a firm cannot simply check what an illiquid security was last publicly traded for. Determining a fair value in such cases will require research into the company issuing the illiquid security; broker quotes, if available; and more. Make sure you have documentation showing the steps you took to properly value such assets.
  • Do your firm’s disclosures to investors accurately describe the valuation process? Expect examiners to scrutinize your Forms ADV, offering documents, limited partnership agreements and operating agreements to see if there is adequate disclosure. Any conflict of interest, such as a compensatory one, should be evaluated for possible disclosure, said Morgan. "The SEC will almost always view more disclosure more favorably than less disclosure."
  • Is your firm’s valuation process monitored and updated? Examiners do not want to see a static, never-changing valuation process that doesn’t take market shifts or better valuation techniques into account. You should be able to demonstrate to examiners that your firm’s valuation process is regularly reviewed and, when necessary, updated, Morgan said. Cohen suggested that one good way to do this is by periodically testing your valuation processes, checking everything from whether calculations were correct to whether your policies and procedures were followed (see above). "Sit in on valuation committee meetings, pay attention to detail, evaluate efforts to override or seek exceptions, determine whether similar securities are valued in a similar manner, and seek to identify stale pricing," he suggested.
  • Is your firm getting "binding marks" or "indicative marks" when getting quotes from brokers? Firms often seek multiple broker quotes when pricing illiquid assets, said Cohen. Make sure those marks are true estimates of an asset’s worth, and not just initial suggestions used to start the conversation to help determine the value ballpark. In weighing the value of quotes, place greater value on binding marks and those that may reflect actual market transactions, he said, adding that you should "be consistent in selecting brokers for quotes." SEC Asset Management Unit co-chief Julie Riewe, in a February 26 speech, noted that "friendly broker marks" were an upcoming agency target.
  • Is your firm using a third-party valuation service? Using qualified independent third-party valuation firms for illiquid and hard-to-value securities would be "seen as a good thing" in the eyes of examiners, said Cohen. But that does not mean that firms not using an independent third-party service will necessarily run into trouble, he said.