With a six or seven figure cheque from an investor into a private fund comes the demand for transparency and periodic reporting. A common feature of this process is the aspect of how the manager has valued the underlying portfolio investments. Many fund managers view periodic valuations as an opportunity to control the messaging in terms of how they’re thinking about their investments, and showcase how they are institutionalizing their businesses and processes. What was once considered a tick-the-box exercise, the portfolio valuation process is now firmly front-and-center in the general partner-limited partner relationship.
Indian fund managers, much like their global counterparts, have upped their game in order to meet their contractual and regulatory duties as fiduciaries on the valuation aspect. Despite the mindset shift, there are still skeptics who ask: does a good portfolio valuation process matter?
The short answer is yes. The valuation process matters to both investors and regulators. It matters regardless of size, asset class, where the fund manager or its investors are located, or where the fund vehicle is in its life-cycle. The opposite also holds true: a bad valuation process pushes investors away.
In an Indian context, SEBI’s (Securities Exchange Board of India) promotion of AIFs (Alternative Investment Funds) as the preferred private vehicle of choice for pooled funds for domestic and, subsequently, international investors, is beginning to hit numbers that are hard to ignore. Data from the SEBI website shows that AIFs raised commitments of INR 1.4 trillion as of December 31, 2017, with half a trillion of it already invested. Well over a trillion of this was raised by Category I and Category II AIFs, which invest in venture capital and private equity situations.
The SEBI AIF Regulations have a separate section outlining the requirements for Category I and Category II AIFs to provide their investors a description of their procedures and methodology for valuing assets. They then specify that Category I and Category II AIFs must carry out a valuation of their investments, at least once a year subject to meeting certain criteria, and appoint an independent valuation agent for this exercise.
Add that to the fact that sophisticated institutional investors (such as limited partners), almost universally, require all investments to be reported quarterly at fair value while reporting periodic performance to their own investors or beneficiaries, determine allocations among asset classes, select managers, manage risk and compensation decisions, and ultimately exercise their own fiduciary duty.
While regulators are keen to insist on the principles of fair value, the process as well as the procedures followed to arrive at the fair value estimates remains outside their purview. As a result, the responsibility for ensuring fund managers provide reliable fair value estimates still rests largely with investors, particularly limited partners, who can reasonably be expected to carry out this level of due diligence. Pressure is increasing on limited partners that use indirect investing strategies to demonstrate that they have undertaken procedures to ensure that the valuation process for the funds rolling up to theirs is rigorous and robust. Regulators have historically been more focused on whether a fund manager follows the procedures they told their limited partners they would follow, not necessarily on the conclusion, though that is changing rapidly in regulator activism seen in the United States and Europe.
As one of the primary functions of fund managers is to create value, and often times they do not have an adequate track record history of realized investments, a good and robust valuation process helps to establish credibility with investors in the context of reporting and fund raising.
Finally, even accounting regimes have moved from a historical cost framework to being more fair value driven, to provide more transparency and comparability of the financial position and value of the underlying investments. Identifying this as a policy area, new frameworks have been rolled out globally in terms of valuation guidance, professional certifications for valuation agents and a mandatory performance framework that a fund manager should adhere to in order to satisfy auditors, along with investors and regulators.
Fund managers in India may wince at this anticipated increased scrutiny on their valuation process and conclusions, however now is the time to relook and spruce up their internal control environment.
Author- Rishi Aswani, CFA is a Director at Duff & Phelps and leads Portfolio Valuation and Secondary Market Advisory in India.