Valuations under AIFMD: A Practical Approach

3rd November 2020

Under the Alternative Investment Fund Managers Directive (“AIFMD”), the valuation function for a fund must be performed by an authorised alternative investment fund manager (“AIFM”), or an external valuer engaged by the AIFM to perform these duties. The review of valuation reports/models and the valuation policy remain the responsibility of the AIFM, and the AIFM will still ultimately be liable for the AIFs which it manages, despite the use of an external valuer

Alternative investment funds (“AIFs”) can be managed by an external legal person that has been appointed as a manager by or on behalf of the AIF, including a host AIFM where the fund sponsor is not regulated under AIFMD. An authorised host AIFM usually provides investment management functions to an AIF, namely portfolio management and risk management which are the minimum functions an AIFM must be directly responsible for (in addition to general fiduciary duties of ensuring compliance with AIFMD generally). The valuation function (along with other functions such as administration, marketing etc.) can also be undertaken by the AIFM, but is not required.[1]

Performance of the Valuation Function

The valuation function can be performed by an authorised AIFM or by a qualified external valuer.[2]

  • Authorised AIFMs must ensure that the valuation function is functionally independent from other duties that would cause a conflict of interest such as the portfolio management. Furthermore, attention must be paid to the remuneration policy to ensure it complies with AIFMD requirements not to unduly encourage risk. This is usually done by appropriate and consistent procedures and policies in accordance with AIFMD and the applicable national law.
  • In case of external valuers, the AIFM needs to ensure that the external valuer is subject to mandatory professional registration and sufficient professional guarantees. Note that the appointment of an external valuer does not affect the AIFM’s liability towards the AIF and its investors.

In practice, the valuation function in private funds is predominantly performed by authorised AIFMs instead of external valuers. In our experience, valuers do not want to be considered as external valuers under AIFMD due to increased liability towards the AIFM. Specifically, the external valuer would “be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer’s negligence or intentional failure to perform its tasks.”[3] 

Within private equity, the majority of valuations are usually based on internal models prepared by the fund sponsor as they would normally conduct the due diligence on the asset and have more in-depth knowledge to build the model rather than an external appraiser, unless the assets were more of a prosaic or fungible nature.

To be able to determine the net asset value (“NAV”) the AIFM usually obtains valuation reports or valuation models (including valuation inputs) from a qualified third party adviser. These models or reports are reviewed and vetted by the AIFM at least for every NAV calculation date. Examples for a sensible review process may include:

  • check for factual correctness of valuation inputs;
  • assess if assumptions are reasonable in the current environment;
  • assess if a valuation technique is appropriate under given circumstances;
  • check if the personnel effectively carrying out the valuation has relevant qualifications; and
  • check if other relevant factors may have occurred that may have a material effect on the valuation.

In order to ensure the AIFM can rely on a third-party adviser, satisfactory due diligence should be conducted on such an adviser. This would include checking if the third-party adviser is qualified and admitted to a professional body (if relevant for the specific asset), and if the adviser has sufficient professional guarantees.

To de-risk limited partners and general partners of a fund it is sensible that the personnel in the AIFM undertaking the valuation function are involved in the engagement process between the general partner of the AIF and a third-party adviser. The engagement process would usually include requesting proof of sufficient professional insurance cover from the third-party adviser and reviewing the engagement letter for the following items that may need to be negotiated for improved clarity: 

  • Any unusual or onerous terms in the general terms of business (and whether specific engagement overrides the general terms where incompatible);
  • whether the valuation will be prepared in accordance with a recognised international professional valuation standard, e.g. RICS Valuation - Global Standards; and
  • acknowledgment of receipt of the valuation policy for the AIF and adherence to it.

Valuation Policy

For the protection of the investor’s interest it is important to provide a reliable and objective asset valuation. To do so, the AIFM needs to ensure that appropriate and consistent procedures and policies are established for every AIF it manages. However, unlike fund sponsors who act as AIFMs, host AIFMs usually manage multiple AIFs with different strategies. Our Luxembourg based AIFM, for example, is authorised to manage private equity, real estate, infrastructure, debt and fund of funds strategies. Thus, every fund strategy requires bespoke policies in line with AIFMD and the applicable national law.

From a timing perspective we would advise to establish a valuation policy at an early stage of the on-boarding process of a fund as they can also be requested by potential investors at the time of marketing. Moreover, it is prudent to discuss internal valuation models and policies with auditors early to ensure that the auditors do not have any objections in principal to the proposed example pricing model.

It is clear then, that proper thought must go into the valuation function from the outset. Doing so reduces the risk on each party involved, and ensures there are no conflicts later down the line. For managers appointing a host AIFM, selecting a provider that can demonstrate proper asset level expertise will likely reduce the burden on the manager themselves in the long run.

Langham Hall is an award-winning provider of Fund Administration, Depositary and AIFMD services to global fund managers. To hear more about how we can help, whatever the requirements, please get in touch with a member of our team.

 

[1] See AIFMD: Annex I. The recent ESMA letter released on 19 August 2020 seeks to recommend that the AIFM should be treated as being directly responsible for these other secondary functions. However, it remains to be seen if the European Commission will incorporate those recommendations.

[2] References to the performance of the valuation function can be found in AIFMD, AIFMD Level 2 and CSSF Circular 18/698 No. 524-541.

[3] AIFMD: Article 19, No. 10. In this respect, the letter from ESMA to European Commission advising on AIFMD changes included a recommendation to add preface negligence with “gross”. If enacted, whether this change would be sufficient to entice potential valuers to be engaged as an external valuer under AIFMD remains to be seen.