a valuation road map for fund executives...a valuation road map for fund executives the art and...

A Valuation Road Mapfor Fund Executives

The Art and Science Explained

By Deirdre O’Connor, FCMA, CGMA and Cindy Ma, Ph.D., CFA

Opening Remarks 2

Valuation Governance 3

Internal Process Controls 8

Value Determination 9

Reporting and Documentation Process 18

Firm Resources 19

Concluding Remarks 20

Biographies 21

2

OPENING REMARKS

Today, alternative asset managers are facing ever-increasing scrutiny from both investors and regulatory bodies.

Investors are focused not only on returns, but also on the valuation governance practices of the funds in which

they may invest. The emphasis on transparency of the valuation process, as well as heightened interest around

internal controls, confl icts of interest, and general fund protocols, has increased the importance of funds having

written valuation policies and procedures with a structure in place to monitor and enforce them.

Recent cases involving the Securities and Exchange Commission (SEC) and alternative investment managers

have put the spotlight on these issues. In a May 2016 article published by the Wall Street Journal, former

SEC enforcement director Andrew Ceresney was quoted as stating that the SEC was looking for “all types of

misconduct by hedge fund managers,” and that “valuation is one of the core issues.”1

It is paramount that fund managers are transparent with the investment community. Managers must ensure

that valuation methodologies are consistently and fairly applied across their investments. After all, valuation is

considered an art and a science, and regulators want to see the science behind it.

It is in this context that we bring this procedural guide on effective valuation governance to the fund management

community. There have been other guides widely referenced by the investment community that have provided

parameters for a general framework.2

However, our hope is that this guide will provide practical solutions that

bridge overarching principles with daily operating protocols in the areas of valuation governance, valuation

controls, valuation methodologies, and transparency on an institutional basis.

The valuation governance procedures discussed herein are intended to be used in conjunction with fair value

reporting requirements of investments in accordance with the applicable Accounting Standards Convention 820

(ASC 820) under U.S. generally accepted accounting principles (GAAP) or International Financial Reporting

Standards 13 (IFRS 13) under international accounting standards.

Deirdre O’Connor, FCMA, CGMAManaging Director

Global Asset Management Firm

Cindy Ma, Ph.D., CFAManaging Director

Global Head of Portfolio Valuation & Fund Advisory Services

Houlihan Lokey

The authors would like to express gratitude for the invaluable contributions made by Rittik Chakrabarti, Randy Drury, Hugh Nelson, and Susanna O’Brien of

Houlihan Lokey.

1 Rob Copeland and Aruna Viswanatha, “Wall Street Cops to Hedge Funds: Treat Investors Better,” Wall Street Journal, May 9, 2016, accessed April 2017,

https://www.wsj.com/articles/hedge-funds-treatment-of-investors-gets-new-scrutiny-1462808155.

2 See, for example, Alternative Investment Management Association, Guide to Sound Practices For Hedge Fund Valuation, October 2013.

April 2017

3

In the U.S., a majority of funds are set up as either partnerships or limited liability companies. A governing body (the

Governing Body) generally supervises the conduct of the fund’s affairs. Depending on a fund’s structure and jurisdiction,

the Governing Body may be a board of directors, general partner (GP), managing member, or trustee.

A Governing Body for the fund typically delegates authority to a valuation committee (the VC) to create and maintain

sound valuation policy and procedures (the Valuation Policy) and enforce segregation of duties.

In this framework, policies and procedures ensure consistent and unbiased application of valuation methodologies,

and provide support to maximize the utility of limited fi rm resources. Stakeholders (e.g., investors, regulators, and

auditors) expect a best-in-class comprehensive valuation process and robust governance procedures. As such, key

controls around the process should be documented, independently audited, and approved by senior fund management

personnel.

Given our collective experience with the preparation and implementation of valuation policies and procedures, we will

provide insights into these areas throughout this guide.

VALUATION GOVERNANCE

There should be a consistent process

for making the periodic independent fair

value determination for each security

based on the fair value hierarchy,

asset class, and investment type, in

compliance with policy.

There should be comprehensive reporting

and documentation transparency

protocols as they relate to internal process

controls, value determination, and

information provided to the Governing

Body for key decision making.

There should be

continuous enhancement

of fi rm resources, with

a focus on personnel,

technology, and third-

party valuation advisors.

Internal Process Controls

Value Determination

Reporting & Documentation Transparency

Firm Resources

The implementation of internal

process controls, including those

related to valuation, compliance,

and audit procedures, is a critical

component of the framework.

4

Fund Manager Ecosystem

Components of Framework

Valuation Committee

Internal Audit &

Compliance Middle Offi ce/Operations Functions

Accounting/Finance/

Independent Price Verifi cation Group

Front-Offi ce/Investment Team

Regardless of the fund structure, a sound governance framework is led by the Governing Body and

includes the following key components: (i) a formal VC, (ii) well-documented valuation policies and procedures,

and (iii) segregation of duties, whereby the ultimate investment valuation oversight should be independent from

the fund’s investment process.

Although the Governing Body is ultimately responsible for the fair

value hierarchy, current best practice is to (i) utilize an external

fund administrator who implements the hierarchy and (ii)

delegate oversight of the valuation process to the VC. Decisions

related to the valuation process and fair value hierarchy should

not be subject to undue infl uence by the front offi ce and/or

those making investment decisions. Valuation responsibilities

fall within the middle offi ce or accounting groups, and some

larger fi rms have created valuation teams within the accounting

groups. Middle Offi ce/Operations generally prices the portfolio

daily in compliance with the Valuation Policy, and the

Accounting/Finance Group generally performs a full revaluation

monthly or quarterly for closed-end funds.

Valuation

Committee

Segregation of

Duties

Valuation

Policy

GOVERNING

BODY

(i) Valuation Committee

When the Governing Body delegates oversight of the valuation process to the VC, the VC may be structured

as a subcommittee of the Governing Body or a separate committee. The VC is one avenue used to mitigate

potential confl icts of interest that may occur when the investment manager is also the GP or managing member

of the fund. The VC typically has authority over the implementation of the fund’s Valuation Policy and should be

diligent in the exercise of its oversight duties.

The fund manager ecosystem typically requires collaboration across the following functions. As such, a sound

valuation framework needs to consider an effi cient fl ow of information and interaction across these functions.

5

From a fair value perspective, the VC is typically responsible for (i) reviewing valuation results and exceptions,

including month-end valuations; (ii) month-end fi ndings of the independent price verifi cation process, including

the documentation of subjective inputs, variances between internal and external conclusions, resolution of any

valuation challenges, and any reporting errors or policy exceptions; and (iii) changes to the established pricing

source hierarchy established by security type.

Ultimately, the VC is responsible for the fair value determination of each security, including illiquid and hard-to-

value securities. The diagram below outlines key characteristics of a best-in-class VC:

VC Meetings

Representation

Committee Charter

• VC members typically include the Chief Financial Offi cer, Chief Operating Offi cer,

Chief Compliance Offi cer, Chief Legal Offi cer, and Valuation Controller.

• The VC should understand the totality of the fund’s business,

including the range and complexity of investments and contractual terms of

governing fund documents.

• Investment professionals may, and often do, contribute to the valuation of

Level 3 securities and participate in VC meetings to the extent their knowledge

and experience related to the investments will be benefi cial to the VC; however, value

determination authority rests solely with the VC.

• Internal audit personnel will generally participate as observers in regularly scheduled

VC meetings, while external auditors should generally observe VC meetings twice a year.

• The VC should meet prior to the publication of the fund’s net asset value (NAV),

which is typically on a monthly or quarterly basis.

• Members of the VC should have suffi cient time (e.g., at least 48 hours) to review the

materials to be discussed.

• Minutes should be taken by a designated member of the VC. All key control areas of the

valuation process should be discussed at the meeting and documented in the minutes,

including any exceptions to the Valuation Policy.

• In addition to the regular meetings, the VC should meet at least annually to review, test,

and approve changes to the Valuation Policy.

• A charter governing the VC should be established and maintained by the

compliance department.

• A quorum of the VC should be established and documented

at each VC meeting.

• Representation on the VC and procedures on how members are nominated

to the VC should be properly documented.

6

(ii) Valuation Policy

Key elements of a sound Valuation Policy include

• Description of the role of each party in the valuation process, including who is responsible for

oversight of the policy

• Identifi cation of valuation sources for each type of security expected to be held by the fund for daily

pricing where possible, and monthly verifi cation

• An outline of the basis of classifi cation of the various asset classes with the ASC 820 fair value hierarchy

• Description of the process and price observability for determining when securities should be placed

in side pockets

• Specifi cation of the procedures for escalation or resolution of confl icts and exceptions

• An outline of the process and procedures for handling and documenting price overrides, including

a review of price overrides by the Price Verifi cation Group (defi ned hereinafter)

• Listing of key controls relied upon

(iii) Segregation of Duties

The appropriate level of segregation of duties will vary across funds based on a number of factors, including the

nature of any related potential confl icts of interest (e.g., the use of performance-based fees tied to the value of

the portfolio) and the complexity and discretion inherent in the valuation process. However, the fund manager

should aim to develop a system that is capable of valuing the portfolio daily (where possible) and that leverages

high-quality vendors to generate independent fair value indications for portfolio securities.

In addition, to further enable the segregation of duties within the organization, it is prudent for the Governing

Body to establish an independent price verifi cation group (the “Price Verifi cation Group”). The Price Verifi cation

Group may reside in either operations or controller functions, but should always be independent of the fund’s

investment professionals.

The other functions necessary are compliance, an external fund administrator, an internal audit team, and middle offi ce.

7

PRICE VERIFICATION GROUP responsibilities should include:

The roles and responsibilities of each of the groups are described below.

• Ensuring appropriate documentation and VC

reporting is maintained and that decisions are

documented, discussed, and approved by the VC

• Reviewing price overrides and associated

documentation

• Monitoring the reporting and resolution of errors

and policy exceptions for the VC

• Conducting periodic due diligence on vendors

• Overseeing the collection of daily pricing data

• Opining on valuation methodology

• Assisting in the development of valuation/pricing

hierarchy and policy, which maps products to

approved pricing sources

• Revaluing the portfolio independently on a

regular basis (e.g., at the end of the month) in

accordance with the policy

COMPLIANCE should be

represented on the VC and

should test and assess

whether the valuation process

is in compliance with the fund’s

Valuation Policy document.

MIDDLE OFFICE should generally

oversee the process of obtaining

prices from vendors in

accordance with the policy

and monitor daily P&L

to ensure position-level

P&L is appropriate

given market movements.

Price Verifi cationGroup

ComplianceFund

Administrator

MiddleOffi ce

InternalAudit

INTERNAL AUDIT should perform

an independent audit of the valuation

governance process throughout the year,

including:

• Observing and participating in

each VC meeting

• Evaluating the quality of documentation

related to key controls, including

technology controls

• Assessing whether the fund’s Valuation

Policy was appropriately applied in the

valuation process

FUND ADMINISTRATORshould obtain:

• Vendor prices in compliance

with investment manager-

prescribed pricing hierarchy

• Broker quotes directly

from brokers and leverage

them in accordance with

the policy

• Level 3 valuations from

independent, third-party

valuation advisors

8

INTERNAL PROCESS CONTROLS

Consistency is a key element of a robust valuation governance process. Below is a framework for establishing

internal process controls that ensure both the process and the results are consistent and in accordance with

applicable accounting guidelines.

V A L U AT I O N G O V E R N A N C E


Value Determination

Reporting & Documentation

Firm Resources

Broker Quote Process

• The broker quote aggregation process should be appropriately documented.

• Broker quote challenges should be documented, reason coded, and centrally stored.

• The VC report should include the number of quotes per source to assess market depth.

Vendor DueDiligence

• Comprehensive market data vendor due diligence should be performed with best practice

mandates in mind.

• In-person due diligence is recommended.

IndependentMonthly PriceVerifi cation

• Obtain independent prices from vendors for Level 1 & 2 securities and monitor variance.

• Obtain counterparty quotes for derivatives while vetting if the counterparty is also the

originator and if it is also fi nancing the fund’s position.

• Broker quotes for hard-to-value assets should be obtained directly from the pricing source

independently of the investment professionals.

• All pricing sources must be documented, and methodologies for price derivation must be

transparent, supported, and approved.

• Variance to prices generated by the external fund administrator should be monitored.

Back-Testing

• A sample of investments should be back-tested periodically to ensure that, historically,

estimates of fair value are consistent with trading activity.

• The sample should be established by the VC, and technology should be leveraged to

screen the appropriate population based on materiality.

• Results should be reported to the VC.

• Back-testing is a particularly effective control for Level 2 & 3 securities to the extent

meaningful trade data is available.

Stale Pricing

• All prices should be checked periodically to ensure they are not stale.

• Tolerance for number of days stale should be established based on asset class-specifi c

market liquidity.

• Stale pricing policy, thresholds, documentation, and VC reporting should be instituted.

Confl icts ofInterest

• Confl icts of interest in the valuation process are typically best managed by the

appointment of an independent and competent third-party valuation advisor.

• If the investment manager is responsible for valuation and/or governance, robust controls

over confl icts of interest should be established.

Escalation Process• A process should be established for escalation and reporting to VC with regard to:

deviations from the Valuation Policy, gaps in available pricing sources over time, changes

in methodology by investment type, price overrides, and identifi ed errors.

P&L Report• Reported values impacting the P&L should be reviewed for consistency with current

market conditions (e.g., immaterial P&L movement in a volatile market environment).

9

VALUE DETERMINATIONASC 820 and IFRS 13 both establish a three-level fair value hierarchy to classify fund investments. Increased

regulatory scrutiny has resulted in an emphasis on the reliability of available pricing data as part of the hierarchy

determination process. The fair value hierarchy decision process should be dynamic and refl ective of the current

market environment. Particularly in dislocated market conditions, it is not uncommon for securities to shift in

level classifi cation.

Attributes of each level of the fair value hierarchy are as follows:

Level

1

Level

2

Level

3

• Unadjusted quoted prices in active markets for identical assets

and liabilities

• Quoted prices for similar assets/liabilities in active markets

• Quoted prices for identical or similar assets/liabilities in markets that

are not active

• The use of inputs (other than Level 1 inputs) that are directly or

indirectly observable

• Unobservable inputs, which represent the entity’s own subjective

determinations regarding inputs and assumptions that market

participants would use in valuing the subject security



Value Determination


Firm Resources

10

Decision-Making ProcessThe chart below outlines questions fund management should ask when developing a valuation process, including

when it may be appropriate to partner with a third-party valuation advisor:L

EV

EL

3L

EV

EL

1L

EV

EL

2

YES

YES

NO

NO

Are observable

pricing data and/or

inputs available?

Is the security

deemed to be

actively traded?

Does your fi rm

have an internal

valuation group

that can perform

and document the

valuation?

Use vendor pricing

if the quality of vendor

quotes is appropriate Assess quality of

quotes (e.g., bid/ask

spread, position size,

number of quotes,

liquidity score, etc.)

Document

subjective decisions,

including rejection of or

challenging of quotes

Collect broker

quotes using

controlled, transparent

process independent

from investment team

Consider partnering with a

third-party valuation advisor

for positive assurance

(confi rming reasonableness

of internal valuation)

Consider partnering with a

third-party valuation advisor for an

independent valuation to obtain a

fully outsourced range of value

Any widely accepted,

non-proprietary model

utilized must use

observable inputs and

be independently

tested

Use public price

with no adjustments

Partner with a third-

party valuation advisor

to assist in providing

comfort around pricing

(as applicable)

YES

NO


InternalProcessControls

Value Determination


FirmResources

11

Valuation Process for Level 1 & 2 SecuritiesAs part of the process to categorize securities as Level 1 or 2, a fund should consider instituting the

following protocols:

Use of Pricing

Hierarchy

Use of Independent

Vendors

Use of Valuation Models

Security

Common Stock

Corporate Bonds

Fair Value Primary Other Multi-Vendor Price Methodology per Primary Pricing SourceHierarchy Source Sources Tolerance

Level 1 Reuters Bloomberg 1.001%

Level 2 Broker IDC 2%

quote Reuters

Markit

Bloomberg

• Last traded price on T (i.e., the valuation date)

• If last traded price on T is unavailable, take bid

price on T if long or ask price on T if short

• If no bid/ask price on T is available, take last

traded price within T-5

• If no last traded price within T-5, take bid price

within T-5 if long or ask price within T-5 if short

• If no traded price or bid/ask within T-5, alert for

stale pricing review

Sample line items from a pricing hierarchy for illustrative purposes are as follows:



Value Determination

Reporting &Documentation

FirmResources

• A hierarchy should be established for each asset class. The hierarchy should state the relevant priority valuation sources approved by the VC.

• The hierarchy should specify valuation variance tolerance by asset class based on the fund manager’s value compared to any valuation provided by the Price Verifi cation Group.

Tolerance should be reviewed at least annually by the VC.

• Quality of vendor quotes should be continually assessed.

• Quality or liquidity score should be understood and assessed.

• The fund should perform comprehensive testing, back-testing, and ongoing due diligence

of market pricing data for each asset class and vendor.

• Price cleansing performed by independent vendors is an important control for handling

perceived outliers in the data. The VC should have a clear understanding of the price

cleansing process used by each vendor in order to have confi dence in the data.

• If valuation models are used, the Valuation Policy should specify the following:

• The approvals needed to use a valuation model, properly justifi ed by appropriate

testing.

• The process to approve valuation models based on back-testing and documentation.

• Monitoring and verifi cation procedures for model-based values against observed

market prices if available.

• A process that outlines the governance mechanism for manual overrides of model

inputs or results, including approvals obtained, documentation prepared, and

evidence of reporting to the fund’s Governing Body or its VC.

• If valuation models or any other valuation methods are not based solely on market quotes

for actively traded securities, the VC’s review should include engaging a third-party

valuation advisor to review a selected sample of valuation models and testing the results

against the available current market color.

• Mean of bid/ask on T

• If bid/ask on T is unavailable, take last traded

price within T-5

• If no traded price within T-5, take mean of bid

ask within T-5

12

Valuation and Documentation for Level 2 Securities

Broker quotes may be considered when valuing the less liquid portion of a fund’s portfolio. The chart below outlines

a framework for the collection, assessment, and selection of data in connection with a fair value process for Level 2

securities, along with a process to handle valuation challenges when there are disagreements among the parties.

COLLECTION SELECTIONASSESSMENT CHALLENGES

Develop and document

a process that is

controlled, transparent,

consistent, and

repeatable

Conduct review of the

process through the

Price Verifi cation Group/

Accounting/Finance

Ensure the Price

Verifi cation Group/

Accounting/Finance is

on the distribution list

used by the brokers who

send quotes, ensuring

independence from the

investment manager.

Evaluate use of parsing

technology for available

broker quotes and

market color.

Assess the quality of the

quote (e.g., the bid/ask

spread, position size,

etc.)

ASC 820 classifi cation

largely depends on level

of price transparency.

VC should have a solid

and repeatable process

around price cleansing

(e.g., calculating average,

outliers, number of

quotes)

Document and receive

VC approval for the

process around using

external quotes (or a

combination of quotes).

Leverage technology

applications to effectively

manage the process

of sourcing vendor

and broker quotes to

ensure policies are in

compliance.

The VC should govern

the quote selection

process and require

reporting of trends (e.g.,

broker consistently

rejected, outlier prices

rejected, etc.)

Funds will need more

substantiation for

fair values as a result

of recent regulatory

developments, which

may require the

expertise of a third-party

valuation advisor

Maintain consistency

in use of brokers and

document any departure

from defi ned set of

brokers.

Investment professionals

may need to challenge

brokers in certain

situations. Key controls

around the process

should be required,

approved by the VC,

and documented

Develop polices to

govern when challenges

can be made and note

level of substantiation

required

Maintain governance

around the supporting

information provided

for the challenge

(e.g., proof of trades

at certain levels).

Challenges with

associated reason codes

and substantiation need

to be held centrally

and robust enough for

intense audit from various

stakeholders.

In the absence of

broker quotes, use of

alternative techniques

should be documented,

back-tested, and

approved by the VC.



Value Determination


FirmResources

13

Valuation and Documentation for Level 3 Securities

If a fund’s investments are highly illiquid, best practice suggests the use of a third-party valuation advisor to either

supplement or complement the fund’s internal valuation work. The documentation and internal controls related to

any illiquid, hard-to-value securities will assist in enhancing fair value reporting and determination of the fund’s net

asset value. The fl ow chart below outlines a summary of internal controls for Level 3 securities.



Value Determination


FirmResources

Consider recent transactions involving

the same security or others within the

same portfolio company

Estimate weightings for each

methodology and document rationale

Document methodology and

all inputs with sound rationale

Select appropriate methodology

at each valuation date

(refer to next page)

Document level of, and rationale

behind, changes to inputs,

assumptions, and weightings

Select appropriate inputs for each

valuation methodology (e.g., discount

rate, multiples, etc.)

Prepare appropriate reporting

package with these elements

for the VC (refer to next section)

Document and communicate to VC any discounts

and/or subjective valuation parameters

Consider calibration of selected

inputs to the relevant transaction or

reference date (refer to next page)

Note the use of stale data

and when documents should

become available in the future

Confi rm receipt of all

relevant legal documents

at underwriting

1

Confi rm receipt and

maintenance of periodic

quantitative and qualitative

updates on the investment

3

Consider what is known or

knowable as of each valuation

date for incorporation into

the model

5

6

8

Compare inputs and assumptions for

consistency with historical results and

current market conditions

10

Evaluate the need for

valuation adjustments for

liquidity, credit risk, or

other asset-specifi c risk

11

12

13

14

15

16

Check all terms utilized in

valuation model against

governing documents

4

7

9

2

14

Selection of Appropriate Methodology

In estimating the fair value of a Level 3 security, the fi rst step generally involves deriving the business total

enterprise value of the subject company. There are three commonly accepted approaches to estimate enterprise

value: the market approach, the income approach, and the asset-based approach. Once the enterprise value has

been ascertained, the fair value of the subject security can be estimated using the valuation framework below.

Unobservable Inputs – Calibration

Given that the fair value estimation of a Level 3 security relies on the use of unobservable inputs, strong

emphasis is placed on the process employed to support these inputs. A key consideration to ensure consistent

development and use of these inputs is the process of calibration when possible.

Calibration refers to estimating the implied value of unobservable Level 3 inputs (e.g., discount rates or market

multiples) by equating the model value to the latest arm’s-length transaction involving the subject security.

Such transactions may include the primary market transaction or sales/purchases of the subject security in the

secondary market.

Business Total Enterprise Value

Market Approach Income Approach Asset-Based Approach

Debt

Non-Performing

Net

Recovery

Approach

Option

Pricing

Model

Waterfall

Approach

Waterfall

Approach

Liquidation

Analysis

Equity

Allocation

Model

Yield

Analysis

Yield

Analysis

Warrants/OptionsPerformingCommon and

Preferred Equity

Equity

Reference Date

Valuation Date



Value Determination


FirmResources

SE

CU

RIT

Y L

EV

EL A

NA

LYS

ISE

NT

ER

PR

ISE

LE

VE

L A

NA

LYS

IS

• The calibration process begins by

estimating the value of the inputs

(e.g., discount rate or market

multiple) at the transaction date

based on the consideration paid

and the associated investment

metric at the time of the transaction

(e.g., projected cash fl ows

or trailing EBITDA).

• This estimation represents a

measurement of the return that a

market participant required in order

to make the investment as of the

reference date.

• At each subsequent valuation date,

adjustments to the implied inputs may

then be considered based on changes

in market factors (e.g., expansion

in spreads of selected guideline

indices or guideline public company

multiples) and issuer-specifi c factors

(e.g., decline in leverage or changes

in company outlook or performance).

15

Level 3 Securities Typically Valued by a Third-Party Valuation Advisor

While Level 3 securities typically make up a smaller portion of a fund’s assets under management (relative

to Level 1 and 2 securities), discussions about Level 3 securities often consume a disproportionate amount

of time during a VC meeting.

Although third-party valuations have historically centered on Level 3 securities, asset managers are

increasingly using third-party valuation advisors to provide comfort around the fair value estimates of

Level 2 securities. In some situations, such a review may result in a reclassifi cation of a Level 2 security

to a Level 3 security.

Listed below are certain types of securities typically valued by third-party valuation advisors.

• Private equity investments

• Preferred stock

• Leveraged loans

− Subordinated mezzanine debt

− Secured/unsecured debt

− Unitranche/other

• PIPEs

• Real estate investments

• Joint venture investments

• Hybrid securities

• Non-performing loan pools

• Marketplace lending

• Mortgage servicing rights

• Equity derivatives

• Interest rate derivatives

• Credit derivatives

• Mortgage derivatives

• Commodity derivatives

• Currency derivatives

• Residential mortgage-backed securities

− Agency, non-agency (subprime,

Alt-A, option ARMs, second liens,

and jumbos)

• Commercial mortgage-backed securities

• Asset-backed securities

− Autos, credit cards,

student loans

• Collateralized debt obligations

(CDOs)

− ABS CDO, CRE CDO,

trust preferred CDO

• Collateralized loan obligations

• Convertible bonds

• Stock options and warrants

• Revenue share agreements

• Litigation claims/rights

• Trade claims and bankruptcy claims

• GP minority equity stakes

• Carried Interest

• E&P/mineral rights

Typical Illiquid

Securities

Corporate Derivatives

Structured Products

Bespoke Products

Over-the-Counter

Derivatives



Value Determination


FirmResources

16

Criteria for Selection of a Third-Party Valuation Advisor

When selecting a third-party valuation advisor, an investment manager should assess the breadth, depth, and

range of other services offered by the advisor in addition to their valuation credentials. Partnering with an

advisor that can deliver market-leading expertise throughout the lifecycle of investments (e.g., pre-transaction

diligence, post-acquisition monitoring, and monetization) creates meaningful effi ciencies for the investment

management fi rm, not the least of which are time and cost savings. This type of partnership may also ensure

a deep understanding of each investment and generate value for the investment management fi rm, whether

it is in the context of valuation services, mergers and acquisitions, capital markets, fi nancial restructuring,

transaction advisory, or strategic consulting.

In addition, both investors and investment managers can benefi t from the added comfort in knowing that the

valuation advice and market color provided by the valuation advisor is best in class and that the advisor is

capable of handling esoteric valuation challenges.

Deliverable• Will the deliverable include all

major input assumptions used to

generate the fair value?

• What is viewed to be an

acceptable range of values for a

valuation conclusion?

Confl icts of Interest• How are possible confl icts of

interest managed?

• How is our confi dential information

managed in the context of your

fi rm’s other service lines?

• How do you handle material,

nonpublic information from your

clients?

Breadth of Firm Offerings• What is the total value of

investments valued by your fi rm?

• Does your fi rm understand the

nuances of the industries and

asset classes in which we invest?

• Does your fi rm have a capital

markets or corporate fi nance

group that provides real-time

insight into the market?

• Does your fi rm have both a

domestic and international

presence to meet our global

investment strategy?

• Does your fi rm have the capacity

to handle growth in our fund size

and number of investments?

Technical Experience• What specifi c experience does

your fi rm have in evaluating the

types of securities we currently

hold as well as those in which we

may invest in the future?

• What is the depth and breadth

of the valuation inputs used

in deriving your valuation

conclusions?

• What are the specifi c internal or

external sources of information you

will be using?

Engagement Teams • What is the rate of turnover among

the senior professionals?

• How involved are senior

professionals in the valuation

process? Will we have direct

access to the head of the

engagement team?

• Does senior management sign off

on the valuation?

• How does your fi rm staff its

engagement teams?

• What is the depth of the internal

and external resources you

will draw upon to perform our

valuations?

Key Questions to Ask Your Prospective Third-Party Valuation Advisor


Value Determination


FirmResources

Ongoing Valuation Process Support• What type of backup and

documentation will be provided for the

valuation conclusions?

• Is your fi rm willing to speak directly with

auditors in order to fully support the

valuations?

• What is the extent of your fi rm’s

experience interacting with auditors,

regulators, investors, administrators,

and other relevant parties?

• Would your fi rm defend the valuation

mark if challenged by regulators?

17

Recent Trends with Level 3 Securities

Level 3 securities require comprehensive reporting, with important details on the valuation methodology (e.g.,

approach, weighting, etc.) included to ensure the VC has suffi cient information to make key decisions. Changes

to methodologies or valuation sources and weightings should be highlighted and reviewed by the VC. Level 3

securities have become an important area of focus in the current regulatory environment, and we have noted

the following trends:

Valuation Policy and Procedures

Cost Savings to Funds and Effi ciencies

Technology

Scope of Third-Party Valuation

Funds have recently begun a concerted effort to

review their existing Valuation Policy.

Such a review ensures that the policies and

procedures are up to date and refl ect current fund

practices for pricing, cover all relevant asset classes/

strategies, and are consistent with the information laid

out in marketing materials and communications to

investors.

While funds are asked to produce signifi cantly

more documentation related to hard-to-value

assets, they are also seeking to control their costs.

Auditors of hedge funds have begun to audit

a fund’s procedures and controls to reduce

the number of extensive reviews required on

individual assets. A robust control process can

reduce audit fees.

The use of technology as a tool in the valuation process

has grown, and growth is expected to continue.

However, it is important to note that technology is a

tool for modeling and making informed unobservable

input selections based on human expertise, and is not

a replacement for the diligent review and interpretation

of security agreements.

A third-party valuation advisor typically offers

limited-scope positive assurance and independent

valuation analysis. Recently, the trend has been

moving away from positive assurance and towards

independent analysis.

A limited-scope positive assurance is used to

assess the manager’s determination of fair value.

This typically results in a deliverable with a limited

level of supporting documentation.

An independent valuation analysis involves a full

valuation process by the third-party advisor and

typically includes a full narrative report with analytic

exhibits and accompanying support.

When considering a third-party valuation advisor,

the professional fees may be impacted by the

number of positions valued, frequency of review,

level of complexity, timing needs, and scope of

deliverable selected.



Value Determination


FirmResources

18

REPORTING AND DOCUMENTATION PROCESS

Internal Market Administrator Market Market Value

Value Value Variance

Level SEC TYPE Pricing Source Count Gross Net Gross Net Gross Net

1 Equities Bloomberg/Reuters 28 213,829,180.2 200,613,358.2 213,829,180.4 200,613,357.9 -0.2 0.3

2 Fixed Income Broker Quotes 3 59,694,839.0 56,479,017.0 59,694,839.4 56,479,016.9 -0.4 0.1

Name of Investment: ______________________________________________________________________________________________

Valuation Prepared by: ____________________________________________________________________________________________

Investment Performance: __________________________________________________________________________________________

Valuation Methodology: ___________________________________________________________________________________________

• Why is it appropriate? _________________________________________________________________________________________

• Change from acquisition? ______________________________________________________________________________________

• Change from prior valuation? ___________________________________________________________________________________

Key Valuation Assumptions: ________________________________________________________________________________________

• Change from acquisition? ______________________________________________________________________________________

• Change from prior valuation? ___________________________________________________________________________________

• Were any discounts applied? ___________________________________________________________________________________

Portfolio Company Information Rights: _______________________________________________________________________________

• Unadjusted portfolio company information received and used: _______________________________________________________

• Adjustments to portfolio company information made: _______________________________________________________________

Level 1 & 2

Level 3

Fund Name Currency Total Value ($000) % Ownership

Illustrative Example: Fair Value Hierarchy Report

Valuation Committee Reporting Package

• Comprehensive, executive-level reporting packages

are required for the VC.

− A summary-level report should include all funds

and all products classifi ed by its corresponding

fair value hierarchy (Level 1, 2, and 3 securities).

− Metrics should show gross and net market value

and variances in value reconciliations across

the securities.

• Each key control should have a summary report

included in the VC reporting package, highlighting

key areas.

• The meeting minutes must refl ect that key controls

were discussed and if exceptions were raised.

• The fund needs to demonstrate that the VC is

receiving appropriate and suffi cient information

so that it can review details and opine on key

decisions.

• The fund provides statistics on pricing vendor

coverage of Level 1, 2, and 3 securities.

Reporting of Errors & Violations

• Often, errors will occur and should be reported on a

timely basis. The VC is responsible for highlighting

detection, quantifying the monetary impact, and

identifying steps for remediation and prevention

going forward. Specifi cally, the VC will need to

− Assess the impact to the funds and investors

and determine whether investors should be

compensated.

− Identify changes to the Valuation Policy as

appropriate to avoid similar errors in the future.

− Revisit changes to materiality thresholds

identifi ed within the Valuation Policy as

appropriate.

− Identify instances where the Valuation Policy

has been breached and prescribe resolution

procedures, including informing the Chief

Compliance Offi cer of the fund.



Value Determination


Firm Resources

19

FIRM RESOURCES

To facilitate meeting each of these standards of proper valuation governance, the fi rm must be equipped with the

appropriate resources. Specifi cally, the use of the right technology and personnel within the fi rm must be considered.

Experienced professionals (both internal and external to the fi rm) with deep asset class expertise are needed

to perform the analytical procedures involved in the fair value determination process. Fund technology needs

to be an enabler of reliable data centralization and access for all functions within the fund, including fi nancial

reporting, investor reporting, and portfolio management.

EXPERIENCED PEOPLE

• It is critical for funds to invest in the

right talent with deep expertise.

• Valuation governance can be

compromised when inexperienced

professionals are involved in or leading

various aspects of the processes

described herein.

• Middle-offi ce/controller/valuation

professionals must be well qualifi ed to

sign off on valuations.

• The valuation community has recently

taken steps to govern the quality of

valuations being performed by requiring

certain valuation professionals to hold

a Certifi ed in Entity and Intangible

Valuation™ (CEIV) credential.

EXTERNAL DATA PROVIDER

• The collection of broker quotes is largely

manual across the industry, but parsing

technology has emerged recently that can

be leveraged.

• These technology solutions work as

standardized adapters into all leading

market data providers.

• Systems exist that have embedded pricing

rule designs for creating custom pricing

and valuation rules, can generate variance

reports, and automate reconciliation

of internal pricing with independent

administrator/third-party service providers.

External Data

ProviderExperienced

People

Technology



Value Determination


Firm Resources

TECHNOLOGY

• Technology can provide critical

exception-level reporting, where

key issues/exceptions are targeted

effi ciently and allow for expedited

resolution.

• Often, funds allocate spending to

manual processes, where they pay

for data processors and receive very

little analytics in return.

• Well-designed and tested automated

solutions can be highly effective

from a data processing perspective.

• The process fl ow needs to be

reviewed to ensure it is robust

and well controlled.

20

CONCLUDING REMARKS

Investors, regulators, and auditors will continue to focus on valuation-related issues given the publicity

surrounding alleged missteps at certain high-profi le funds in recent years. There is no doubt that

the valuation process will continue to be challenging for investment management fi rms, especially

as those managers enter into new and more complex investments. However, it is important for

investment managers, fund CFOs, and other members of senior management to recognize their duty

to all stakeholders. In that respect, a well-executed valuation framework that includes appropriate

valuation policies and procedures, an adequate governance mechanism, effective use of technology,

and a competent team of internal valuation personnel supported by third-party valuation advisors

goes a long way in minimizing institutional risk. Although the use of external valuation expertise is not

a substitute for a sound valuation framework, incorporating such expertise can considerably improve

the effi cacy of the valuation framework and assuage investor concerns related to the valuation of

fund investments.

Mary Jo White, a former Chair of the SEC, summed it up best in a keynote address to the Investment

Company Institute’s General Membership Meeting in May 2016:

“As portfolio strategies and permissible investments for a fund are being developed, it is essential that the

accurate pricing of the portfolio holdings and NAV calculations are carefully considered. It is also important

that the services used to assist funds with pricing do so accurately, in the manner disclosed in the fund’s

prospectus and consistent with the law. This is of high importance to everyone. I, along with your investors,

expect that you will get it right.”3

3 White, Mary Jo. “The Future of Investment Company Regulation.” Speech, Keynote Address Investment Company Institute 2016 General Meeting, DC,

Washington, May 20, 2016.

21

BIOGRAPHIES

Ms. O’Connor is a Managing Director at a global asset management fi rm and was previously a Managing Director

at Goldman Sachs, an Executive Director at Morgan Stanley, and a Vice President at J.P. Morgan. She has

deep expertise in the asset management industry and has held various roles including Global Head of Finance,

Controller for $150 billion multi-strategy funds, CFO for a private equity fund, North America Head of Credit,

Real Estate Controller, Global Head of Equity Derivatives, Director of Accounting, and Global Head of Valuation.

Ms. O’Connor is a Chartered Management Accountant with CIMA and GCMA and is a fellow at the Chartered

Institute of Management Accountants. Her board of directors experience includes The Women’s Bond Club,

Irish Repertory Theatre, Goal USA, and Women’s Initiative. Ms. O’Connor has been a senior advisor to the

New York Digital Irish Group and the Diaspora Irish Angels. She was named one of the Top 50 on Wall Street by

Irish America magazine for three years.

Ms. O’Connor is from Cobh, County Cork, Ireland, and studied Accounting at the Cork Institute of Technology.

Dr. Ma is a Managing Director and the Global Head of Portfolio Valuation & Fund Advisory Services at

Houlihan Lokey, focusing on illiquid and complex securities valuation. She has over 20 years of extensive

training, academic expertise, and hands-on experience in commodities, derivatives, securities, foreign

exchange, fi xed incomes, structured transactions, hedging strategies, and risk management issues. Dr. Ma

has qualifi ed and testifi ed as an expert witness in U.S. District Court, U.S. Bankruptcy Court, and arbitration

and deposition proceedings. She has also worked as a consulting and testifying expert for the U.S. Securities

and Exchange Commission.

She is on the Standards Board of the International Valuation Standards Council (IVSC). She holds the

designation of Chartered Financial Analyst and is a senior fellow (FRICS) of the Royal Institute of Chartered

Surveyors. She obtained her CPA license (now inactive) in the State of Colorado.

Prior to Houlihan Lokey, she was a partner at Ernst & Young and directed a number of signifi cant projects

related to derivatives valuation, commodities trading, hedging, and risk management. She also advised

the boards of directors of energy and fi nancial companies on risk management, valuation, and corporate

governance issues. For over fi ve years, she traded derivatives and designed new risk management products

for a global commodity fi rm. Dr. Ma served as an adjunct professor at Columbia University, where she taught

an MBA-level course in futures and options. She also developed several corporate training programs on the

complex aspects of capital markets.

Dr. Ma graduated from Columbia University’s Graduate School of Business with a Ph.D. in Finance and from

Indiana University with highest distinction with a B.S. in Accounting. Her Ph.D. thesis addressed energy

futures and options markets. She has published numerous articles on energy, derivatives, risk management,

valuation, and corporate governance, and she is a frequent speaker at industry conferences. She has also

co-authored a college textbook on futures and options.

Deirdre O’Connor, FCMA, CGMAManaging Director

Global Asset Management Firm

[email protected]

Cindy Ma, Ph.D., CFAManaging Director

Global Head of Portfolio Valuation & Fund Advisory Services

Houlihan Lokey

212.497.7970 • [email protected]

22

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