Value This! Hot Topics in Valuation for Investment Advisers. Fall 2017

Transcription

1 Value This! Hot Topics in Valuation for Investment Advisers Fall 2017

2 Presenters Nicole M. Kuchera Counsel Chicago, IL Nicole Kuchera represents securities and commodities professionals in a variety of complex regulatory, compliance and corporate matters. She has extensive experience launching and advising various investment vehicles, such as hedge funds, private equity funds, venture capital funds, real estate funds, commodity pools, fund of funds and socially responsible investment (SRI) vehicles. Nicole provides legal and compliance guidance to registered and exempt investment advisers, commodity pool operators (CPOs), commodity trading advisers (CTAs), futures commission merchants (FCMs), introducing brokers (IBs), forex (FX) firms, proprietary trading firms and broker-dealers (BDs). She also serves as counsel to boards, mutual funds and exchange-traded funds (ETFs). Nicole drafts and develops disclosure documents, compliance manuals, policies and procedures, corporate documents, contracts/trade agreements and advertising materials. She also provides legal and structuring guidance concerning complex master-feeder structures, domestic and foreign funds, international offerings and separately managed accounts. Stradley Ronon Stevens & Young, LLP 2

3 Presenters (cont d.) Paul Clark Managing Director Chicago, IL Paul Clark, CFA is a Managing Director and has advised businesses and business owners on mergers and acquisitions, recapitalizations, leveraged buyouts, and other corporate planning matters. Mr. Clark has provided numerous fairness and solvency opinions for corporations, private equity groups, board of directors and significant shareholders. These assignments have involved many Fortune 500 companies and mid-market entities, including Employee Stock Ownership Plans (ESOPs). Additionally, Mr. Clark has provided numerous business enterprise, equity and intangible asset valuations for financial reporting and tax compliance purposes. Further, Mr. Clark has valued debt, preferred stock, options and complex securities for various purposes. Prior to joining Houlihan Capital, Mr. Clark was a Director in Ceteris US, LLC's valuation group. Previously, Mr. Clark was a Senior Vice President in the Financial Advisory Services group of Houlihan Lokey. He began his valuation services career at Arthur Andersen. Prior to that, he was a flight test engineer on the F-15 program with McDonnell Douglas Aerospace. Mr. Clark has earned an MBA from Washington University, a Master of Science in Mechanical Engineering from the University of Missouri and a Bachelor of Science in Mechanical Engineering from the University of Iowa. Mr. Clark holds the designation of Chartered Financial Analyst (CFA) and is a member of both the CFA Institute and the CFA Society of Chicago. Stradley Ronon Stevens & Young, LLP 3

4 Valuation - High-level Overview Advisers Act and the related rules do NOT include any specific provision relating to valuation or pricing of investments held by clients o Yet, SEC exams and enforcement actions regularly focus on valuation o INVESTORS are interested/litigious Stradley Ronon Stevens & Young, LLP 4

5 Where does the focus on valuation come from? o As a FIDUCIARY, an adviser must always act in a client s BEST INTERESTS This includes pricing investments held in client portfolios to ensure fair, accurate and current valuations o Proper valuations are also necessary for accurate performance and fee calculations Stradley Ronon Stevens & Young, LLP 5

6 Challenges to Valuations Regulators may not challenge an adviser s valuations as wrong per se, they tend to focus on: o Absence of adequate policies ( P&Ps ) o Failure to adhere to policies o Improper disclosures o Insufficient statements to auditors Stradley Ronon Stevens & Young, LLP 6

7 Why is Valuation So Important? If an adviser inflates the value of the investments, then: o overpaid in performance fees o overpaid in management fees o investors think holdings are worth more than they are o new investors in a fund will overpay for their interests o redeeming investors in a fund will receive too much for their interests o performance will be overstated The opposite will occur if the adviser understates valuation Stradley Ronon Stevens & Young, LLP 7

8 SEC Focus on Valuation The SEC views valuation as a critical risk area because there are so many inherent CONFLICTS OCIE - specialized Valuation Working Group to oversee advisers valuation processes Stradley Ronon Stevens & Young, LLP 8

9 Times of Economic Turmoil Enforcement staff looks closely at valuation during times of economic turmoil o Advisers often seek to enhance performance using valuation during such periods o Need to follow robust valuation procedures to avoid issues Stradley Ronon Stevens & Young, LLP 9

10 Valuation at Cost = Bad Advisers cannot simply continue to value investments at cost o Fair value (FV) is supposed to deviate from cost o Regulators generally deem investments at cost as a RED FLAG, especially if such valuations last for an extended period o Valuation as between classes of shares should likely have different values Stradley Ronon Stevens & Young, LLP 10

11 Ignore Outside Valuations at Own Peril Advisers should heed caution if seeking to ignore outside valuations o Public valuations are observable inputs that should be incorporated into any valuation analysis o If conflicting valuations exist, it s wise to document your reasoning behind ultimately choosing a given valuation Stradley Ronon Stevens & Young, LLP 11

12 Policies & Procedures (P&Ps) So what is an adviser to do to avoid valuation related suits? First, develop solid valuation P&Ps Second, strictly follow these P&Ps Third, update P&Ps every few years and when its investments or circumstances change Stradley Ronon Stevens & Young, LLP 12

13 Recent SEC Enforcement Case In 2016, the SEC alleged that Equinox Fund Management deviated from its stated methodologies for calculating management fees and for valuing fund holdings o Disgorgement of $5.4M, $600K in interest and a $400k penalty o Equinox had disclosed that it charged management fees based on NAV, but actually valued using notional trading o Equinox had disclosed that its method for valuing certain derivatives was corroborated by weekly counterparty settlement values, when in fact Equinox valued certain derivatives at values substantially higher than its counterparties Stradley Ronon Stevens & Young, LLP 13

14 Equinox Case (cont.) Equinox disclosed that an option had been transferred between two fund series consistent with its fund s valuation policies, but was actually transferred using a different methodology (and the transfer was different from substantially identical options held by another fund series) Equinox failed to disclose as a material subsequent event a series early termination of an option that constituted its largest investment at a materially lower valuation than had been recorded for that option Stradley Ronon Stevens & Young, LLP 14

15 Valuation P&Ps SEC guidance concerning Rule 206(4)-7 (the compliance program rule) indicates that advisers should implement P&Ps concerning the valuation and assessing fees Advisers may be deemed to have violated ANTI-FRAUD provisions or their FIDUCIARY duties if they misprice client investments Stradley Ronon Stevens & Young, LLP 15

16 Two Key Valuation Principles Basic Valuation Principles: o First, value assets at market price o Second, if no market quotation is available, obtain a fair and accurate valuation Stradley Ronon Stevens & Young, LLP 16

17 The Guts of a Valuation P&P Valuation P&P should include at least : o List who is responsible for valuation o Coverage for all types of potential investments (liquid and illiquid) o Methodologies to determine valuation Include sources of prices, priority of sources and how such sources are used Be consistent across types of investments Include factors that may be considered when making valuation determinations Stradley Ronon Stevens & Young, LLP 17

18 Guts of P&Ps (cont.) P&Ps should outline procedures for: o using and overseeing pricing services/related 3 rd parties o managing conflicts/risks o documenting determinations o handling trading halts o handling price overrides o detecting and correcting violations and errors o reviewing and updating the P&P o retaining relevant records Stradley Ronon Stevens & Young, LLP 18

19 Guts of P&Ps (cont.) Emphasize independence from any inappropriate influence by the adviser s investment or other personnel Tailored to each firm s business Tailored to the type of investments managed Stradley Ronon Stevens & Young, LLP 19

20 Key Valuation Considerations Considerations when crafting valuation P&Ps: o Valuation P&Ps are likely to be the starting point for SEC examiners o P&Ps should be drafted to promote fairness and consistency in the valuation process o P&Ps should clearly indicate the methods, principles and models that be will used to value of investments This is especially the case for hard-to-price investments Stradley Ronon Stevens & Young, LLP 20

21 Pricing Methodologies Identify the methodologies that will be used for each type of financial instrument held before acquisition of the instrument Establish criteria for determining when market quotations, if available, are not reliable for a particular investment Determine what pricing methodology will be used when market quotations are not readily available Stradley Ronon Stevens & Young, LLP 21

22 Methodology Considerations Methodologies should consider a variety of factors, such as: o sources of prices o priority of sources o how the sources are used Methodologies should generally include, as applicable: o readily available quotes (for exchange traded securities) o broker-dealer quotes o third-party pricing services o proprietary pricing models o original cost of investment, etc. Stradley Ronon Stevens & Young, LLP 22

23 Typical Valuation Methodologies If current market data is not available, some common methods for determining value are: o Dealer quotes (actual or indicative) o Third-party valuations o Matrix or model pricing o Pricing based on market price changes o PM pricing Note that there are various other common valuation methodologies depending on the type of investment Stradley Ronon Stevens & Young, LLP 23

24 Dealer Quotes Two types of quotes: o Actual transaction quotes (most recent market prices) o Indicative quotes (opinions solicited concerning the likely price less weight) Advisers should target about three to five quotes o If this requirement is in an adviser s P&Ps, however, the adviser should actually obtain this number of quotes Stradley Ronon Stevens & Young, LLP 24

25 Evaluating Dealer Quotes Factors to consider when analyzing the accuracy of a quote: o Quality of broker o Nature of quote o Basis of quote o Relationship with broker o Spread between quotes (common to toss out the high and low quotes) Stradley Ronon Stevens & Young, LLP 25

26 SEC Enforcement Cases: BD Valuations In 2015, the SEC charged AlphaBridge Capital and two of its owners with fraudulently inflating the prices of securities in their hedge fund o AlphaBridge told investors and its auditor that it obtained independent price quotes from BDs for certain unlisted, thinly traded mortgage-based securities o AlphaBridge had instead given internally-derived valuations to the BD to pass of as their own o The inflated valuations caused the funds to pay higher management and performance fees o Disgorgement of $4M, penalties of $1M, the owners paid $5M and the funds were shut down Stradley Ronon Stevens & Young, LLP 26

27 3 rd Party Pricing Services Use of third party pricing services may reduce potential conflicts of interest To ensure the appropriate level of expertise, do not delegate pricing determinations to individuals without the necessary training or qualifications Assess the quality of the prices provided Stradley Ronon Stevens & Young, LLP 27

28 3 rd Party Valuation Considerations Third-party valuators are not always right Adviser is still responsible for all valuation determinations Review third-party s P&Ps to see if at least as good as your standards/requirements, and not contradictory Understand why their value might differ from your own Document all deviations and how resolved Stradley Ronon Stevens & Young, LLP 28

29 SEC Enforcement Cases: 3 rd Party Pricing In 2016, the SEC alleged that PIMCO overvalued its Bond ETF portfolio: o PIMCO valued bonds using prices provided by a third-party pricing vendor without any reasonable basis to believe such prices accurately reflected what the fund would receive if it sold the bonds o PIMCO overstated the ETF s NAV by as much as 31 cents o PIMCO agreed to disgorgement of $1.3M, interest of $200K, a penalty of $18.3M and to enhance its P&Ps relating to valuation Stradley Ronon Stevens & Young, LLP 29

30 Evaluation of Pricing Service Prices: To determine whether an evaluated price from a pricing service constitutes FV, consider: o the inputs, methods, models and assumptions used o how those inputs, methods, models and assumptions may be effected as market conditions change Stradley Ronon Stevens & Young, LLP 30

31 Verification of Pricing Methodology Review the accuracy of pricing methodology by checking the accuracy of fair value prices against other sources This double-check should be done at the time of use of the pricing (if possible) and periodically after pricing Back-testing is also valuable Stradley Ronon Stevens & Young, LLP 31

32 Ways to Test Valuation Ways to test the accuracy of your valuation: o Compare today s prices against yesterday s prices o Compare changes of today s to yesterday s prices to changes in a related index or similar products o Be watchful over holdings whose prices haven t changed in a while (especially if volatile markets) o Compare NAV changes across days to changes in a related index or similar products o Compare volatility in NAV to the relevant market and related products o Review trade blotter data for patterns and sham transactions Stradley Ronon Stevens & Young, LLP 32

33 Pricing/Valuation Committee Consider forming a pricing/valuation committee to address valuation difficulties: o Committee should address potential or actual conflicts of interest concerning valuation o Committee should be independent from pressure to obtain highest valuation o Committee should engage in training Stradley Ronon Stevens & Young, LLP 33

34 Shouldn t PMs Determine the Valuations? PMs are the closest to the market However, due to significant conflicts of interest, advisers should limit their PMs involvement in the valuation process Still consult with PMs concerning valuation though PMs should be allowed to challenge valuations Communications between PMs and pricing services/bds should be reviewed Stradley Ronon Stevens & Young, LLP 34

35 Documentation Considerations The pricing committee (or similar personnel) should document pricing determinations The committee should document the manner in which the fair value was determined. They should test the accuracy of that valuation based on the next reliable public price quote for the investment, if available, etc. Stradley Ronon Stevens & Young, LLP 35

36 Valuation Challenges Adopt a process for challenging and resolving valuation disputes Have a formal process for escalating valuation disputes o Valuation committee should likely have a final say on all disputes Stradley Ronon Stevens & Young, LLP 36

37 Price Overrides Any errors in pricing or valuation should be resolved as promptly as possible generally on a same or next day basis Re-pricing information should be approved by a designated person or committee Document all determinations made and factors considered Stradley Ronon Stevens & Young, LLP 37