Valuation of Unlisted Assets. AIST Trustee Practice Guide

Transcription

1 AIST Trustee Practice Guide

2 What are AIST Trustee Practice Guides? AIST Trustee Practice Guides provide guidance to trustees on specific, and at times contentious, aspects of their duties. They are non-binding on trustees, and are reviewed from time to time in light of industry developments. They are written in plain English and draw on examples and theory. AIST invites member feedback on our Trustee Practice Guides to ensure they stay relevant to our members roles. Trustee Practice Guides are intended to work in conjunction with both trustees obligations under law and regulator guidance. AIST does not intend that Trustee Practice Guides will be exhaustive of the many different facets of trustees roles, but rather are issued as required to support best practice in superannuation fund management. About this Trustee Practice Guide This Trustee Practice Guide examines the principles, policies and methods that need to be considered by trustees when valuing unlisted assets in their portfolio. The guide does not take a position on the merits of unlisted investments in a portfolio, nor does it aim to provide guidance on associated operational matters such as unit pricing and custody. Disclaimer This Trustee Practice Guide and the information contained in all associated materials are intended as information only and should not be used in the place of legal or other advice. In particular, such information is not intended to, and does not constitute financial product advice of any kind. The Australian Institute of Superannuation Trustees (AIST) has made every effort to provide current and accurate information at the time of printing. AIST expressly disclaims all liability and responsibility to any person who relies in full or in part on any of the information contained in this seminar, or is omitted from it. If advice is required, AIST offers compliance consulting services for its members.

3 Table of contents Introduction... 1 The governance framework for valuation policies... 2 Recommended steps in developing a valuation policy... 3 Consider valuation needs... 3 Determine the governance structure... 3 Understand the nature of the underlying assets... 3 Determine the valuation frequency... 3 Assess external managers valuation processes... 3 Establish a recruitment process for valuers... 3 Identify critical assumptions and trigger events... 4 Determine a frequency and process for review... 4 Asset classes and valuation practice... 5 Property... 5 Infrastructure... 6 Private equity... 7 Hedge funds... 8 Inappropriate practices and risks... 9 Indexes and valuations... 9 Systems and model risks... 9 Resources and capabilities of independent valuers... 9 Appendix A Historical background Listed and unlisted assets Implications of direct or indirect holdings Appendix B Holding structures Appendix C Accounting standards Common valuation methods The valuation cycle lead times... 13

4 Introduction The superannuation industry has evolved from a simplistic retirement model, in which funds offered little investment choice, to the current situation, which includes choice of fund combined with an increased range of investment options within funds. Furthermore, funds investment portfolios have evolved from containing predominately listed assets to including a significant amount of unlisted assets. This characteristic is most evident in not-for-profit funds. However, given the success of investing in unlisted assets during the recent downturn, it is now becoming increasingly present in retail funds. A critical feature of this current environment is that, at any time, any member may exit or enter a fund or change their investment choice. Therefore, it is imperative that such transactions are effected using the most accurate valuation of the funds assets to preserve the equity of all members. Equity is a fundamental concept in law stemming from trust law and the common law duty to act in the best interest of all members. The concept of equity has been further codified in Section 52 of the SIS Act. Under Section 52 covenants, the trustee must ensure that duties and powers are exercised in the best interests of all beneficiaries. Valuations are a critical component when ascertaining the true value of a fund s assets. Valuations that are current and reflect assets true market value greatly enhance member equity, as member transactions are conducted at values that are materially fair and equitable. This becomes more important when a fund is experiencing a larger than normal membership movement, as might be expected in a highly volatile asset market. While this guide argues for robust valuation policies and methods, it is important to remember that valuation processes necessarily contain subjective elements and estimations. 1

5 The governance framework for valuation policies AIST believes the following key principles should guide trustees in valuing unlisted assets in their portfolios: 1. Trustees should develop a transparent, robust and well documented valuation policy that is endorsed by the board and communicated widely amongst the fund s managers, consultants and staff. Trustees should ensure that valuations are applied consistently from period to period. 2. Trustees will need to establish a program of regularly reviewing their valuations policy. Such reviews should be conducted at least annually. In times of extreme market volatility and uncertainty, trustees should be prepared to undertake additional reviews of the valuation policies of specific asset classes. Such reviews should focus on the historical volatility of the asset class with emphasis placed on the more volatile asset classes. 3. Trustees should allocate responsibility for research and preparation of valuations to appropriate internal staff, external valuers, and/or subcommittees of the board. APRA considers the establishment of a separate valuation committee to be good practice. AIST believes trustees should establish a separate valuation committee in light of the scale and complexity of their unlisted investments. Alternatively, trustees should give responsibility for valuations to the investment committee. 4. Trustees will need to demonstrate the segregation of duties between those responsible for managing unlisted investments (e.g. external managers, or internal staff in the case of direct investments), those responsible for researching and preparing valuation reports (e.g. asset consultants, internal staff or a sub-committee), and those responsible for approving the report (e.g. senior executive fund staff and the fund s CEO). Valuations should flow through to unit prices and/or crediting rates only after sign-off at the senior executive level. A review of this process should be a standard agenda item for each audit committee meeting. 5. Trustees will need to demonstrate that conflicts of interest are being closely monitored in instances where investment manager valuations are being relied on. AIST believes best practice is for external managers to use independent valuers, and trustees should consider valuation policies of managers as part of their manager selection processes. Trustees need to ensure that existing managers who do not use independent valuers move toward independent, external valuers. However, in the case of private equity AIST is aware that such an approach may be costprohibitive or impractical. Nonetheless, trustees should continue to seek valuation confidence and independent confirmation where possible. 6. Trustees policies should be detailed, and should be relevant to the particular unlisted assets the trustee holds. Trustees should consider valuation policies and frameworks developed by professional bodies associated with asset management for the specific assets in question when developing their own policy. 2

6 Recommended steps in developing a valuation policy Consider valuation needs Consider the valuation requirements when making a decision to invest in unlisted assets. While the primary considerations will be the investment s fit with the rest of the portfolio and the desired risk/return characteristics of the portfolio, liquidity requirements and equity among members needs to be considered. Determine the governance structure Determine the governance structure for valuations, taking into consideration the trustee s existing resources in terms of consultants, executives and internal staff, and sub-committees. Clearly, governance structures will need more attention where investments are direct, or where external managers do not use independent valuations. Understand the nature of the underlying assets Understand the nature of the underlying assets for each investment. This will assist in deciding the frequency of valuation, the sources of information relevant to valuation processes, the relevance of external professional guidance, and the availability and costs of independent valuers. Determine the valuation frequency Determine the valuation frequency for each investment, taking into account the anticipated volatility, the fund s unit pricing and/or crediting rate processes, the costs of valuation, and the timeframes for completing each valuation cycle. Trustees will need to carefully balance the trade-off between the regularity and cost of asset valuation. Where possible, trustees should seek to stagger valuations of different assets within an asset class, to minimise step movements in unit prices. Assess external managers valuation processes Assess external managers valuation processes in terms of frequency, independence, method and conflicts of interest, and exert pressure for improved practices where necessary. Trustees should be satisfied that the valuation methodology within the vehicle is robust and timely. Where trustees cannot satisfy themselves that external managers valuations meet their needs, consideration should be given to appointing their own independent valuer. Incorporate valuation methodology into the selection criteria for external unlisted managers. Establish a recruitment process for valuers Establish a recruitment process for valuers of direct unlisted investments. Valuation is an important external professional service, and the recruitment 3

7 and management of the service needs to be subject to similar standards as for legal and actuarial services. Trustees also need to consider whether their preferred valuer provides other services to the fund, e.g. audit. While best practice would indicate that responsibility for valuation should be separated from tax and audit, auditors may need to replicate valuation processes, and it may be more efficient to use internal valuations with audit oversight. Identify critical assumptions and trigger events Trustees will need to be mindful of events that have a material impact on the critical assumptions inherent in the valuations of their unlisted assets. The policy should identify critical assumptions and trigger events for intra-period valuation reviews, and consider what actions are required should a trigger event occur. Note that the critical assumptions and trigger events will vary between investments. Determine a frequency and process for review At a minimum, the valuation policy should be reviewed every two years. Trigger events for automatic review of the policy should be identified and documented and the documented trigger events should be regularly reviewed by the investment committee. Furthermore, this review should be a regular agenda item. The review process for the valuation policy should be built into the fund s risk management plan, with the audit committee responsible for monitoring compliance to the plan. 4

8 Asset classes and valuation practice Property The Australian Property Institute is a body that represents the interests of approximately 7,500 property professionals in Australia. The Institute publishes the Australia & New Zealand Valuation and Property Standards. Generally, institutional property valuations are derived from a discounted cash flow model (DCF). Whilst the existence of several commercial software providers offers the industry an element of consistency in its valuation approach, it is important to understand that all DCF valuation models are premised on a series of carefully calculated assumptions. Critical assumptions found in property valuations In the case of property the purpose of the DCF model is to forecast a series of periodic cashflows for the property over a set period of time, usually ten years. The forecast cash flows are then discounted back to a present value. As mentioned, using the DCF approach involves the user making several key assumptions regarding income growth, expense growth, vacancy levels, future capital expenditure, and forecast economic growth. Together, these assumptions are used to derive a terminal value in the future and it is on this basis that a property s internal rate of return is derived. When reviewing such valuations, it is important to assess the variables in the underlying calculations. For example, when it comes to forecasting the future vacancy rates for a property, a reasonable input would be the historical vacancy rate for that sector, but a better example could be the correlation of vacancies to economic growth, so that the vacancies are forecast in line with the growth forecasts in the model. Economic sensitivities for property All assumptions used in the calculation are critically linked to the fortunes of the domestic and global economies. Variables therefore will need to reflect an appropriate correlation to the underlying growth assumptions in the model. For example, flat line economic growth projections might be inferior to more sophisticated economic growth projections. Trustees can request that managers or valuers provide them with a portfolio analysis of the global variables used. These forecast values can be compared to industry standards, treasury forecasts and Reserve Bank forecasts. Best practice in property Valuations should be independent and conducted on a quarterly basis. Valuers should be appointed and rotated through a predetermined cycle, with no valuer valuing the same asset for a period greater than three years. 5

9 Infrastructure Infrastructure valuations are currently not covered by any industry guidelines. However, a number of boutique infrastructure valuers are entering the market. It should be noted that much of the present material relating to infrastructure valuations has been compiled by governments seeking to sell public assets through privatisation, or for government accounting purposes. Such valuation methods may not be appropriate for valuation of assets for fund accounting and unit pricing purposes. The methodology typically used in relation to infrastructure assets is the DCF model, which seeks to model all variables to arrive at the valuation. Trustees should be mindful of the key variables in the valuation process. The values ascribed to these variables should be cross-checked against other sources of information and the market place generally. Once again, in the case of a large portfolio, trustees may choose to review the key global variables. Critical assumptions found in infrastructure valuations As is the case with property, the valuation process is based on a range of variables, some easily observable and others somewhat subjective. However in terms of infrastructure, there is a greater degree of certainty with some underlying assets. For example, social infrastructure assets with long term leases to government agencies are highly predictable. Airports, on the other hand, are more vulnerable to the global economic environment. Economic sensitivities for infrastructure Once again for some assets there is a high degree of correlation with the underlying global economic drivers and, as such, it makes sense to analyse the assumptions inherent in valuation forecasts in this light. Best practice in infrastructure Valuations should be independent and conducted quarterly. Valuers should be appointed and rotated through a predetermined cycle, with no valuer valuing the same asset for a period greater than six years. In the case of infrastructure the complexity of the assets involved dictate that valuers will need to develop an intimate knowledge of the asset being valued, as such efficiencies may be eroded by rotating the valuer on a frequent basis. 6

10 Private equity The private equity valuations are comprehensively covered by two major frameworks: the US standards: Statement of Financial Accounting Standards No. 157 Fair Value Measurement (FAS 157); and the International Private Equity and Venture Capital Valuation Guidelines (IPEVCVG). The Australian Private Equity and Venture Capital Association limited (AVCAL) promotes the use of the IPEVCV guidelines. AVCAL represents and promotes the long term interests of the private equity and venture capital industry in Australia For private equity valuations, the first step involves calculating the enterprise s earnings; the most common measure used is earnings before interest, taxes, depreciation and amortisation (EBITDA). Many enterprises will only produce a fully reconciled EBITDA three to four weeks post quarter end. For more complex entities, the lag time may be many months. This information then becomes the key input into the valuation process. Once EBITDA has been established the valuation process is reliant on estimating value through a process by which the enterprise s earnings are multiplied by a comparable industry multiple. In some cases the industry s multiple is easily discernible, for example a sector s average price/earnings ratio (PE). In other instances the exercise may involve determining the multiple for a private sector company based on past sales. Once derived, the value is discounted to reflect the asset s marketability. Critical assumptions found in private equity valuations Key variables need to be identified, and once identified their values should be assessed in light of the prevailing company, industry and economic conditions. Economic sensitivities for private equity Of all unlisted assets, private equity has arguably the highest correlation to the economic environment. This correlation comes from two angles. Firstly, given that private equity has a tendency to operate with a higher level of gearing, it is vulnerable to the general level of interest rates. Secondly, by its very nature, private equity is linked to the economic cycle and, as such, forecast variables should exhibit a higher than usual correlation to the economic cycle. Best practice in private equity Valuations should be conducted annually, at minimum. Internal valuations from investee companies should be actively reviewed by the manager, or the trustee for direct investments. Where fund-of-fund structures are employed, trustees will need to satisfy themselves that valuations from investee entities or sub-funds are properly reviewed at the fund-of-fund level. 7

11 As private equity valuations typically rely heavily on financial statements for investee companies, extra attention should be paid to the audit processes for those statements. Hedge funds Hedge funds are generally opaque vehicles, but the global financial crisis has focussed more scrutiny on their processes and risks. Hedge fund strategies usually involve listed assets and therefore trustees can find comfort in the fact that at least the majority of their underlying investments are priced in a transparent marketplace. Hedge funds are largely unregulated and to date have vehemently opposed any form of regulation. Hedge funds form a small portion of total fund assets and in most cases the valuation risk is low; however the following points should be considered. Critical assumptions found in hedge fund valuations Given that in most cases hedge funds investments are predominately listed or traded in an active over the counter (OTC) marketplace, the relevance of critical assumptions for this asset class lie mainly in the accounting policies of the manager. The central issue is the mark-to-market policies of the manager, how frequently the OTC assets are re-valued, and whether the manager may be adopting a model valuation above a market valuation. The US financial accounting standards board (FASB) recently allowed a relaxation of mark-tomarket accounting rules. In such cases, risks may be concealed through compliance with the financial accounting standards, whilst a forced liquidation will deliver a completely different value. Economic sensitivities for hedge funds The label hedge funds is used collectively to describe a wide variety of investment styles. Some styles are clearly more vulnerable to the economic cycle than others. For example, a manager investing in distressed debt prior to the financial crisis may experience larger losses than forecast. Other managers have had their investment strategies decimated by regulatory changes such as recent bans on short selling. In short, trustees should seek to familiarise themselves with the strategies of their managers where transparency exists. Armed with this knowledge trustees should seek to deduce the risks inherent in their managers. Best practice for hedge funds In the case of hedge funds, the valuation responsibility lies predominantly with the manager. Best practice involves ensuring that mark-to-market policies are being practiced consistently, with losses and gains realised on a systematic basis. Where the manager is in compliance with US FAS, trustees should determine the extent to which mark-to-market differs from any modelled carrying values. 8

12 Inappropriate practices and risks Indices and valuations Unit pricing and valuations, while connected, are separate processes and should remain segregated. In particular, while it may be appropriate to use an index to determine unit prices in an intra-valuation period, it is not appropriate to use indices as the primary basis for valuation. Notably, a key investment benefit that unlisted assets often contribute to a portfolio is low correlation to listed assets. Use of a listed index as a primary valuation method has the potential to undermine this benefit. Indices may be used as part of a more complex valuation process. Systems and model risks Trustees should encourage the independent validation and verification of any internal models used in valuation processes. Where models are used for valuation of different investments, it is important that trustees encourage a standardised format for model construction, maintenance and documentation. Where trustees are aware that investment managers are employing similar models, trustees should encourage their managers to mitigate model risk in their processes. Model risk can be as simple as incorrect referencing in an excel spreadsheet, or as complex as a fundamental structural or logic error. Resources and capabilities of independent valuers Where independent valuers are employed, trustees will need to ascertain that they have the appropriate resources, qualifications and relevant industry experience and reputation to undertake the valuation. Likewise, trustees will need to ensure that the appropriate valuation methodology is employed for the asset in question. 9

13 Appendix A Historical background The listed vs. unlisted asset valuation debate can be traced back to a series of articles by industry commentators and others with a vested interest in the subject. Research houses highlighted the large performance differential between retail funds and not-for-profit funds, stating that the outperformance of the not-for-profit funds was due to the fact that funds typically re-valued only one quarter of their unlisted assets every three months. Since then the story has run in many forms with most commentators focusing on the same theme: Stale valuations for unlisted assets. In response to this increasing scrutiny and speculation surrounding unlisted valuations, the Australian Prudential Regulation Authority (APRA) has released a guidance letter, entitled General Principles for Trustees. Following the release of these general principles, it is now increasingly likely that future APRA reviews will seek to document evidence of adherence to these principles. Accordingly AIST has produced this best practice paper to assist trustees in formulating a best practice valuation policy. Listed and unlisted assets Listed assets are considered to be assets whose values are readily identifiable in a regulated market place. Common examples of listed assets are equities and bonds, both of which have prices which are readily discernible on a daily basis. Unlisted assets on the other hand are unique in that their value is in most cases derived via a proven and widely accepted methodology. Whilst the methodology for their value derivation is well documented and accepted industry-wide, there exists an element of subjectivity embedded within the asset s value. The subjectivity lies within the critical assumptions that form the input to the valuation process. Implications of direct or indirect holdings Whether a fund holds unlisted assets directly, or through an externally managed vehicle will be an important factor in developing the valuation policy. Where assets are held indirectly valuations of these assets are in most cases conducted by independent valuers. Trustees should ensure that the external vehicle has appropriate polices and processes in place which reflect the principles stated in this Trustee Practice Guide. Where assets are held directly it is increasingly important that the principles stated in this Guide are carefully considered and applied where necessary. 10

14 Appendix B Holding structures When valuing an investment portfolio, it is important to have an understanding of the underlying assets as well as the holding structures that those assets are held in. Unlisted assets may be present in many forms. The most common, and the subjects of this paper, are property, infrastructure, private equity and hedge funds. A fund holds these assets either directly or indirectly. Directly held assets are purchased and managed by the fund. Indirectly held assets are held in the form of units in an investment trust, with the investment manager of that trust purchasing and managing the assets. For example, an investment in an Australian equities portfolio via a pooled vehicle is in effect an unlisted asset. However within the investment manager s portfolio the majority of assets are listed. On the other hand a direct property investment via a pooled vehicle will have the majority of their investments in unlisted assets, with possibly a small amount, if any, of listed assets. Therefore, there are four categories within which we can easily classify an investment: Direct investment into listed assets These investments include investment in listed securities and in over the counter products that have prices readily available through regulated exchanges, and/or recognised brokerage markets. Indirect investment into listed assets These investments include unlisted securities that have quoted redemption prices based on the market values of underlying assets. Direct investment into unlisted assets These investments include direct investments in unlisted securities where valuations might be either derived internally or by an external independent valuer. Indirect investment into unlisted assets These investments include externally managed unlisted securities with quoted redemption prices based on valuation of assets within the portfolio. These valuations may be done by an external independent valuer, or as internal manager valuations. Valuation only becomes a potentially contentious issue in relation to the last two categories. 11

15 Appendix C Accounting standards Naturally, valuation practices need to be consistent with accounting standards. Currently, the relevant standard is AAS25, Financial Reporting by Superannuation Plans. The Australian Accounting Standards Board currently has an Exposure Draft in circulation ED179, under which amendments to this standard are proposed. Trustees will need to review the relevant accounting standards in formulating their valuations policy. Common valuation methods Discounted cash flow (DCF) models are the cornerstone of modern finance. They have been used by investors and analysts for well over 70 years. The central premise behind a DCF model is that the asset in question is an income-producing asset and, as such, cash flows for the asset can be predicted into the future. Fundamentally this gives the purchaser of an asset a fairly robust method by which to analyse the asset s fair value. If the cash flows that can be reasonably expected over a period are known, then the value is a function of the sum of those cash flows, discounted by the opportunity cost of not having the cash flows today. First and foremost there is the element of forecasting cash flows with a high degree of probability. Some assets will exhibit a higher predictability of cash flows than others. A good example might be found in the property sector. For example, two identical commercial buildings are offered for sale. The first building is leased entirely to a government agency on a 15 year lease, while the second is leased to three separate tenants with leases expiring in year five of the ten year valuation. Stark differences in the valuations can be immediately predicted. The first building clearly has more predictable cash flows, and hence is valued higher than the second. On the other hand the second building may offer a greater opportunity if the investor believes that they will be able to successfully retain the tenants in the future at increased rents. The investor would then capture the valuation uplift associated with greater cash flows. In practice, DCF valuations are cross-checked against comparable sales. Valuers will identify recent sales of comparable assets, and analyse the revenues and other financial factors of those assets against their prices to arrive at a market comparable valuation. Comparable sales may include listed assets, in which case earnings multiples need to be adjusted to reflect a number of other complicating factors. 12

16 However, comparable sales have an inherent flaw: in a hot market such an approach will overvalue assets, and in a flat to falling market the use of comparable sales will undervalue assets. For this reason, valuers often adjust the weight they assign to comparable sales in conditions where prices do not conform to the standard definition of fair value: The price that would be negotiated at the valuation date in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and knowledgeable, willing but not anxious seller acting at arm s length. Subjective elements can arise through the assumptions inherent in the DCF process, or through the intrusion of market sentiment from the use of comparable sales of listed assets. By combining both methods, valuers can diversify these subjective elements, and arrive at a more reliable result. The valuation cycle lead times When discussing the merits of different valuation frequencies, an often cited factor is the trade off between cost and frequency. However, an equally important and often overlooked factor is the valuation lead time. Given an asset s complexity, a comprehensive valuation may take anywhere up to five weeks before it is finalised. If we are to add APRA s recommendation that valuations be subject to oversight by an appropriately segregated body then a realistic timeframe for completing valuations moves closer to six or seven weeks. Bearing this in mind, for some assets the reality may be that quarterly valuations are the best that can be achieved. 13