Previously, the private equity funds fell outside of the EU disclosure and transparency framework. They were only regulated by partnership agreements between general and limited partners. This has all changed with the Alternative Investment Fund Managers Directive (AIFMD), which AIFMs need to comply with in order to get a passport to operate in the European market.
The AIFMD was created to protect investors and consists of a broad range of standards that seek to improve financial stability reporting and disclosure as well as risk management processes.
One of the key issues that AIFMD addresses that is a concern for a private equity fund is the valuation of underlying investments. The valuation shall be performed according to procedures that “ensure a sound, transparent, comprehensive and appropriately documented process”. The fund should be able to calculate the Net Asset Value of its investment in order to provide limited partners and regulators with mandatory reporting information. In some cases, it is also used to evaluate intermediary remuneration for the portfolio managers.
With regards to the valuation function, AIFMD allows Management Companies to have it “in house” or to have recourse to an external valuation agent. It is important to differentiate between the valuation process and the valuation function. The function refers to the responsibility for the performance of the valuation whereas the process refers to the valuation itself (how it is performed).
Under certain conditions, the regulator gives the possibility to the Management Company to delegate the valuation function to an external Entity (being different from the depositary).
|The most frequent exit strategies|| |
|• Trade sale – The sale of the investment to a strategic buyer (competitor) at a price determined by negotiations or auctions. May be substantially simpler and yield a good price due to the nature of the buyer but there is a risk of treading on thin ice with regards to competition law, ethics and employee approval.|| |
|• Initial Price Offering – A procedure by which a private company issues its shares in the stock exchange market. It is generally dreaded for its complexity; as such, it is viable only for the largest companies. If successful, it allows for higher profit, and change of ownership is least likely to fetter its future operations.|| |
|• Recapitalisation – It allows the investors to extract money from the firm whilst retaining the ownership. In practice, this is very popular as long as the leverage does not get too excessive as to negatively impact the firm.|| |
|• Secondary Sales – The sale to another private equity firm or other investors.|| |
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In such case, the Management Company keeps the responsibility for the valuation towards investors and shall therefore perform a recurrent due diligence process on the delegated Entity. On the other hand, the external valuation agent endorses some responsibilities towards the Management Company: they are liable for any loss suffered by the AIFM as a result of negligence and/or intentional failure to perform their task.
AIFMD also defines certain criteria for endorsing the valuation function. The external valuation agent shall:
- be subject to mandatory professional registration and
- be able to provide professional guarantees that prove its capacity to be in charge of the function.
It is therefore obvious that an AIFM choosing to delegate the valuation function to an external valuation agent, to some extent decides to opt out of the valuation process. Such a decision makes sense when the AIFM wants to disengage its responsibility in this field. By doing so, the AIFM accepts to lose part of its management capacity.
The AIFMD also authorizes to keep the valuation function inside the AIFM, provided it ensures that:
- the task is performed independently from the portfolio management and
- conflicts of interest are mitigated.
This means that the regulator considers that conflicts of interest can exist in a valuation process, but in that case, they request these conflicts to be mitigated and documented. Indeed, in many cases, it is difficult to completely avoid having recourse by any means to the portfolio management to evaluate the investments. This is due to the fact that in the absence of quoted prices, it is often the case that only portfolio managers can provide the necessary information.
A solution for AIFMs willing to keep the valuation function internally while setting up an AIFM compliant valuation process is to on-board an external valuation agent acting as advisory. In that case, the external entity guarantees the independence and transparency of the process but leaves the ultimate responsibility to the AIFM.
The key word in valuation for regulatory reporting disclosures is therefore fair value. In case of IFRS, the standardised definition of fair value at which funds are required to measure the assets and liabilities, is the price of a given asset or liability if the transaction is conducted in an orderly manner between market participants at a given date. This requirement is similar for accounting standards in the US (US GAAP) and NAV calculation under AIFMD (the AIFM shall ensure that a proper and independent valuation of the assets of the AIF can be performed).