In-house valuation teams, with experts for every asset class, will become a standard feature among Alternative Investment Fund Managers, known as AIFMs, write Universal Investment’s Gerrit van Vliet and Krzystof Czerner in this contribution as knowledge experts to Investment Officer Luxembourg. “Fair value calculations are not only necessary to pass regulatory audits, but also to provide a value-added to investors and their relationship with the AIFM.”
Market volatility in recent months has strengthened the role of illiquid assets. A look at portfolios of professional investors on our platform shows that alternative investments such as private equity, private debt or infrastructure have stabilised the performance when equity and bond funds went south.
Unlike traditional assets, the valuation of alternatives such as off-shore wind-farms, solar parks or railroads however is a more complex matter. It is the very same market volatility that makes it increasingly important for investors to properly understand the fair value of their alternative investments in fund structures – and for an Alternative Investment Fund Manager, or AIFM, to credibly analyse and defend their valuations of assets.
Fair value calculations
In the current dynamic environment, credit spreads and interest rates are changing more rapidly than we have experienced in the past decade. Fair value calculations are therefore not only necessary to pass regulatory audits, but also to provide a value-added to investors and their relationship with the AIFM. Because as an investor, you have a substantial interest to know the value of your asset, even if you are not planning to sell it now.
The challenge, however, is to determine what fair value is. There is neither a one-size-fits-all model to value assets nor would such a model necessarily be accepted by every party involved.
In fact, what we see today is a variety of principles being used: market-based approaches that utilise multiples, recent investments or available market prices. Alternatively, an income approach based on the Discounted Cash Flow model is used. As a result, many times a value considered fair is filled by assumptions, yields and reference data calibration rather than based on a plain and simple process. AIFMs thus need to be in the position to discuss with external surveyors, auditors and fund managers based on the information available and convince them of the valuation used for the fund is most appropriate.
Specialist knowledge
To find common ground with investors and auditors, one needs to understand the assets themselves and the market environment – something traditionally associated with Portfolio Managers rather than AIFMs. Specialist knowledge is required to interpret the available array of information and to take the complete asset structure as well as the exposure into account.
Asking external service providers the right questions and defending the valuation in front of auditors is a skill required to provide value for investors: Are the changed interest rates reflected? Have they considered a reduction in future profits due to the withdrawal of the investee company from a specific region? Are the significant increases in energy prices or potential supply chain shortages included in the cash flow estimation? The list of items to factor in is endless.
The CSSF, Luxembourg’s supervisor, understands this predicament for entities that are supposed to provide oversight but lack competencies and rightfully so put pressure on market participants. CSSF Circular 18/698, issued in 2018, demands AIFMs to create independent value functions, separated from portfolio and risk management teams, which often take over but are exposed to potential conflicts of interest. We expect this pressure to be further increased in the future, contributing to a changing market landscape.
Valuation teams
For one, we expect AIFMs are going to need dedicated in-house valuation teams with experts for every asset class. Universal Investment is already planning to further expand their existing team and we expect others to follow.
Secondly, smaller AIFMs may continue to fall back on costly external support for the time being but eventually see themselves left by the wayside. For some, the rising AML/KYC requirements already has been a struggle. The ever-increasing substance requirements must be met with expertise and capacities that can only be obtained if sufficient assets under management are under oversight. Finally, the current situation also leads to too much dependency on external valuation parties. This could harm funds and their investors through high, unexpected costs and furthermore with reputational damage in case of mispriced assets and audit delays.
At the end of the day both asset owners and the financial hub Luxembourg will benefit from this development. Especially those clients coupled with like minded partners will benefit from better insight into valuations and their assets, staying ahead of the curve.
Krzysztof Czerner is alternative investments valuation manager at Universal Investment Luxembourg, a knowledge partner of Investment Officer Luxembourg. He wrote this article together with Gerrit van Vliet, head of alternative operations at Universal Investment Luxembourg.