Fund managers of illiquid assets face growing scrutiny and complexity, writes Ingo Wichelhaus
Institutional investors are continuing to turn to alternative asset classes to help match liabilities. Many have opted to access less liquid assets via funds or funds of funds, where valuations are embedded in a portfolio net asset value that the manager is required to deliver to investors.
For direct investors in illiquid assets, however, most valuations to date have been undertaken using the ‘at cost’ method, combined with an impairment test; assets are valued at amortised costs and valuations are only adjusted when they fail to pass impairment tests, normally taking collateral valuation into consideration. This has traditionally been the case for real estate loans.
However, the credit investment world is changing.
As alternative investment fund managers (AIFM) deploy capital into increasingly complex investment opportunities that require appropriately skilled staff and advanced systems, regulators and auditors are, in response, applying additional pressure on fund managers and institutional investors to deliver more transparent and current asset and fund valuations.
The UK’s Financial Conduct Authority dictates that valuations must be undertaken independently from the portfolio management and in cases of complex, private credit investments AIFMs that conduct valuation exercises internally are having to direct resources towards employing highly sophisticated (and expensive) staff who will be required to operate behind safe-guarded walls from their fund managers. Even then, the integrity of the valuation process will need to be audited internally and perhaps externally, introducing further expense and convolution to the process.
Moreover, in the environment of evolving credit fundamentals in which we now operate, valuations at amortised costs do not provide current and clear pictures of portfolio asset values. The shortcomings of at-cost valuations are becoming unacceptable to both auditors and regulators, in turn necessitating more sophisticated valuation methodologies. An example might be availability-driven infrastructure debt investments, such as toll roads or motorways. During the COVID-19 pandemic, valuations were substantially impacted by reduced traffic and funds invested in the asset class required valuation adjustments. But this could not be reflected using a pure amortised cost-based valuation approach.
So, in the face of this growing scrutiny and complexity, how can fair market values be determined without a ‘real market’?
The challenge is twofold: first to model the asset cashflows and second to determine an appropriate discount rate to apply to those cashflows using a discounted cashflow model. One of the ways to address this challenge is to split the discount rate into its individual components, namely a risk-free element and a risk premium.
Amongst others, the main components of the risk premium could be asset class or portfolio strategy-specific credit-risk premium and liquidity premium. For each individual component, an observable benchmark from a liquid asset class with a high correlation in respect of historical performance and/or underlying risk can be determined, which can then be adjusted appropriately. In addition, publicly available market evidence and research of asset classes in comparable jurisdictions can be assessed, providing an indicator to calculate market influenced shifts of the risk premium components.
But it remains a complex and multi-layered process requiring specific and deep expertise. Therefore, for multiple reasons – including staff cost reductions (or avoidance of additional staff costs), difficulty in attracting talent with the requisite experience, and a desire to provide increasingly demanding clients and regulators with truly independent asset valuations – more and more AIFMs are mandating qualified, independent third parties to support their valuation processes.
As the weight of regulation and cost, which is met generally from the investor-return pot, increases, the trend towards outsourcing the more complex areas of fund administration is growing. The challenge is even greater for those operating across multiple geographies, which brings the additional complexity of adhering to local market requirements, demanding the staff, systems and technological capabilities more frequently found in a widely regulated, international bank.
With many AIFMs operating across global financial markets, it is critical that asset valuation functions have a broad geographical reach across complex investments. To meet the increasing expectations of investors and regulators effectively and efficiently, the trend towards outsourcing will no doubt grow, enabling AIFMs to focus their energies on client delivery.
