Regulation: A game changer for fund valuation?

The Alternative Investment Fund Managers Directive has implications for real estate fund valuations. Michael Hornsby and Christian Ostbringhaus explain 

The Alternative Investment Fund Managers Directive (AIFMD) has fundamentally changed regulation of the alternative funds industry. It has not, however, transformed in substance the way in which funds value their assets. The review and oversight of the determination of the net asset value (NAV) of a fund has been formalised, and the roles and responsibilities of the various functions involved more defined.

It is important to bear in mind that a real estate fund’s NAV includes other assets and liabilities than just these related immediately to real estate investments. Further important components include debt and derivatives, provisions for taxes, working capital balances and financial investments. To ensure an accurate, transparent and concise valuation, the AIFM shall establish, implement and maintain a set of adequate valuation policies and procedures.

It is important to distinguish between the roles of all parties involved in the valuation process. These include the AIFM board, those responsible for the valuation function – which could be an individual, team or committee – and specialist service providers who value the individual assets and liabilities included in the NAV as well as the risk management and compliance function at the review and quality assurance level.

In addition, the depositary also has a responsibility to understand and examine the valuation process and resulting outcome, and, on an annual basis, the external auditor will also be involved. Ultimately, valuations should be performed in accordance with the standards envisaged in the Private Placement Memorandum (PPM) of the AIF and, in any case, in accordance with commonly accepted market standards – such as the International Valuation Standards or the valuation standards of the Royal Institution of Chartered Surveyors – to meet investor requirements.

It is important to note that, for an internal valuation function, the liability of the AIFM for its role in organising, overseeing and possibly performing asset-level appraisals is unlimited, whereas the liability of the specialist property appraiser is generally limited by the terms of its engagement with the AIF, the AIFM therefore effectively assumes the liability for work of the appraiser and therefore needs to qualify them and be comfortable with their work. Particular attention should be paid to requirements regarding delegation oversight and valuation reviews, or – otherwise – at least to a proper service provider due diligence oversight.

The structure of the overall valuation process is summarised in figure 1. 

The valuation function has to be well-documented in policies and procedures covering:

• The valuation frequency;
• Responsibilities of all parties involved in the valuation process;
• Competency and independence of people in charge of the valuations;
• Control over the determination of valuation parameters, sources and methodologies;
• Escalation procedures in case of detected flaws or material valuation differences.

In addition, the valuation function can be performed internally or delegated according to one of the following options with respective advantages and disadvantages (see figure 2).

Looking at these options in more detail, it can be observed that a full internal valuation is not very common in Europe, as investors often expect independent appraisals of real estate assets as defined, for example, by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) in its guidelines. However, it might be attractive to be in control of the entire process while probably representing the most cost-efficient mode. This first option is rather used in closed-ended special funds.

The second option is the most commonly used model, which allows using external expertise in local real estate markets as the AIFM function may not have all the specialist skills to value all components of the NAV.

The third possibility, the complete outsourcing of valuation, is being used more. Engaging external firms gives access to a broad range of competence and geographic coverage as they are familiar with the more formal review and documentation requirements playing a role in this process while having required resources and skills available. In addition, AIFMs are enabled with diverse and specialist investment strategies to function effectively.

As already mentioned, the ultimate responsibility for the adequate valuation of the AIF’s assets for the NAV calculation, as well as its publication, lies with the AIFM. Therefore, there is a focus on the ability of valuation service providers to furnish professional guarantees backed by adequate insurance. Specifically, the external valuer should demonstrate sufficient professional indemnity insurance to protect the AIFM from any liability for any losses resulting from the external valuer’s negligence or intentional failure to perform its task. Eventually, it can be argued that the scope of liability under AIFMD and the willingness of external parties to accept such liability remain both driver and challenger in the process of engaging external valuation support parties.

The AIFMD does not introduce fundamental new concepts in the field of real estate valuation, but formalises the overall organisation and process of oversight of the valuation. Taking this one step further, we can expect some AIFMs to outsource or seek technical support for the oversight function with parties that have expertise across all components of the NAV, not just on the real estate asset itself. The valuation process can be organised in many different ways given the diversity of geography, fund type or asset class. With regulations being fairly generic in terms of requirements, AIFMs need to take practical approaches to be fit for purpose.

Michael Hornsby is a partner & Christian Ostbringhaus works in the RE trans-actions and advisory services team at EY Luxembourg