As the attractiveness of commercial real estate as an investment class continues to grow, a key challenge for fund managers is to organize the robust oversight of portfolio valuation activities.
As for any growing asset class, market participants do face organizational and regulatory challenges to maintain their activities on a sustainable growth track. Amongst such challenges for real estate fund managers is to efficiently and securely organize the oversight of the portfolio valuation activities, especially in light of the Alternative Investment Fund Managers Directive (“AIFMD”).
According to the data released by “Real Capital Analytics”, global transaction amount has increased from EUR 763 billion in 2007 to EUR 952 billion in 2019. EUR 634 billion worth of transactions recorded during the first 3 quarters of 2020, by being at the same level as the first 3 quarters of 2019, proves also how resilient and important this asset class can be during downturns of economic activities.
Parallel to the increase of transaction volume, as well as the asset values, the investors are seeking constantly for more flexible, innovative yet reliable real estate investment products. The Alternative Investment Funds structure, established under Luxembourgish legal framework, offers diversity and flexibility to meet a wide range of investor needs.
How it started
The Alternative Investment Fund Managers Directive, published in “Official Journal of the European Union” at issue of 01 July 2011, numbered 2011/61/EU (“Legislative acts”), was set as the main regulatory framework for alternative investment fund managers (“AIFM”) operating in the European Union. This AIFMD was supplemented with Regulations (“Non-legislative acts”) issued by the same body in December 2012 and published in the Official Journal at 22 March 2013.
It should be also noted that Luxembourg, as one of the first EU member states, has implemented the AIFMD in July 2013 with a law (“AIFM Law”) passed by the Parliament, providing also a special tax regime with a reduced tax rate on Alternative Investment Funds (“AIFs”) domiciled in Luxembourg.
The objective of the AIFMD is to ensure a high level of investor protection by laying down a common framework for the authorization and supervision of AIFs. Among many requirements and founding regulations, the AIFMD also regulates “Valuation” requirements of AIFM’s. Appropriate and consistent procedures for proper and independent valuations, that can be performed by an either internal or external appraiser are clearly dictated in the AIFMD.
The internal valuation function within AIFM’s are required to be conducted independently from portfolio management and the remuneration policy should avoid any doubt about the objectivity of this function. Other measures have to ensure mitigation of conflict of interest and prevention of undue influence upon the employees in charge of valuation tasks.
On the other hand, external valuers, being independent from the AIFM have to be subject to mandatory professional registration recognized by law, legal or regulatory provisions or rules of professional conduct.
Along with the valuation task emerges also the valuation oversight obligations, which remain with the AIFM regardless of whether the valuation function is internalized or externalized.
What is valuation oversight?
Valuations have to be conducted in a way that ensures independence and objectivity, eliminating any possible bias and promoting high professionalism as also requested by international valuation standards.
At the end, AIF investors rely on these valuations for their investment decisions. Consequently, the overview of valuation procedures and asset valuations, in other words valuation oversight, became an essential yet complex task for AIFMs over the years, as the number of the assets and participants in the valuation process increased significantly along with the number of the investors and investment volume. This complexity caused valuation oversight to become time consuming and even, if one may say, a daunting task for AIFMs, requiring a comprehensive but precise approach.
Valuation oversight requirements are described in the above-mentioned AIFMD and Regulations but for sure it can go beyond these legal requirements. Let’s focus into some of these legal requirements:
§9 of Article 17 “Valuation” of the AIFM Law Luxembourg, which is tied to Article 19 §9 of the AIFMD, points out that CSSF (the Luxembourg financial sector supervisory authorities) may require the AIFM to have the valuation procedures and valuations to be verified by an external valuer or by an auditor in case the valuation function is not performed by an independent external valuer. This request is also enhanced by the article 68 of the Regulations, which points out that the competent authority has the right to require that the [valuation] model be verified by an external valuer or auditor, if the model is used to perform the valuation function on its own.
Article 17, §10 of the AIFM Law also holds AIFMs responsible for the proper valuation of AIF assets. Therefore, the fact that the AIFM has appointed an external valuer shall not affect the liability of the AIFM towards the AIF and its investors. This liability means also that the AIFM should be in charge of the alignment (and oversight) of the external valuation and (internal) NAV calculations.
There might be also cases in which some investments of AIF portfolios are valued internally and ‘AIFM’s are liable to set a valuation review process in line with the policies and procedures’ some of them conducted externally, possibly by more than one external valuer. It is again the AIFM’s task to oversee that selected valuation policies and procedures have been correctly implemented in unity in all of the valuation reports, that have been prepared by different parties and processes of different valuers comply with the sector standards as well.
Maybe, we can explore here what is meant with “valuation policies and procedures”.
Article 19 “Valuation” of the AIFMD has been supplemented with Section 7, Article 67 (“Policies and procedures for the valuation of the assets of the AIF”) in the so-called Level 2 AIFM Regulations. This article entrusts AIFMs with establishing, implementing and reviewing written policies and procedures that ensure sound, transparent, comprehensive and appropriately documented valuation process for each fund they manage. The valuation policy and procedures shall cover all material aspects of the valuation process and valuation procedures and controls in respect of the relevant AIF.
According to Article 67 as referred above, the valuation policies and procedures shall address at least the following:
(a) the competence and independence of personnel who are effectively carrying out the valuation of assets;
(b) the specific investment strategies of the AIF and the assets the AIF might invest in;
(c) the controls over the selection of valuation inputs, sources and methodologies;
(d) the escalation channels for resolving differences in values for assets;
(e) the valuation of any adjustments related to the size and liquidity of positions, or to changes in the market conditions, as appropriate;
(f) the appropriate time for closing the books for valuation purposes;
(g) the appropriate frequency for valuing assets.
In addition, this article also requires an initial and periodic due diligence of the third parties that are appointed to perform valuation services, to be conducted by AIFM.
The use of policies and procedures is also found in Article 71 of the Level 2 AIFM Regulation, “Review of individual values of assets”. With this article, AIFM’s are not only liable for proper, fair and appropriate valuations but they are also obliged to set a review process in line with the policies and procedures, when a material risk of an inappropriate valuation exists.
The review process should include sufficient and appropriate checks and controls on the reasonableness of individual assets and be described clearly in policies and procedures. Considering technical and formal details that should be reviewed within a real estate valuation report, which could be subject of another article, it is needless to say how time consuming this task would require for portfolios of dozens, in some cases hundreds of assets, in many different classes and from various geographies with their own dynamics.
Complying with valuation oversight responsibilities
Development and maintenance of these policies and procedures are essential valuation oversight duties. Complying with these tasks requires the capability to cope with different stakeholders such as valuers, fund managers, auditors and regulators, extensive (and preferably international) real estate sector knowledge, high level of valuation expertise rooted by internationally accepted standards and supported with technical skills, precise documentation capacity, as well as widely recognized reporting expertise that would be known and acknowledged by global investor base.
Some of the questions that should be raised by a proper valuation oversight function to avoid regulatory sanctions would be as follows:
“Does the valuer possess adequate skills and expertise as requested by regulation?”
“Are the valuation methodologies and approaches consistent among different investment portfolios?”
“Have the accuracy and coherency of the assumptions been tested?”
“Is the valuation work in compliance with international standards?”
“Has the documentation required by regulators as well as by investors been completed in accordance to policies and procedures, and cover all necessary information?”
AIFMs are increasingly considering solutions to support the complexities of the valuation oversight tasks. In this context, externalizing of specific valuation oversight tasks should enable the AIFM to answer these and more questions thoroughly and frankly, while it undertakes the following:
• A clear description of the AIFM’s organization and responsibilities with regards to the valuation oversight process, including focus on independence, competencies, etc.
• Reviewing the onboarding process of new funds, dealing with questions like engaging external support, information flows, use of models & IT tools, etc.
• Execution of actual valuation and model review
• Ensuring that process flow occurs as designed by the AIFM
• Performing and documenting due diligence conducted on external appraisers and experts
• Reviewing and updating valuation policies and procedures
• Documenting valuation policies and procedures appropriately
• Reporting of exceptions, addressing areas of focus and concerns from a regulator point of view
Applying state of art technology to manage enormous quantity of data required by different valuation oversight tasks would be also key for AIFMs wishing to allow scaling of their business. An outsourced valuation oversight service provider with the appropriate technical platform can deliver digital solutions to cope with regulatory complexity, by building an effective data management that would enable cost and time efficiency, enhanced operational productivity, simplified decisional process and reduced potential data loss.
An efficient valuation oversight supported by the appropriate technology to enable AIFMs to sustainably grow and navigate the complex environment of portfolio valuations, to hold on to strict deadlines and provide assured independence while seamlessly performing these undoubtfully essential tasks.