Mutual fund directors and investment advisers digest

Revisiting oversight process of alternative investments

As the search for alpha continues to consume active managers, we believe that investments in alternative investments will continue to grow, which could create challenges for valuation and board oversight. Our latest digest takes a closer look at some of those challenges and how SEC Rule 2a-5 could allow fund groups to revisit and refine their current practices.

A new cornerstone of asset management

As the investment industry concludes one of the more volatile and challenging periods, it is becoming increasingly fashionable and an industry trend to accelerate and expand the manufacturing of alternative products. In fact, over the past 30 years, alternatives have evolved from a cottage industry to a cornerstone of asset management. Traditional mutual fund shops have continued to expand their product lineups to include alternative products in the form of interval funds, private equity, private debt, infrastructure, natural resources, and real estate funds, as well as business development companies (BDCs).

While the appeal to launch alternative products and seek to generate higher alpha and grow assets under management (AUM) is alluring, such products come with portfolio holdings that increase complexity and create challenges to the fund groups’ valuation operating model and the board valuation oversight process.

Further, some mutual funds registered under the Investment Act of 1940 (the "Act") have made it an investment objective to invest a portion of their capital in alternative investments with the goal to add alpha. Private equity investing is filled with blowups, cautionary tales, and success stories. 

Even funds without a focused strategy to invest in alternative investments may end up holding one or more of these instruments. Thus it can become a point of interest for a majority of funds and their boards and a good practice to establish valuation governance protocols and enhancements to the valuation operating model.

Revisiting oversight process of alternative investments

What Rule 2a-5 might tell us about the SEC’s expectations

Fund groups spent considerable time refining their respective approaches to implementing the US Securities and Exchange Commission’s (SEC) Rule 2a-5 under the 1940 Act (the “Rule”), which funds were required to adopt by September 8, 2022. More than 90% of 2022 Deloitte Fair Valuation Survey participants indicated that they spent a moderate or significant amount of time, effort, and expense on the effort. Fair valuation has never been a static process for fund groups. The Rule certainly provided a catalyst for change.

The Rule itself does not require that fund groups make changes to how they value private equities and private credit products. However, the adopting release of the Rule sheds light on the SEC’s expectations on how mutual funds and their boards should consider this asset class relative to valuation. The adopting release is clear in stating that “Rule 2a-5 sets forth certain required functions that must be performed to determine the fair value of the fund’s investments in good faith.” Thus, the Rule reflects what a mutual fund needs to perform when valuing an investment without a readily determinable fair value. What follows are a few key points of the Rule.

Periodically assess and manage valuation risks: The adopting release highlights that the SEC expects that mutual funds will identify the key inputs and assumptions necessary to value alternative investments and that such is critical to meeting the requirements of the Rule.

Test fair value methodologies for appropriateness and accuracy: There are different methodologies that fund groups use to value their investments. Given the potential for different viewpoints, testing the methodologies can be very important. The adopting release focuses on the potential for using calibration and back-testing to assist in testing fair value methodologies.

Pricing services: In the 2022 Deloitte Fair Valuation Survey, 31% noted that they employ a third-party valuation specialist to value private equities. Additionally, the Deloitte Private Equity Survey found that 90% of participants that manage a business development company indicated that they use a valuation specialist.

Board valuation “active” oversight: The SEC has clear expectations that boards will more carefully consider investment risk in determining the level of oversight they provide.

Considerations for board members

Implementation of the Rule has occurred, but that does not mean that the valuation operating model will now continue to be evergreen, nor does it mean that board valuation oversight should be any less active. One area in which the board may want to focus more time and effort is the valuation of private equities and private credit investments. This is not to say that boards have not spent time in this area. Many have spent considerable amounts of time. The Rule provides a path for boards and their designees to develop valuation procedures for these investments through the risk assessment process.

Here are some key points that boards and their designees may want to consider relative to private equities and private credit instruments:

  • Population of investments
  • Approriateness of model used
  • Impact of inputs and assumptions to determine valuation
  • Adequacy of valuation resources
  • Potential conflicts relating to members of the valuation team
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