CSSF spotlight on AIF valuations

As it appeared in Agefi in December 2023, with slight date-related modifications.

The unveiling of the European Securities and Markets Authority’s (ESMA) findings on the Common Supervisory Action (CSA) on Valuation, and the subsequent recommendations as per the CSSF's feedback report, in July 2023, have ignited intense discussions among market participants and valuation professionals in the Grand Duchy, which were further amplified by the limited timeframe for investment managers to achieve compliance by 31 December 2023. The intensified scrutiny of valuation functions, arising from the alignment of ESMA and national supervisory authorities, is expected to place a considerable burden on valuation teams. 

Our ongoing conversations with alternative investment fund managers (AIFMs) and depositaries on the CSSF recommendations have particularly focused on the appropriateness of valuation policies and procedures, implementation of annual model reviews, and performance of liquidity stress-testing. Furthermore, and for the first time in many years, we have noticed a renewed interest in debates pertaining to the role and responsibilities of AIFMs, depositaries and portfolio functions in the context of valuation. ESMA's recommendations on valuation came amidst the remarkable growth of alternative investment funds (AIFs) and undertakings for collective investment in transferable securities (UCITS) over the past decade, reflecting a concerted effort by supervisory authorities to further safeguard end-investors by ensuring that reported valuations mirror their true and fair value as closely as possible, minimizing the potential for misinterpretations among investment managers and “responsibilizing” the valuation function.

We believe this is a good opportunity for valuation professionals and investment managers to rethink their valuation process and reconsider the various ways they are dealing with valuation-related risks. Motivated by the factors mentioned above and, in particular, the need to comply with the CSSF’s requirements, we are sharing our view on the regulatory update for investment fund managers (IFM), with a particular focus on the Luxembourgish market.

Valuation Procedures and Policies (VPP)

Importance of valuation policy

Our current interactions with the AIFM community indicate that while VPP have been established by investment managers, these frameworks often fail to effectively capture the nuances of the valuation process and may not always be tailored to the specificities of the funds, by over-relying on other group entities’ valuation policies. We notice an increased reliance on external service providers to support the update of existing valuation policies as AIFMs want to ensure they are not missing the mark and that grey areas are ironed out.

The CSSF reminds all investment managers that VPP should provide a transparent and comprehensive overview of the valuation process for each fund. This includes clearly outlining the roles and responsibilities of the parties involved, the sources of information utilized, the applicable valuation methodologies employed, the documentation and validation process of financial models, the backtesting, and the approval mechanisms in place. A yearly review of VPP is expected by the CSSF to ensure its ongoing relevance and alignment with evolving valuation standards and restrictions. Detailed documentation of all modifications and securing senior management's approval are indispensable aspects of the valuation policy review.

Uses of valuation model

We believe that this section of the CSSF recommendation is the most debated one, considering the critical role valuation models play in illiquid asset valuation. Initial discussion with valuation specialists revolves around the definition of a model, its inherent nature, and the spreadsheet models developed internally clearly within scope. But does valuation software also fall within this purview?

Important question marks are being poised about the intensity of a model review, more precisely on whether a full review or limiting the review to a model update should suffice. It is worth reminding that a model review is a deep-dive into a valuation model with a cell-by-cell analysis to ensure that valuation assumptions transform into the desired output. Consequently, complex models will require substantial time commitments to review, which may exceed hundreds of hours. Dedicated tools, software and trained workforces will be needed to tackle this challenge head-on. Such resources are not always readily available within AIFMs, so reaching out to specialized external experts is a likely route to take.

This model review requirement came to light as the CSSF’s assessment revealed weaknesses in practices of certain IFMs, with a particular focus on those managing open-ended funds invested in unlisted equities and direct real estate. IFMs are reminded of the importance of performing regular reviews of financial models employed for valuation purposes, emphasizing that such reviews should be conducted by individuals who have not been involved in the model's development process. These reviews, which should be comprehensively documented, should encompass an examination of data inputs, data sources, and underlying assumptions, as well as an assessment of the logical flow, consistency of formula derivation, and overall limitations of the model.

Valuation under stressed market conditions

Liquidity stress-testing (LST) is discussed within the AIFM ecosystem, for various reasons. Namely, it may require further interactions between risk management and valuation functions, and also raises questions as to whether this also applies to closed-ended AIFs. On the latter point, we note further questions as to whether liquidity is to be considered at the level of the fund's NAV, or if it should be extended to the level of the fund's financing commitments. In any case, even if no significant LST needs are identified for closed-ended AIFs, it remains a good practice to perform such assessment and document this.

In light of the recent Russia-Ukraine war, investment managers are reminded by the CSSF that their valuation policies should clearly define the applicable valuation methodology during stressed market conditions. Additionally, these policies should establish the triggering criteria for such conditions, ensuring that these factors are adequately considered in determining the final valuation and related fair value adjustments. Any significant uncertainty or limitation that may impact asset valuation should be promptly and transparently disclosed to investors.

Independence of the valuation function and use of third parties

ESMA emphasizes the importance of effective conflicts of interest management when valuation-related functions are outsourced to third parties, including other group entities. The CSSF underscores the importance of having an independent valuation function that can be clearly distinguished from a portfolio management function and whose remuneration should not be influenced by the performance of the funds. The valuation function should essentially be further protected from undue influence.

The CSSF further observed that valuation assumptions such as pricing and data sourced from third-party providers, and mark-to-model valuation provided by external valuers, were insufficiently controlled. Investment managers should document the reason for choosing a pricing source, independently review third-party pricing models and frequently backtest the pricing or valuation obtained. Internal models that can be controlled should be favored.

Early detection mechanisms for valuation errors and transparency to investors

Safeguarding investors’ interests is once more in the scope of the CSSF’s recommendation, whereby remedial procedures need to be formally established to allow swift investor compensation in the event of valuation errors or NAV miscalculation. It is likely that investment managers and valuation functions will be subject to stricter scrutiny and greater accountability than ever before.

The CSSF further specified that these remedial procedures must be subject to regular monitoring, especially during periods of market stress.

Private equity and real estate funds in light of the LST

Valuation and liquidity risks associated with less-liquid assets, such as unlisted equity and direct real estate, are amplified by the redemption feature inherent to open-ended funds. In light of these risks, IFMs must ensure that the fund's investment strategy, liquidity profile, and redemption policy are closely aligned.

Involvement of depositaries in the verification of the valuation framework of IFMs

The CSA on Valuation revealed a general lack of depositary involvement in the verification of IFMs' valuation methodologies. The information collected suggests a lack of standardization in the role and market practices of depositaries. Depositaries are being reminded that they are responsible for conducting comprehensive reviews of VPP to verify compliance with the applicable UCITS and AIF requirements. Any valuation policy drafted by IFMs should be further checked against when reviewing the valuation methodology used to value the underlying fund’s assets. This is particularly interesting, and we expect depositaries to be more engaged in valuation debates going forward.

The CSA on Valuation conducted by ESMA and reinforced by the CSSF Feedback Report marks a significant advancement in the effort to achieve a more accurate and fair representation of the financial position reported by AIFs and UCITS, with an approach that foster cohesiveness and transparency.

IFMs and valuation professionals have been provided with a detailed roadmap outlining the areas for improvement and the desired regulatory standards by 31 December 2023. Substantial efforts will be required to redefine valuation policies and procedures, ensuring that critical inputs, ranging from data to financial models, are thoroughly evaluated.

IFMs and valuation professionals were provided with a detailed roadmap outlining the areas for improvement and the desired regulatory standards by 31 December 2023. While this deadline has passed, there is no doubt further alignment work that is still needed now and going forward, especially in light of the requirement for the implementation of annual model reviews. Substantial efforts are needed to redefine valuation policies and procedures, ensuring that critical inputs, ranging from data to financial models, are thoroughly evaluated.

How EY can help

For IFMs and valuation professionals seeking expert guidance on the roadmap and areas for improvement, as well as general support navigating the complex regulatory landscape as it impacts the valuation function, our Strategy and Transactions team stands ready to assist you in achieving compliance and protecting your reputation.