Exploring the impact of AIFMD's fair valuation requirement

It is easy to see the fair valuation requirements of the AIFMD as superfluous for private equity. NAV for hedge funds directly impact management and performance fees, therefore deepening the argument for regulating hedge funds and private equity separately.

What is more, private equity firms on the whole tend to value their assets conservatively. GPs would much rather under-promise and over-deliver by keeping valuations low and then nicely surprise LPs with a juicy realisation.

However, there are dangers involved when conservatively assessing NAV. According to Mathias Schumacher, managing director of Duff & Phelps' valuation advisory service, the first is the impact on LP allocations. "LPs will ultimately be over-allocated to private equity if GPs are using conservative valuations. If GPs are valuing conservatively it could look like the LP has a 5% allocation but in reality could be more like 6-7%."

The second issue lies specifically where pension funds with deficits are invested in private equity. "If this group of investors had a more realistic view of their private equity allocation then their under-funding may not be as pronounced," says Schumacher.

Independent ruling
The AIFMD requires private equity firms to perform valuations of their assets, and this can be done internally or externally, on a regular basis. However, if a firm is performing the valuation internally, it must prove it has been done ‘independently from portfolio management'. In practice, this means whoever is performing the valuation must do it separately from the deal team. Unfortunately this is easier said than done – it would be near-impossible to value a portfolio company without interacting with the investment team on some level. 

Furthermore, the AIFMD states the ultimate responsibility of the valuation comes down to the manager. Therefore, even by bringing in a fully independent valuation service provider, the GP remains in the firing line.

Finally, if the valuation is performed internally, the AIFMD in the UK states the FCA may require the valuation procedures and/or valuations to be verified by an independent party.

Best practice
Despite the heavy-handed rules, the ultimate aim of fair valuation is to instil high levels of best practice throughout the alternative asset class. If GPs implement and maintain fair valuation when reporting to LPs, that increased level of transparency and total clarity on performance should benefit all stakeholders.

Furthermore, as the secondary market continues to thrive, the involvement of independent valuation service providers will surely aid the transaction process and boost comfort levels of both buyers and sellers.

But the most important impact of this particular rule is its ability to determine a GP's future. According to Schumacher, there are very few firms in the US that do not use an independent valuation provider: "It has become industry standard when GPs are fundraising, as part of the LP's operational due diligence." And, unsurprisingly, the trend is now catching on in Europe. Buyout houses that fail to take the fair valuation requirements seriously may suffer on their next road trip.

However irksome the new rules are, particularly for small funds that have limited resources to ensure compliance, it is vital that GPs take into account the ultimate impact of the rules. By implementing a thorough valuation procedure, GPs could in some part ensure the success of their next fund.

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