The Alternative Investment Funds Committee is pleased to share an article by Vusala AHMADOVA focusing on the Role of the Valuation Committee. Vusala is a Conducting Officer responsible, inter alia, for valuations at Vistra Fund Management, a third party AIFM, and facilitator on valuation at the ILA Fund Governance Masterclass.

Independence of the valuation function has increasingly become an area of focus of regulatory scrutiny. The topic was highlighted in ESMA’s valuation related observations as part of their ‘Common Supervisory Action’ on UCITS and AIFs, re-emphasised in the CSSF’s feedback report on the same topic and persistently re-emerges in the 2023 CSSF annual report published on 19 September 2024.  

Why does this topic persevere in regulator findings, and what role can a valuation committee play to ensure independence and boost trust?

The challenge clearly stems from the less liquid nature of certain assets, which include a broad range of hard-to-value positions with limited availability of observable data demanding well-elaborated and coherent valuation frameworks.

The role of a valuation committee in ensuring the independence of the valuation function, free from undue pressure, cannot be overestimated. 

A properly documented valuation committee charter should elaborate on responsibilities, composition of members and  voting rules ensuring independence from portfolio management. 
In practice, there are two prevalent valuation committee operating models in the Luxembourg fund industry: 

a) One performing high-level oversight and supporting the valuation function on policy development
b) The second getting into a deeper level of involvement at each valuation date to review and approve individual asset values, in addition to its general oversight role.

A valuation committee with an oversight role typically focuses on:

• adoption, implementation and annual review of valuation policies, processes and procedures, 
• validating valuation models, 
• handling escalation matters and conflicts of interest, 
• selecting external valuers, as well as reviewing and approving related due diligence, 
• conducting periodic risk-based reviews of asset valuation exercises where a risk of material inappropriate valuation may exist. 

Accordingly, such committees meet less frequently (e.g. quarterly, semi-annually or annually) but may reconvene on an ad-hoc basis if any urgent matter is escalated – for example, where a valuation function identifies a material risk associated with judgments on key valuation assumptions, inappropriate use of data and inputs or conflict of interest situations.

However, regulatory expectations are increasingly leaning towards the second model, where valuation committee members meet at each Valuation Date to review and approve asset values before the final release of the NAV.

In its 2023 annual report, the CSSF raised a concern on the frequency of valuation committee meetings not being aligned with NAV calculation periodicity which could hinder the ability of AIFMs to demonstrate their oversight of the final asset values used in the calculation of the NAV at each valuation date. 

To obtain sufficient comfort over the reasonableness of asset values before final approval, a valuation committee is expected to challenge key valuation assumptions, reliability of data and inputs used in determining fair value, along with other control procedures, and to have sufficient competence, expertise and resources to do so.

As part of its observations, the CSSF further questioned adequacy of the composition of the valuation committee, for example with regards to technical expertise in valuation and less-liquid asset types, and called into question the independence of the valuation function.

The main attributes of an independent valuation function within IFM are:

• strict separation of portfolio management and valuation activities
• appropriate remuneration schemes aimed to prevent rewarding valuation function team based on asset performance

Additionally, article 533 of CSSF Circular 18/698 recommends separating risk management and valuation functions of AIFMs managing complex and illiquid strategies with higher valuation risk. Although not a legal requirement, such segregation helps to preserve the risk management function as a second line of defence independent from the valuation function and ensures good governance.

Lack of appropriate documentation and evidence justifying decisions taken by valuation committees is another point of typical regulatory concern, as underlined in the latest edition of the CSSF annual report. In this context, a valuation committee should be in a position to demonstrate that valuation approval decisions are well substantiated and backed up with adequate documentation providing a proper basis to approve asset values.

Finally, in its annual report, the CSSF highlighted a lack of clarity in describing the AIFM’s responsibility as regards valuation, both in internal documents (such as valuation policies and procedures) and in the issuing documents of funds. In addition to internal rectification of policies and procedures, this calls for increased collaboration of the valuation committee with other functions at the fund onboarding stage, to be involved in review of fund issuing documents, to ensure that the responsibility of the AIFM for the valuation of the portfolio is explicitly stated. It is not uncommon for such documents to dwell on the valuation activities and responsibilities of a portfolio manager (PM) or General Partner (GP), in particular where the involvement of a PM in the valuation process is more extensive; however, care must be taken to ensure that there is no ambiguity in the language of an issuing document to distinctly formulate that the responsibility for the valuation of portfolio assets resides with an IFM and not the PM or GP.

It is worth noting that a Valuation Committee per se is not a regulatory requirement. Article 536 of CSSF Circular 18/698 lays down certain recommendations relating to its organisation, should an AIFM opt to establish one. Nevertheless, the CSSF increasingly views this function as an important and necessary internal body capable of ensuring independence and appropriateness of asset valuations, and expects robust operational routines from such a Committee, if an AIFM chooses to set one up.

Vusala Ahmadova Conducting Officer at Vistra Fund Management