Favourable demographics in emerging markets are encouraging institutional investors to increasingly look outside traditional markets for higher returns.
However, with this heightened interest comes greater scrutiny around how emerging market fund managers provide transparent and objective valuation reporting. Fund managers are being encouraged by investors to improve their performance and put in place robust valuation practices, resulting in relevant and reliable valuation estimates, to enhance their credibility and reassure LPs about the merits of investing in emerging markets.
Emerging markets have historically suffered from a perception of poor governance practices. Whether this perception has any basis in reality is a moot point – when it comes to valuation of hard-to-value illiquid investments, even the perception of poor governance leads to a credibility gap. Investors in alternative investment funds are becoming increasingly sophisticated and are less inclined to compromise on their standards of governance. They are demanding greater transparency and assurance that funds measure and report their assets in accordance with accounting standards and industry best practices. Governance has become a key criteria for LPs in their selection of emerging market fund managers.
Given the illiquid nature of many alternative investment strategies in emerging markets, a robust valuation process is a critical element of governance. Moreover, proper valuation practices are essential to capturing the impact of existential risks on the value of investments and enabling a more vigorous monitoring of a fund performance.
Valuation best practices
Alternative investment fund managers are required to report fair value by their investors – typically through their LP agreements. To meet these requirements, they must put in place robust valuation practices that follow industry best practices and impose upon themselves a valuation framework for consistently determining the fair value of their investments. These valuation practices are codified in a fund’s valuation policy document, which must cover the types of investments held by the fund and describe the respective appropriate valuation methodologies, while formalising the timing and frequency of valuations and defining the roles and responsibilities of those involved in the valuation process.
Fair value is the best basis to report periodic performance to investors and make “apples to apples” asset allocation decisions. In contrast, a historical reporting basis such as “cost” is not informative to investors and does not allow comparability across funds. Investors would be very surprised if firms did not reflect current economic conditions from the relevant emerging market in the individual periodic valuation conclusions.
Setting common standards for valuation
The world’s top financial centres are developing good governance practices for valuation, and emerging financial centres are following them by putting policies in place that aim to reassure investors and avoid the bad publicity that results from a lack of transparency and independence. One example is the Collective Investment Funds regime introduced by the Dubai Financial Services Authorities, the regulator in the Dubai International Financial Centre, to state best practice standards for disclosure, governance and valuation. This will no doubt ramp up following the outcry caused by recent scandals in this area, as both local authorities and fund managers want to avoid a loss of confidence among investors.
Generally, fund managers in emerging markets appear happy to accept the greater due diligence demands placed upon them. They are becoming far more active in their approach to best practice because they want to demonstrate they are “doing the right thing”. They are also beginning to realise how a lack of confidence in one part of the market can impact another. For example, when the Turkish lira plunged in value, it had a knock-on effect on currencies in India, South Africa and throughout the Gulf countries – a clear sign of how investors view emerging markets as one block. Increasing the standards of governance – valuation governance in particular – is therefore seen as beneficial for the sector as a whole.
Independent portfolio valuation is becoming a must
Although large firms often have the skills and resources to perform valuations in-house, having the same people investing and preparing the valuations creates a potential conflict of interest and may result in biased valuation reporting. Hence, the need to separate the two functions. The separation of fund management functions is already a key factor examined by any investor carrying out due diligence. In some places it is becoming mandatory, such as the EU, where the Alternative Investment Fund Managers Directive (AIFMD) states the requirement for independent valuation. Valuations under AIFMD can be performed by either an external valuer or the AIFM itself, provided that the valuation is functionally independent from portfolio management and the remuneration policy.
Investors are increasingly requesting the use of qualified, experienced independent third-party valuation specialists to corroborate the fair value estimated internally by fund managers. Having an independent external valuer helps enhance the robustness of the valuation process and provide comfort to investors, as well as to fund administrators, accounting managers and auditors.
Even major investors such as sovereign wealth funds (SWFs) are using independent valuation advisers to value their own direct investments. This comes after a voluntary code of practice was developed by the SWFs and the International Monetary Fund in 2008, which aimed to improve transparency among SWFs, primarily in the Middle East and Asia. Furthermore, as they invest their countries’ savings for future generations, SWFs receive greater scrutiny from their respective governments and therefore need to report the most robust estimate of their interests. SWFs have extended their good governance requirements to the funds they invest in – and the demand for independent portfolio valuations is a key part of this.
Many emerging markets fund managers are taking a reactive approach to investor requests for independent valuations. However, increasingly managers are seeking to get ahead of the curve by proactively implementing best-in-class practices, including defining a clear timeline for the valuation process, segregating responsibilities and consistently applying appropriate valuation methodologies. They are keen to assure not only current investors but more importantly prospective investors that they are doing things properly. After all, managers realise that although investors are willing to forgive poor performance caused by market events, they won’t forget a firm’s failure to put the right governance tools in place.
The demand for independent valuations in emerging market funds is indicative of the way investors select funds today. A singular focus on returns, at the expense of all other factors, is now a thing of the past. Outperformance is well and good, but investors want to ensure they get strong returns with good governance – and that includes independent valuations.
Hakim Abdeljaouad is Director of Valuation Advisory Services at Duff & Phelps.
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