Valuation of AIFs in India vs funds in the US
The Securities and Exchange Commission (“SEC”) recently adopted the “Good Faith Determinations of Fair Value”1, (“rule 2a-5” or “final rule”) under the Investment Company Act, 1940 (“Act”) which will apply to registered investment company or business development company (“Fund”). The final rule regardless of their classification or sub-classification (e.g., open-end funds and closed-end funds) will come in force within 60 days from their publication in federal register.
The SEC has introduced these changes after 50 years, and the funds industry in US has seen major development since then. 2 There has been a change in the way that market participants – such as boards, investment advisers and auditors - in the US deal with valuations under the federal securities laws.3 In light of these evolutionary changes, the introduction of the Rule 2a-5 will lead to modernization of fund valuation in the United States of America (“US”).
We look at this change brought about in the US as compared to the valuation norms currently prevailing for Alternative Investment Funds (“AIFs”) in India which are registered with the Securities and Exchange Board of India (“SEBI”) under the SEBI (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”).
A brief analysis of fund valuation practice in US
The US funds regulatory regime extensively covers fund valuations and reporting standards - giving specific definitions to key terms4, appointing designated parties having supervisory and regulatory functions5 and imposing penalties for default. The final rules have made the board more accountable for the funds, where the board has to look after varied disclosures including fair value methodology (‘FVM’) policy, material conflicts of interest and managing identified valuation risks. The SEC identifies that the board should not be burdened with micromanaging the valuation of the funds and has introduced Rule 2a-5 accordingly with appropriate mechanisms to ensure fair valuation methodologies.
It will be mandatory for a fund to establish an FMV policy which shall be in compliance with principles of the valuation approaches laid out in the accounting principles ASC Topic 820.6
The final rules have also made the board or valuation designee responsible to determine which of the identified sources and types of valuation risk are relevant to the fund’s investments depending on the type of investments, sector disruptors or fair value methodology. (‘FVM’).7
The valuation designee must provide to board at least quarterly and annually reports in writing along with summary or description of material fair value matters that occurred in the past year or prior quarter and various material changes relevant to the fund. A prompt notification is also introduced whereby value designees within 5 days has to a notify the board of material matters related to valuation controls or errors that either the valuation designee has identified itself or that the valuation designee has been notified of by an independent third party, including the fund’s auditor.8
Further, the SEC has also affirmed the principle of back-testing whereby a comparison of the fair value ascribed to the fund’s investment against observed transactions or other market information, such as quotes from dealers or data from pricing services and other appropriate testing methods to check the accuracy of valuation.9
A juxtaposition of Rule 2a-5 with Indian Laws
In India, AIF Regulations cover valuation10 and performance benchmarking11. This year, the AIF regime saw the introduction of performance benchmarking and standardisation of the Private Placement Memorandum (“TPPM”)12, which helped to formalise an already common industry practise, while ensuring flexibility for the AIF Managers. The TPPM has added a separate section on valuation whereby details of frequency of valuation of the portfolio companies and valuation principles used by the Fund have to be provided in the placement memorandum. Further, if the fund follows the TPPM and deviates from International Private Equity and Venture Capital Valuation Guidelines, it has to state the same in supplementary section.
The AIF Regulations have indicated that the benchmarking agencies and the AIFs can mutually agree to cover the mode and manner of data reporting, specific data that needs to be reported, terms including confidentiality in the manner in which the data received by the benchmarking agencies may be used.13 SEBI has also provided operational guidelines for such implementation.14
In India, the AIF, investment manager and trustee are responsible to do the requisite reporting as per AIF Regulations. The reporting is already exhaustive, and SEBI assiduously reviews the fund documents while registering an AIF in India.
The AIF Regulations are compendious on its reporting regime through the principles of valuation are still evolving in India. Investments in AIFs has been progressively growing in India, seeing more than 75% year on year growth in the past 2 years.15 SEBI took many initiatives this year to increase transparency and including aspects like performance benchmarking and easing compliances taking COVID-19 into consideration.
1 Final Rule – Good Faith Determinations of Fair Value, available at - https://www.sec.gov/rules/final/2020/ic-34128.pdf
2 ”Several funds now engage third-party pricing services to provide pricing information, particularly for thinly traded or more complex assets, which were perhaps not existing in 1970”; SEC Modernizes Framework for Fund Valuation Practices, available at - https://www.sec.gov/news/press-release/2020-302#:~:text=Performance%20of%20Fair%20Value%20Determinations,can%20make%20this%20determination%20itself..
4 For instance, the Investment Company Act of 1940 defines the word “value” u/s 2 (a) 41 (B) which is not defined in the AIF regime in India, available at - https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf
Also, Rule 2a-4 defines “current net asset value”, available at - https://www.sec.gov/rules/proposed/1964/ic-4105.pdf
5 Some parties involved with designated functions concerning valuation are - Board of the Fund, “Valuation designee” and sub-advisors under the Board, Chief Valuation Officer.
6 SEC, 17 cfr parts 210 and 270, good faith determinations of fair value available at https://www.sec.gov/news/press-release/2020-302.
10 Regulation 23, AIF Regulations
11 Disclosure Standards for Alternative Investment Funds (AIFs), available at - https://www.sebi.gov.in/legal/circulars/feb-2020/disclosure-standards-for-alternative-investment-funds-aifs-_45919.html.
12 Supra note 11
13 Ibid, Paragraph 12
14 Operational Guidelines for implementation of Performance Benchmarking, available at - https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/ann_4_p.pdf.
15 Consultation Paper on Introduction of Performance Benchmarking and Standardization of Private Placement Memorandum for Alternative Investment Funds, available at - https://www.sebi.gov.in/reports-and-statistics/reports/dec-2019/consultation-paper-on-introduction-of-performance-benchmarking-and-standardization-of-private-placement-memorandum-for-alternative-investment-funds_45215.html.