Illiquid assets in Australia: Increased regulatory focus on fair valuation

As the impact of COVID-19 continues to ripple across the globe creating significant economic and financial uncertainty, the fair valuation of fund assets including illiquid assets is becoming increasingly necessary.

On 1 April 2020 APRA and ASIC published a joint letter instructing super funds to pay particular attention to valuation of unlisted assets and liquidity given the government decision to allow members early access to their superannuation funds.

On 11 August 2020, ASIC released a new article highlighting the importance of accurate and timely valuation of assets for fund reporting and warned that regulatory actions will be taken against responsible entities (RE) who failed to comply with their obligations to provide fair and reasonable valuations of fund assets.

Per ASIC Regulatory Guide 94: Unit Pricing (RG94), REs need to develop asset valuation policies that outline the valuation methodologies for each asset class and these policies should be regularly updated as market conditions change. In its new article, ASIC further laid importance on the governance framework by instructing REs to ensure that valuation polices are regularly reviewed by REs management and board, and such valuations are carried out by unbiased valuers who are periodically rotated. The objectives of rotating valuer periodically are very similar to audit firm rotation policy i.e. to allow more independence between valuers and fund managers and to provide unbiased valuations avoiding any long-term relationship bias. It's believed this is also helpful in fostering a competitive vendor market.

In light of current market conditions and increased regulatory focus on unlisted asset valuation, it is imperative that super funds (and their external investment managers) pay particular attention to:

• Fair Valuation. In volatile markets where the volume of investors switching between pension plans and redemption requests rises, member equity issues become more sensitive and in focus. A fair valuation approach for unlisted assets held in balanced portfolios is the best way for member balances to accurately reflect the value of these assets and maintain member equity.
• Earlier valuation reviews than usual are required to ensure current market conditions are captured in member balances. Additional monitoring may also be necessary by way of more frequent valuation reviews. For such reviews, valuers might require additional information such as monthly sales, latest financial forecasts, details of any restructuring or loan waivers, etc. to capture the impact of current market conditions on fair valuation.
• Additional analysis of each investment is required. This point was recognized by IPEV who issued a Special Guidance Note in March 2020 to assist with valuations during the crisis. The IHS Markit Private Equity & Private Debt Services team has also written about this topic here.
• Timely and full disclosure of fair value to investors is required. This includes highlighting the relevant methodologies and assumptions used in valuation and explaining the use of judgement and estimates. Also, per RG94 guidelines, the methodologies need to be consistent with the rules governing the operation of each fund and REs need to disclose about any changes in methodologies from previous period as market conditions change.

Valuation appraisers must consider that private investments, which often carry a high degree of risk, uncertainty and/or incomplete information cannot be valued using the standard valuation techniques (such as income and market multiples based approaches) in all cases. For example, early stage companies are especially hard to value due to the difficulty of gauging the probability or financial impact of the success or failure of development activities.

Consequently, the most appropriate valuation techniques to measure fair value are those based on observable and reliable market data, as well as market participant assumptions to the potential outcomes. Scenario Analysis is one of the commonly used valuation techniques where asset valuation is computed under different scenarios, varying the severity of assumptions for both macroeconomic and asset-specific variables. However, in some valuations, risk is not only discrete, but sequential and Decision Trees can be used to devise the right outcomes at each stage.

Unlike scenario analysis and decision trees where investment level valuations are examined under discrete scenarios, Simulations allow for more flexibility and provide a way of examining the consequences of continuous risk at the macroeconomic level. Thus, using any of these valuation techniques can help to estimate fair value during period of such uncertainty.

It is important to note that the key difference when dealing with Level 3 assets is the heavily analyst-driven approach to valuation. Valuations analysts in such investments must have the aptitude to understand and analyse the legal documentation of the deal, corporate finance theory, financial performance and the relevance of milestones and disclosures, as well as the modelling skills to ensure these are appropriately captured at inception and throughout the life of the deal.

Thus, as REs continue to co-invest or directly invest in unlisted assets given the benefit of diversification and higher yield, it is equally important to have proper governance framework and valuation policies in place to provide fair valuation of such unlisted assets both to comply with regulatory guidance and to maintain investor's confidence.

Appendix 1:

Key aspects of the Special Guidance Note from IPEV:

• Fair value must capture current market conditions. Fair value does not equal a "fire sale" price.
• Valuation inputs such as performance metrics and/or future cash flows need to be adjusted for the impact of the crisis.
• Greater uncertainty may translate into greater risk which may translate into greater required returns which may translate into lower asset values.
• It may no longer be appropriate for recent transaction prices, especially those from before the expansion of the pandemic to receive significant, if any, weight in determining fair value. This will increase the need for mark-to-model valuation techniques.
• Scenario analysis is likely to be necessary to assess and incorporate the probability of the crisis extending for 3-, 6-, 12-, 18-months or longer.
• Liquidity needs must be evaluated. What is the likelihood of a loan covenant breach? What is the impact of customers delaying payments or nonpayment and the impact on reduced cash flow? What is the source of working capital required to "restart" the business if impacted by the crisis? A scenario analysis that weighs various potential outcomes (including the risk of default or potential government support) may be appropriate to assist in estimating fair value.
• Par value or face value or cost value is not automatically fair value.

Posted 26 August 2020 by Mukul Singhal, Head of Business Development - Australia, Private Equity & Debt Services, IHS Markit and

Leon Sinclair, Global Head, Private Equity & Debt Services, IHS Markit

For further insights, please refer below to our thought leadership articles published earlier this year:

• Valuation of Private Equity and Debt Investments Amid Market Uncertainty.
• Valuation Considerations for Pension Fund Investments into Private Equity - Recent lessons from Europe and Australia.