The volatility experienced by financial markets in 2020 demonstrated how firms’ approaches to valuation needed to be re-assessed, as many firms struggled to complete asset pricing within time constraints, leading them to circumvent their own internal processes to remedy this. During this time, the SEC was already in progress of reviewing comment letters and feedback on a proposed new regulation regarding fair valuation. This regulation, Rule 2a-5, was adopted and became effective March this year allowing firms 18 months to comply with the new guidelines. This aims to create common framework for valuation that firms have to operate within. However to comply with the new rules companies face several operational hurdles and to overcome them firms must not only increase their investment in technology, but also look towards the potential opportunities and benefits of a cross-industry approach.
What is the new rule and what does it mean?
Some have questioned why fund managers need worry about Rule 2a-5, given that they have been valuing non-exchange traded assets for some time already. The answer is that the new rule is not specific to the valuation of non-exchange traded assets or those without an observable price but is much broader and incorporates adjustments to observed prices as well. Therefore, the question is not so much about the valuation methodologies used to price a security without a readily available market quotation. It is about what the definition is for “readily available market quotation” and the protocols which a fair value determination must follow.
What this means for firms at a top level is that they no longer have the same flexibility to determine their own practices and procedures when it comes to valuation. They now have to ensure that they sit within the new framework, which interestingly, is more prescriptive than those the SEC has established in the past.
What operational challenges does the industry face?
The crucial challenge is how different parties operate and collaborate throughout this entire process. The requirements are data intensive and may involve multiple systems across multiple firms including Funds Board, Fund Managers, Accounting Agents, Data Vendors, Sub-Advisors, etc. This not only involves operational risk but can be a time consuming effort to aggregate. Unfortunately, the current technology used by most firms is often not adequate to meet this challenge. A survey of 100 fund managers conducted by Deloitte in 2020 highlights the extent of the problem with 83% of participants indicating they use an Excel-based tool in their valuation process. In addition, 85% indicated that they do not have workflow tools that cover the full end-to-end valuation process.
The disparate systems mean that the information is often siloed, making it difficult to bring everything together and have proper controls. Our conversations with industry participants suggest that fund managers are either not happy with their current practices or see Rule 2a-5 as the trigger for upgrading their valuation infrastructure to meet the more stringent requirements.
Positively, half of survey participants indicated they are exploring new valuation-related technology solutions. Our experience certainly backs-up these findings, as we are seeing a lot of interest from firms in how they can take advantage of process management solutions tailored specifically to the fair valuation process.
The new rules provide a catalyst for a cross-industry approach
The disjointed nature of existing processes is where technology will play a crucial role. A key focus for firms must be collaboration, both with other companies, and also ensuring greater cooperation and smoother hand-offs between their internal teams. The right solution will bring together all the different participants in a modern, digital format, with defined workflows and full auditability.
Having the right technology that can bring together these disparate systems will also provide much needed clarity. With the valuation process involving so many different parties, transparency is also key, with it being important that there’s irrefutable evidence of supervision. This ensures that all parties will have complete trust in the system.
Automation sits at the heart of this. It will make the process much smoother, as valuation won’t be reliant on manual processes and the errors that come with that, and should reduce costs, without staff having to pick up the extra workload.
Valuation has long been an area representing an opportunity for increased efficiency and standardization of different practices that have existed across firms. Similar to previous regulatory driven market issues such as oversight and backup or contingent NAV arrangements, Rule 2a-5 provides the opportunity for firms to adopt an industry standard outcome. Technology will also play a role in streamlining and industrializing processes in a way that will provide the right levels of control, participation and oversight in the fair value process.