Originally Published: June 5, 2012, Phocion Investments Inc.
While the world economies are still trying to recover from the global financial crisis of 2007-08, much discussion has been spent on the causes behind the crisis. Among others, there were significant failures in risk management, regulatory oversight, in the Fed’s mortgage lending standards, and in the valuation policies and processes of investors. The importance of valuation is often ignored or just plainly taken for granted. In 2012, as shocking as it may seem, there are still many investment firms with little or no valuation policies and procedures in place. This type of approach to investment management leads to performance shocks when firms try to close out positions in hard to value assets and quickly discover that their valuation did not accurately reflect fair market value. Guidance is abundant with respect to valuation and, as a consequence of the crisis of ‘07-08; both the FASB and IASB have issued standards to improve the practices of firms.
Factors in Valuation
Years before the global financial crisis, the investment world fell in love with Mortgage Backed Securities (MBS) and their sexier cousins (CDOs, CDO Squared, etc…). Similarly to the dating world, where the degree of complexity has a direct and exponential relationship with attraction (“I’ve done the math”), these derivatives’ complexity attracted an enormous amount of investors the world whole and brought a sense of excitement that simple securities could not do. Unfortunately for all involved, including the global economy, few took the time to properly conduct the valuation required to justify these products’ valuations. Moreover, the factors involved in maintaining a high quality valuation process and preventing misguided pricing, were either poor or non-existing in many of these investment firms. From categorizing the security type to maintaining the proper oversight, every factor is important and intertwined with the others to ensure that mistakes of the past are avoided.
The crisis’ itself had an impact on the accounting standards boards. The FASB and the IASB had to relook at their framework of fair market value. The FASB, in 2007, issued FASB Statement 157 which was designed to expand on their existing framework and provide a single definition of fair market value. This framework uses a hierarchy to classify assets with respect to the facilitation of their valuation. The first level, Level 1, includes assets with readily observable prices such as stocks, bonds, funds and any security that has a mark-to-market mechanism for pricing. These are the easiest to value and maintain the lowest risk of mispricing. Next on the hierarchy is Level 2 assets, which represent assets whose pricing can be derived from other data values or market prices. The valuation of Level 2 assets can be approximated using models and extrapolation methods with known and observable prices as parameters. Interest rate swaps and the underlying rates and risk premiums are examples of Level 2 assets. Lastly, the most difficult assets to price are designated as Level 3. These include any asset that cannot be priced by using observable measures and fair value can only be determined using estimates or risk-adjusted value ranges. Moreover, these assets tend to be highly illiquid. Level 3 assets include the famed mortgage backed securities that investment banks failed to mark downward during the credit market collapse of ‘07.
It took the International Accounting Standards Board approximately 4 years later to issue IFRS 13, which similar to FASB 157, breaks down the hierarchy of assets into three levels. The IASB new guidance on valuation was done in response to the 2007-08 global financial crisis and its goal is to bring greater detail and clarification to the pricing practices for all three levels of assets. The importance of these boards’ actions should not be understated and every investor and firm should place greater emphasis in understanding and recognizing the type of assets they’re investing in.
Regardless of the asset level of the security in question, one should always verify for liquidity. Level 3 assets have the characteristic of illiquidity but this is not limited solely to that level of the hierarchy. Levels 1 and 2 assets may suffer from the same issue and ignoring this important characteristic may result in a firm not being able to meet the redemption requests of their clients. Furthermore, it will limit its flexibility of selecting the most appropriate security to meet any redemption requests. Lastly, there is an added complexity in valuing illiquid assets and their significance to holdings directly impacts the accuracy and reliability of the portfolio NAV.
Policies & Procedures
Firms with poor or no policies and procedures in place usually place themselves in a high risk situation with respect to valuation. Poor policies and procedures lead to firms erring in their valuation of holdings, performance, risk and strategy management. A set valuation policy is one that includes pricing practices, procedures, controls and encompasses all three levels of assets. Reviewing methodologies in valuation, verifying that regulatory requirements are met, comparing sale proceeds to their value prior to sale are just some examples of procedures required. In addition, documentation, application, treatment of special circumstances and training are controls that ensure that the policy is being followed correctly.
Record keeping is an additional factor in valuation and is an important component of the policy and procedures. Documentation of issues and their resolutions, including the reasoning behind them, leads to an increase in transparency. Furthermore, all reviews and changes or non-changes for that matter to the policy, should be documented as well. This will provide the firm the leverage from learning from the past and avoiding repeating the same errors. With turnover or firm reorganization, documentation facilitates the transfer of knowledge and creates an awareness of the policy at all levels of the firm.
Having a valuation policy in place does not suffice alone; application is another important factor. The application of the policies and procedures must be done consistently and their interpretation must not be dependent on the situation. Any deviation from the policy should follow the procedures the firm had set prior to the special situation. Making decisions on-the-fly leaves to much room for error and is not an effective or efficient way of operating a firm.
Whether it is created internally or with the assistance of an outside consultant, every department of an investment firm should be involved in this process with the board taking an oversight role. Balance, independence and oversight are all key in the quality of a valuation policy.
Segregation of Duties & Board of Directors
As in all things that require a certain level of independence, valuation policy application is dependent on the segregation of duties. Without this independence, the policy can easily be manipulated and rendered non-effective thus increasing the risk of performance shocks. Independence itself cannot be maintained unless there is a level of oversight and the establishment of a well-balanced committee. This committee should meet on a monthly basis to create, maintain and reevaluate the policy. With a well-balanced member composition, the hard to avoid conflicts of interest, which are far too prevalent in many investment firms, can be minimized. Ultimately the board holds the responsibility of ensuring the firm is applying the standards to best serve the shareholders.
The board of directors should not allow the valuation/pricing/product committee be dominated by members of the front office. On top of that, the board members themselves should be up to date on the products that the firm deals with. This empowers the board to ask the right questions and oversee the operations of the firm with greater confidence. Insufficient knowledge considerably hinders the decision making ability of the board and the independence of any committee. Lastly, as any properly structured board should be, they should have the resources available to gain access to any expertise they may lack when dealing with more complex products and valuation issues.
Knowledge of Products and Valuation Methodologies
Valuation can become a very difficult process when the knowledge of valuation methodologies and investment products is limited. The global financial crisis exemplified many things, and one of them was the lack of understanding of the products the firms were investing in. Even today, with 20/20 hindsight and the difficult lessons the world economies have learned, there are many investment professionals who still do not fully comprehend the products their firms’ invest in. Before any firm or individual embarks on investing in any financial products far more complex than they are used to, there should be a moratorium on any active positions until the firm fully comprehends the product and the required valuation methodology.
New complex products are often tempting for firms since there is this unfortunate positive correlation between complexity and intelligence. Simplicity just doesn’t sell as well for many firms when dealing with their clients or boards. An example of this occurred during the latter end of the last decade when numerous municipalities, worldwide, bought into MBS derivative products with absolutely no understanding of them. Investors and firms need to be educated about the characteristics and the pros and cons of new products. Investment firms should require that every department have a solid understanding of the new products; a comprehensive policy would facilitate and guide firms in this task.
Commitment to Ethics
The last factor, and the foundation of effective valuation, is the commitment to ethics that a firm espouses. An ethical commitment guides a firm in the right direction to incorporate the highest standards the industry offers. It should not be relegated solely to speeches and interviews for investors and the media but rather, it should be a living philosophy exemplified on a daily basis by each employee of the firm.
This commitment begins at the top and can quickly permeate to every other level of the firm. A CEO who is determined to do the work with integrity and serve the firm’s clients will eliminate the risk of over-inflated valuations for the sake of personal remuneration. What is more, these leaders attract similar minded employees with the direct impact of creating or changing a firm into a highly efficient and functional organization. On the other hand, placing someone with little to no ethical values does the opposite. It leaves a firm’s clients at risk of having their interests superseded by those of the firm’s employees and creates an environment of conflict between ethically minded employees and the firm’s leadership. In the end, you end up with a highly inefficient and dysfunctional organization that is slowly deteriorating any true value it brought to the market. Without this commitment, valuation becomes only as good as the paper it is written on.
Valuation & Performance
We can’t speak about valuation without spending some time on performance. Performance sheds light onto the effectiveness of a firm’s asset management and is highly dependent on the quality of valuation. As mentioned earlier, poor valuation leads to performance shocks and failure in strategy. A performance shock is a sudden, unexpected negative change in the return of an asset or portfolio. Although there can be positive shocks, without much complaint, they would still be considered a failure in valuation since the asset was considerably mispriced.
For a significant period of time before the financial crisis, investment firms were mispricing their MBS products and continued managing their portfolios/strategies based on their expected returns. At the moment the whole housing market collapsed, there was a severe correction to the valuation of these products and hence, performance shocks. Not only were losses taken, the stewardship of these firms turned into panic with the consequences of indecision and uncertainty.
Moreover, the past performance of the firm was put into question since none of the valuations of these products were accurate. Adding to the invalidation of historic performance, past evaluations of managers and strategies were rendered inaccurate. Decisions made during that period were made based on erroneous information and resulted in sub-optimal stewardship of the firm and its assets.
Now, what if the valuation of these products was done correctly? From a performance point of view, firms would have had a better understanding of their strategy and their financial condition; it would have enabled them to act quicker in altering course to minimize or eliminate the risk of these products and or, to take advantage of the mispricing and end up on the opposite end of the trade. That is, the profitable end. Perhaps this is too optimistic of a scenario, but the message should be clear and that is, if your performance analysis is correct (i.e. based on proper valuation) then your probability of making the right decision is greater.
The Global Investments Performance Standards(2), a body created to develop and maintain a higher level of performance standards with the underlying principles of fair representation and full disclosure, has its own take on valuation. With consideration into the work done by the FASB and IASB, GIPS has set out its own standards to deal with valuation. Firstly, the value of an asset is based on fair value rather than market value. For highly liquid, publicly traded securities, this should have no impact as market value accurately reflects fair value. On the other hand, there may be a difference for less liquid and harder to value assets. GIPS also deals with the issue of independence and states that firms should segregate the valuation duties and ensure that pricing is done independently of the portfolio management team. In addition, policies and procedures need to be documented and applied consistently, including any changes. GIPS also address more specific issues but as a guiding principle, it has a set hierarchy on valuation:
First and foremost, use objective, observable, unadjusted quoted market prices for identical investments in active markets. If not available, then investments should be valued using:
Objective, observable quoted market prices for similar investments in active markets. If not available or appropriate, then investments should be valued using;
Quoted prices for identical or similar investments in markets that are not active. If not available or appropriate, then investments should be valued using;
Market-based inputs, other than quoted prices, that are observable for the investment. If not available or appropriate, then investments should be valued using;
Subjective unobservable inputs for the investment where markets are not active at the measurement date. Unobservable inputs should only be used to measure fair value to the extent that observable inputs and prices are not available or appropriate. Unobservable inputs reflect the FIRM’S own assumptions about the assumptions that market participants would use in pricing the investment and SHOULD be developed based on the best information available under the circumstances.
Eleven years removed from the Market Crash of 1929, The Investment Company Act of 1940 set standards for investment companies to ensure that firms fairly represent themselves and the securities they dealt in. Similarly to 2007, the valuation of many of the securities being traded in 1929 was significantly different from their true value. The lessons were learned during the Great Depression but move forward and by the time of the new millennium, much was forgotten. The investment industry found itself repeating its mistakes and consequently, with a new crisis, the Global Financial Crisis. Valuation is such a critical aspect of the investment process and cannot be overlooked or taken for granted, as many firms still do today. A greater awareness and understanding behind the pricing of investment products on a firm wide basis would go far in preventing performance shocks and ensuring a firm has the right information to properly manage its holdings. With clear and concise policies and procedures, firms would be prepared to quickly act on any valuation issue that may arise. Uncertainty and indecision would not hold these firms hostage in critical periods. Documentation of all decisions, applications and changes would provide firms the ability to leverage the past to effectively manage the valuation of all assets. Where would the global economies be today if investment firms had properly valued the derivatives they were investing in? And there lies the importance of valuation.