ALTLOOK: The Alternative Investments Podcast

David Larsen is a managing director in the Alternative Asset Advisory, based in Seattle. He leverages more than 37 years of transaction and accounting experience, specializing in fair value accounting specifically for valuation, accounting and regulatory issues faced by alternative asset managers and investors.

Ross Hostetter is a managing director in the Alternative Asset Advisory practice and Portfolio Valuation leader, North America. Ross has more than 25 years of experience serving clients across the financial services industry. He works primarily with private equity funds, hedge funds and business development companies.

Passages from the episode

In today's episode, we'll focus on a new regulatory rule that has come out from the U.S. Securities and Exchange Commission (SEC), which is named rule 2a-5. And while it's applicable for those regulated by the SEC, we expect over time that many of its principles will impact a number of managers around the globe, definitely those that are registered investment companies in the United States through the SEC–that's mutual funds, business development companies and unit investment trusts. But also over time, I think that the new rule is going to impact registered investment advisors, meaning those managers or GPs of private funds, which is a much more pervasive group that will be impacted by the regulation. – David Larsen

One of the things that didn't change is the board still has that obligation to provide or report fair value in good faith. And fair value in the context of the SEC in rule 2a-5 is conceptually similar to the definition of fair value that we used in our episode one, that being what would you receive in an orderly transaction using market participant assumptions as of the measurement date. But the SEC uses a little bit different words. Fair value in rule 2a-5 seems to mean just looking at the actively traded securities or just looking at those that are not actively traded. – David Larsen

Can you give us a highlight on what those new articulated provisions are?

One is that when the SEC's eyes to have a full and complete valuation, you need to first assess and manage the valuation risk. The second is establish and apply fair value methodologies, the third is to test those fair value methodologies and the fourth is to evaluate pricing services. So those are four elements that have to be included. – Ross Hostetter

So I think on a quarterly basis, if you're delegating, then you need to summarize and document changes in your valuation risk methodology, and there's a need process for overseeing a pricing service. So the context of the way we think about the work that we do, the notion of calibration, which is to say you reconcile your evaluation at T0 to the price that was paid. You have a process in place, methodologies and so forth to get you back to a starting point. And then on a go-forward basis, you're trying to understand what's changed over time. – Ross Hostetter

I think there are two things, both highlighted here, but one is understanding the valuation risk, just the inherent risk in valuing the assets that you have in your portfolio. And I keep coming back to the same point: that as we've seen funds grow over time–funds that we started working with years ago that were traditional buyout funds or maybe single strategy funds–they evolve over time, they move into different asset classes. And understanding as a board member, an audit committee member, how has that risk changed and are you addressing that risk and the procedures that you put in place. So that's the first point I would make.

And the second point, and this is one that's tripped up boards in the past quite a bit, is understanding the valuation methodologies. And not from a technical textbook point of view, but understanding what methodologies are employed to value the assets that you're charged with overseeing and what the key value drivers are. What is the risk inherent in the valuation approaches that are being applied, and understanding what they are. – Ross Hostetter