Predictions indicate that global alternative assets under management are projected to exceed USD 23 trillion by 2026, more than doubling the 2019 figure of around USD 10 trillion. This substantial growth in assets, participants, investors and investment volumes poses increasing complexity for professionals engaged in valuation and valuation oversight. Their responsibility to deliver impartial and reliable valuations is essential and will require swift operational adaptation to accommodate this surge in volume.
On 15 June, EY Luxembourg’s Alternative Investment Funds Club organized a roundtable discussion, offering an in-depth exploration into the primary challenges encountered by these professionals and presenting valuable insights and recommendations for the industry's progression. The event was attended by senior professionals of the Luxembourg fund industry engaged in the valuation oversight field. They included conducting officers, heads of valuation and oversight, vice presidents and senior managers employed by global asset managers with sizable portfolios invested in a diversified spectrum of assets.
Reconsidering valuation approaches in the current macroeconomic environment: expectations and opinions diverge
Valuation oversight continues to draw significant attention in the Luxembourg fund industry. Conducting officers are confronted with the changing regulatory environment, and increasingly, the effects of higher inflation and interest rates on their portfolios. Increased inflation and higher interest rates that have been dominating the macroeconomic environment since mid-2021 were high on the roundtable discussion’s agenda. For example, 30% of participants observed increased interactions with various stakeholders such as auditors, external valuers and investors, linked to changes in the asset values year-on-year and anticipation of potential impairments.
Participants appeared divided on whether exits from portfolio investments should be postponed. 40% indicated postponement seemed necessary, while 20% stated the contrary. In the discussion that followed, it became apparent that it is mainly the exits from venture capital investments in high technology startups that are being postponed as a result of the turmoil in the technology sector which witnessed lower valuations and mass layoffs in 2022, suggesting a potential differentiation across alternative strategies. Another important point that was taken note of was that as investors hold on to their high technology startups for longer, they become more mature companies with stable earnings. Given these developments, valuation committees might need to reconsider the valuation approach to these investments in the future.
We have also ascertained that with higher inflation comes higher capital return expectations. Half of the participants were facing demands for higher returns from their investors, while fewer than a quarter of the participants indicated not having received such demands.
Furthermore, half of the participants considered that real assets provide an effective inflation hedge, but only in the long term; and a further 30% of participants found them to be effective both in the long and short term. A more detailed discussion revealed that assets such as private equity, private debt and venture capital have generally shown drops in their value. However, most professionals agreed that the revenue for illiquid assets such as real estate and infrastructure tends to increase with inflation, which helps counteract inflationary pressures.
Challenges in measuring and quantifying the impact of ESG on valuations
ESG (environmental, social and governance aspects) continuously demonstrates its importance in the alternative investments industry, also in view of the implementation of the EU Sustainable Finance Action Plan and regulations such as SFDR and the EU Taxonomy. Similar to past discussions, the question remained as to how to measure and properly quantify the impact of ESG improvements in valuations.
Participants were asked if they applied any specific ESG parameters in their current valuation models. These parameters could be anything from CO2 emissions, energy efficiency ratings and ESG certifications such as LEED and BREEAM. While more than 75% of respondents are not yet utilizing ESG criteria in their valuations, most are planning to start soon.
Some asset classes, such as real estate, appear to have better quantitative data that could be used to reflect ESG improvements. For example, the 2022 Quantifying ESG in Real Estate report published by Knight Frank was brought up as a good example of ESG quantification1. The report aims to estimate the premium an occupier is willing to pay to rent premises with a higher ESG rating. Still, ESG data remains sparse, and broader studies on ESG’s impact on capital values of real estate across different markets are not yet available. For now, the industry is still largely using qualitative, rather than quantitative, measures to incorporate ESG into their valuation process.
On the other hand, the private equity industry is still in its very early stages of quantifying ESG in valuations as no quantitative surveys were known to the participants. Nevertheless, ESG is expected to grow in relevance in the coming years and the industry will certainly gain a better understanding of the subject matter from better data sets, valuation standards and government regulations on ESG disclosures.
The need to rethink fund valuation to reflect market realities
Another discussion topic that emerged was AIFM corporate governance and the possible difficulty of applying the proportionality principle in the future. This could lead to a demand for enhanced separation of responsibilities amongst conducting officers and teams for each key function such as investment management, valuation, risk management and compliance – potentially resulting in a higher AIFM cost base, making the operations of Luxembourg AIFM structures less lean. The participants agreed that these new regulations pose a challenge in keeping the Luxembourg structures cost effective. The common practice, at least among smaller Luxembourg AIFMs, is to combine the valuation and risk functions.
Another topic of importance was the need to keep up with current regulations and trends in the asset markets that might affect the valuation process. The European Securities and Markets Authority (ESMA) in their 2022 report on valuation raised concerns regarding a lack of documentation and well-established valuation policies. These concerns include: a lack of clear allocation of operational tasks, an unclear identification of the person in charge of the validation of the valuation models, and policies that do not clearly define the valuation fund’s valuation methodologies.
Valuation professionals agree that fund valuation policies should be revisited and updated to reflect current market and regulatory realities. When it comes to the robustness of their own valuation policy framework, a small majority were confident to highly confident, whereas a significant minority were only somewhat confident.
In terms of areas for improvement in their valuation policies, most participants saw the greatest need in the process of performing and documenting model validation. Other participants indicated the need for establishing clarity of rules and regulation with regards to valuation, and the remainder of participants expressed a desire for establishing clarity with regards to the valuation models applied. All agreed that a valuation model can take on many different forms and it is not always clear what is defined as a valuation model by the regulations. The guidance on model review and validation also appears to be incomplete as one cannot employ the same methodology for reviews of all types of models.
“In summary, it is crucial for the alternative investment industry to keep a close eye on both the prevailing market forces and the constantly evolving regulation framework. Our EY experts are always available to augment the valuation oversight function through our valuation, valuation oversight and ESG service offerings – from full outsourcing of the valuation function through our managed services to ad hoc expert consultation,” concludes Christophe Vandendorpe, Partner, Strategy and Transactions Leader.
[1] Quantifying ESG in Real Estate, Knight Frank, 2022
Article originally published on Agefi.
