PKF O'Connor Davies Accountants and Advisors
PKF O'Connor Davies Accountants and Advisors
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A Primer for Fund Managers: Incorporating Third-Party Pricing Vendors and Valuation Firms into a Robust Valuation Process

By Noam Hirschberger, Shalini Chandran, Vic Peña, Rachel DiDio and Edward Lentini

With private credit markets booming and regulators taking note, fund managers should be ready for additional scrutiny. Internal valuation policies and procedures are high up on the radar of regulators and compliance professionals. One aspect of the process that continues to be scrutinized relates to how fund managers use services and data from independent third-party pricing vendors and valuation firms. Ultimately, fund management carries the responsibility for its fair value estimates, regardless of whether or not they use an outside party to value a particular security.

If a highly subjective estimate is being disclosed to its investors, regulators expect management to be able to speak to the assumptions used in creating that estimate. It does not matter that third-party pricing vendors and valuation firms provide varying levels of transparency about their models, methodologies and underlying assumptions. In times of increasing regulatory scrutiny, a black-box approach will not work.

Such challenges are particularly acute in private debt markets, where notes are often held to maturity and secondary markets are slim to non-existent. Therefore, how can fund managers work effectively with third-party pricing vendors and/or valuation firms in ways that create the most thought out, defensible valuation documentation? It is not easy, particularly given the subjectivity and the risk, but it is imperative to regularly look for ways to incorporate the expertise and independent views of numerous outside parties into the valuation process.

Ideally, the valuation process is robust, incorporating professional skepticism and challenging of assumptions, leading to highly detailed and defensible analysis in the documentation in case it is questioned, especially during an audit, where audit firms are required – and often engage their own valuation specialists – to review the methodologies and assumptions employed. In that spirit, consider the following items regarding third-party pricing vendors and valuation firms.

Selection of a Pricing Vendor

  1. Scrutiny of Professional Qualifications – The valuation process must be conducted and overseen by professionals with the necessary skills, knowledge and experience to build confidence in the accuracy and reliability of their valuation conclusions.

    • (External) Qualifications of Third-Party Pricing Vendors and Valuation Firms: The valuation team must possess sufficient modeling experience and the relevant expertise required for the type of securities/investments that need valuation. Fund managers should scrutinize the team’s professional qualifications, with a focus on relevant valuation credentials (e.g., CFA, CAIA, FRM, ASA, CVA, etc.), and experience with valuation in the subject asset class.
    • (Internal) Qualifications of Management: Equally as important are the credentials and experience of the point-person designated to oversee the work performed by the third- party pricing vendors and/or valuation firm.

  2. Objectivity and Independence – Valuation conclusions need to be unbiased and impartial. Take reasonable steps to ensure that the third-party pricing vendors and valuation firms have strict commitment to objectivity and independence. Fund managers should determine if they have incorporated adequate checks and balances to eliminate all potential conflicts of interest when engaging a third-party pricing vendor and/or valuation firms.

  3. Data Providers or Valuation Firms – More liquid instruments, typically held by money market funds and mutual funds, can generally be valued via third-party pricing vendors that provide price data from exchanges and/or broker-dealers. Market evidence should always be emphasized over subjective valuation assumptions. A wide range of market prices and/or large bid/ask spreads suggest an illiquid market and less reliability in the data.

    For financial instruments with little or no liquidity, it may be necessary to employ valuation firm specialists with expertise in valuation of illiquid securities. Such instruments include term loans, asset backed loans, convertible debt and other similar instruments often held by business development companies, hedge funds and various other types of alternative lenders.

Scrutinizing the Pricing Vendor’s Methodology and Assumptions

  1. Multiple Data Sources and Methodologies – Valuation models, particularly those of complex securities with bespoke structures, often incorporate subjective assumptions. To overcome any potential biases arising from data or a specific modeling process, fund managers should collect and consider multiple data points and valuation methodologies. Broker quotes can be informative, but multiple broker quotes would generate more confidence, particularly when the quotes are in a tight range. Quotes based on transactions should be allocated more weight in the analysis. It may be necessary to consider both broker quotes and valuation models, depending on the facts and circumstances. It is important for the fund manager to understand and be able to explain the third-party pricing vendor or valuation firm’s methodologies used to generate a fair value estimate for a particular security.

  2. Validation of Assumptions – In addition to contractual features, pricing models may depend on various non-contractual assumptions. Assumptions on these factors are primarily derived through two methods: estimation based on historically observed behavior from inception to date of the subject securities, and/or reliance on available comparable market data points.

    When utilizing historical indicators, fund managers should ensure that third-party pricing vendors and valuation firms have considered data that is both recent and aligned with market dynamics and trends as of the measurement date. Fund managers may consider ascribing a lower weighting to stale data points. Similarly, when relying on prices observed on comparable securities transactions, transaction data is preferred to indicative broker quotes, and recent transactions are generally deemed to carry more weight than the older ones.

  3. Diving into Pricing Differences – Fund managers should identify the securities that exhibit a wide range of valuations across different third-party pricing vendors or valuation firms and understand the cause of the wide dispersion. It may be that sparce transaction data is available and more judgment is applied within the financial models. For example, differences may be caused by different outlooks on the future performance of the borrower. Reasonable and intelligent minds may differ in their conclusions; however, the analysis should document the consideration of those differences.

    On the other hand, differences may be caused by less convincing underlying factors. Analyses of comparable securities may be oversimplified. For example, debt and derivative instruments do not all belong to a homogenous group. Each instrument may contain terms and rights that are unique and idiosyncratic. Attributes of securities, such as issuer type (government vs. private bonds), structural characteristics (secured vs. unsecured, fixed vs. floating rate) and tenor (short-term vs. long-term) can all have significant impact on its market price. The presence of embedded options in debt instruments should also be considered when determining comparability.

  4. Perform Proactive Back-Testing – Fund managers should be proactive in addressing any potential issues that could arise from a retrospective review by external auditors. It is advisable to back-test the assumptions in the third-party pricing vendor or valuation firm’s process using the actual sales of securities when such information is available — leverage hindsight. By fund managers benchmarking the sales prices against the prices provided by third-party pricing vendors and valuation firms, the precision and reliability of the modeling techniques can be validated prior to any testing conducted by external auditors.

Opening the Black Box

The above items will open the black box of the valuation process and provide fund managers, investors, auditors and other stakeholders a transparent view on the inner workings of the process when using third-party pricing vendors or valuation firms to achieve accurate valuations. It’s important to remember that the responsibility for the fair presentation of the fair value ultimately lies with the fund manager, not with the third-party pricing vendor or valuation firm.

Robust documentation regarding the various key factors and considerations surrounding valuation, such as the ones outlined above, will often yield a more compelling case as to the fund manager’s ultimate determination of fair value and a higher understanding and willingness of external auditors to accept it.

Contact Us

Our subject matter experts stand ready to help you with the items noted above and any others you may have surrounding valuation and related audit implications. For more information about the valuation process, contact your PKF O’Connor Davies client service team or any of the following:

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