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5 Easy Steps to Accurate Valuations for Alternative Investments

Let’s talk about valuation processes. Before you’re like, ” Stop, I don’t want to hear about it,” let me provide some context.

The last three or four exams I’ve been a part of this year, valuation has come up with the examiners, specifically regarding alternative products. You can no longer just rely on your custodian or fund managers. You have a fiduciary obligation when it comes to valuation.

Today, I want to talk about the five things you need to know when it comes to putting a value on the alternative products in your client’s portfolio:

Step 1: Have Clear Valuation Policies and Procedures

First and foremost—policies and procedures, policies and procedures, policies and procedures! Yes, you need to have policies and procedures when it comes to your valuation process. Whether or not you’re doing it internally or outsourcing it to a third party, you need to have very clear policies and procedures.

Not only do you need to document them, but your team actually needs to be following them. Yes, you can be fined for violating your firm’s own compliance policies and procedures. Make sure they’re prepared, they’re practical, and you’re actually executing them.

Step 2: Establish Criteria and Methods for Each Product

The second thing you need to know is that you have to have criteria and methods for evaluation for each of your alternative products. The criteria and method for valuation will differ based on the alternative product and the underlying assets. So, I’m going to give you a few examples.

Private Equity Valuation

So, for example, with private equity, you can look at:

  • Similar performing funds
  • The future cash flow projections for the fund
  • The market outlook and what’s happening in the market
  • The performance of the underlying companies and assets in the fund

There are a lot of things you can look at when it comes to creating an evaluation of that product, but the important piece is that you’re looking at different factors.

Hedge Fund Valuation

The second example I want to go over is hedge funds. So I know a lot of times, RIAs and BDs alike rely upon the fund manager when it comes to valuation And that’s fine if the fund manager is performing valuation and has a methodology to do so. Your responsibility is going to independently review and verify that that process is appropriate.

However, if you determine that the process is not appropriate or your fund manager is not providing valuations, you are going to have to look at things like benchmark indices to look at performance similar to the strategy that’s in the fund.

You’re going to want to look at the risks and liquidity, you want to look at these different factors to determine if the valuation is appropriate and (if you’re not receiving that valuation from the fund manager) determining what that valuation should be. The second example I want to discuss is hedge funds.

A lot of you probably rely on broker-dealers or fund managers for the valuation, and that’s fine so long as you review their process for evaluation and determine that it’s appropriate. If they’re not providing you the valuation or their process is not appropriate, then you’re going to have to look at some other criteria to determine what the valuation of that hedge fund product should be.

You can look at publicly traded securities or benchmarks that are similar in strategy to the hedge fund strategy. You want to look at redemption capabilities in the hedge fund. You want to look at liquidity, is there liquidity or not? And you want to look at potential risks and performance of the underlying assets. Reviewing these items should help you come up with a good value for a hedge fund.

Real Estate Valuation

The third example I want to go over is real estate. There are a lot of real estate based products out there, and it’s likely you have some of your clients in them. You can look at, when it comes to valuation, similar properties in the area. You can look at projected future rental income or revenue from the real estate. You can look at zoning ordinances in the area. Look at potential licensing restrictions in the area.

There are a lot of different criteria you can review when it comes to real estate. Unfortunately, a lot of funds that are evaluating their REITs or other real estate backed funds are really kind of going off of a cash basis, which is not appropriate. So you want to look at market performance. You want to look at the valuation of similar properties, and you want to use that rather than what the fund is providing you if it’s not appropriate.

So overall, the methods and criteria for valuation are going to differ based on what the underlying asset is, and you want to make sure that part of your due diligence product, when you’re evaluating whether or not to make a product available to your clients, includes a review of the valuation process.

How are these funds determining what is the value of an investor’s investment in their fund? Include that in your due diligence. And to the extent they don’t have an appropriate method or don’t provide you with an evaluation, you have to make sure your team has the appropriate method and criteria to follow in order to come up with the valuation itself.

Step 3: Review Valuations On An Ongoing Basis

So the third thing you have to know once you’ve got your policies and procedures, your methods and criteria, like anything else, when it comes to alternatives, you’ve got to review that valuation on an ongoing basis. You’ve got to look at what similar products are doing and make sure that to the extent evaluation needs to be altered or updated, that you’re able to do so.

Step 4: Document the Valuation Process Thoroughly

The fourth thing you should know, and I say this about anything that happens in the RIA business—CYA—cover your ass. That means, document!

Document your process, document your due diligence, document the valuation process you went through to update the value of an investor’s investment. Document, document document!

Step 5: Conduct Annual Reviews of Your Valuation Process

The fifth thing you’ve got to know is that you’ve got to do an annual review of your valuation processes to make sure they’re still appropriate and effective.

So that means:

  • Reviewing your policies and procedures
  • Reviewing the methods and criteria for evaluation
  • Looking at the documentation of previous valuations conducted
  • Determining if there are any changes that need to be made,
  • And of course, document that review

These are all going to help you during your next SEC exam and show regulators that you know what the hell to do when it comes to evaluating alternative investment products. Now remember, this all falls under that special word you all love – your fiduciary obligations.

That’s right, valuating products, ensuring that the third party that’s evaluating them is appropriate, and if not doing the valuation yourself is all part of your requirement to do what’s in the best interest of the client and to act as a fiduciary towards them.

Get Help Implementing Proper Valuation Processes

So, if you are making alternative investments available to your clients, you’re recommending these different types of products to them, you really got to make sure you’re evaluating whether or not you have an appropriate valuation process in place. So now that you know these five things when it comes to the valuation process, if you are looking at your firm and you’re like, “we’re good, we’re great,” then kudos to you.

But if you’re like most of the advisers I’ve talked to where you have an incredibly lax or no evaluation process in place at all, and you’re routinely selling and recommending alternative products to your clients, then you need to give us a call today to avoid any potential SEC enforcement or fines or regulatory action.

Contact us and we’ll help you clean up house before they come in for your next exam.

Author Bio

Leila Shaver is the Founder of My RIA Lawyer, a law firm that provides compliance and legal consulting for financial institutions. With extensive experience as a securities attorney and compliance expert, she has served as Chief Compliance Officer and General Counsel to RIAs, BDs, and TAMPs with billions in assets under management.

Leila understands the challenges RIAs face and is committed to helping RIAs streamline their processes, mitigate risks, and ensure compliance with regulatory requirements. She received her Juris Doctor from Atlanta’s John Marshall Law School and is a West Georgia Young Lawyers’ Association member. Leila has received numerous accolades for her work, including the Carroll County Bar Association’s Outstanding Young Lawyer Award in 2017.

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