In December 2020, the Securities and Exchange Commission (“SEC”) adopted a new rule 2a-5 to update the regulatory framework around valuations of investments held by a registered investment company or business development company (“fund”). Boards of directors of funds are obligated to determine fair value of investments without readily available market quotations in good faith under the Investment Company Act of 1940 (“Act”).
Rule 2a-5 specifies requirements to fulfill these obligations. Concurrently, the SEC also adopted rule 31a-4, which provides recordkeeping requirements related to fair value determinations. Rule 2a-5 was effective as of March 2021, and funds are required to be compliant upon the conclusion of an 18-month transition period following the effective date (voluntary early compliance allowed).
Prior to adopting rule 2a-5, the SEC last addressed valuation practices under the Act more than 50 years ago. Over the intervening period, the variety of securities and other instruments held by investment funds has proliferated. The volume and type of data used in valuations have also increased. Funds increasingly use third-party services to provide pricing information, especially for relatively illiquid or otherwise complex assets. In addition, accounting standards and regulatory requirements have advanced including developments related to ASC 820, Fair Value Measurement.
Against this backdrop, rule 2a-5 establishes a framework consisting of four primary functions required to determine fair value in good faith. A fund board may choose to determine fair value by executing the functions. Rule 2a-5 also allows a fund board to designate these functions to a “valuation designee.” The required functions are:
When fair value determinations are made by a valuation designee, which can be the fund adviser or an officer of an internally managed fund, the board is required to actively oversee the valuation designee’s work and compliance with the rule. In general, rule 2a-5 limits possible designees to entities that that have a fiduciary duty to the fund. While the adviser may have some conflicts, the fiduciary obligation to the fund would ensure that the valuation designee acts in the fund’s best interest and mitigates or discloses conflicts. The rule states that fund boards should approach oversight of the valuation designee’s work with a skeptical and objective view that considers valuation risks, the appropriateness of the valuation process, and the skill and resources devoted to the endeavor. In order to assist the fund board in its oversight function, a valuation designee is required to present both annual and quarterly written reports to the board.
Quarterly reports should include:
Annual reports should include:
In addition to periodic reporting to the fund board, the valuation designee is required to state the titles of the persons responsible for the valuation of portfolio investments. The valuation designee should also reasonably segregate fair value determinations from the portfolio management of the fund so that the portfolio manager does not determine or exert influence on the valuation of portfolio investments.
Rule 2a-5 updates decades-old valuation guidance from the SEC for investment funds. Fund boards have the primary responsibility to adhere to the valuation framework outlined in the rule. When a valuation designee performs these functions, active oversight is required of the board. The rule prescribes a framework that emphasizes understanding and managing risks around conflicts of interest and promotes a principles-based valuation regime that aligns with recent accounting and regulatory developments, notably ASC 820.
Originally published in the Portfolio Valuation: Private Equity and Credit, Third Quarter 2021.
Sujan Rajbhandary, vice president, is a senior member of Mercer Capital’s Financial Reporting Valuation Group, which provides fair value opinions and related advisory services to public companies, private companies, and alternative investment vehicles. Sujan has valued financial ...
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