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).

Valuation Framework

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:

  1. Periodically assess and manage valuation risks, including conflicts of interest. The rule does not prescribe a required minimum frequency for re-assessing valuation risks, instead stating that different frequencies may be appropriate for different funds or risks. Re-assessment of valuation risks should generally consider changes in fund investments, significant changes in investment strategies or policies, market events, and other relevant factors.
  2.  Establish and apply fair value methodologies. Satisfying this function will require selecting and applying appropriate valuation methodologies, periodically reviewing the appropriateness and accuracy of the methodologies (and making any necessary changes or adjustments), and monitoring for circumstances that may necessitate the use of fair value. A fund board or the valuation designee is required to specify key inputs and assumptions used in the valuation of particular asset classes or portfolio holdings. Appropriate valuation methodologies for investments may vary, even within the same asset class. However, these methodologies are expected to be applied consistently to minimize the risks of selecting methodologies to achieve a specific outcome. Further, the rule states that appropriate methodologies must be consistent with the principles outlined in ASC 820.
  3.  Test fair value methodologies for appropriateness and accuracy. This function is intended to ensure the selected valuation methodologies are appropriate and adjustments are made as necessary. The fund board or the valuation designee should identify the testing methods and the minimum frequency with which such methods will be used. However, the rule does not prescribe any particular testing method or specific minimum testing frequency. Examples of testing methods include calibration and back-testing against valuations obtained from observed transactions.
  4. Oversight and evaluation of pricing services. The fund board or the valuation designee must establish a process for approving, monitoring, and evaluating pricing service providers. A process to initiate pricing challenges, as appropriate, is also required. Pricing services are described as third parties that regularly provide funds with information on evaluated prices, matrix prices, price opinions, or similar pricing estimates or information to assist in determining fair value of fund investments. The rule discusses the possibility of conflicts of interest on the part of the pricing services, arising from the need to maintain continuing business relationships with the fund board or valuation designee. Accordingly, the oversight function is intended to ensure the fund board or the valuation designee has a reasonable basis to use the pricing information it receives as inputs in performing valuations.

Valuation Designees

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:

  • Items requested by the board related to the fair value of investments or the valuation process.
  • A summary or description of material fair value matters that occurred in the prior quarter, including any significant changes in valuation risks, fair value methodologies, and the process for selecting and overseeing pricing services.

Annual reports should include:

  • An assessment of the valuation process, including a summary of the results of the testing of fair value methodologies.
  • An assessment of the adequacy of resources allocated to the valuation process.

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.

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