Fair Market Value: How to Craft the Best Policies and Procedures in Today’s Environment

By Kevin Wolf, Executive Vice President, Head of Fund Administration and Product And Jim Colantino, Senior Vice President, Financial Administration

>Fair Market Value: How to Craft the Best Policies and Procedures in Today’s Environment

Fair Market Value: How to Craft the Best Policies and Procedures in Today’s Environment

By | 2020-06-30T09:02:47-05:00 June 16, 2020|Registered Funds|

The coronavirus pandemic is changing the market today in many ways, particularly how advisers and investment firms are reevaluating client portfolios and looking for the best outcomes for their shareholders. We have witnessed unprecedented levels of market volatility resulting in an increased focus on a fund’s valuation policies and procedures used in determining a fair market value for its investments. This blog addresses the meaning of fair valuation, the key role advisers play in the process, and the best practices that can be supported by fund administrators, fund accounting agents and fair valuation committees.

Fair Valuation Overview

Δ  Fair value refers to an asset’s agreed upon sale price by a willing buyer and seller in the marketplace, under the assumption that both parties are knowledgeable and entering into the transaction freely (i.e., an “arm’s length transaction”).

Δ  In a broad sense, fair value represents the potential price or value assigned to goods or services. Considerations include utility, supply and demand, and the amount of competition for the asset.

Δ  Most commonly, shares are publicly traded on stock market exchange or other platform with market makers providing a bid and ask price for those shares daily.

Δ  For example, investors can sell a stock at the bid price to the market maker and buy a stock at the ask price. Since investor demand for a stock largely determines bid and ask prices (bid ask spreads), the exchange is a reliable method to determine a stock’s fair value.

Fair Value and Investments

A highly functioning fair valuation program should include an administrator working between the fund adviser and the board to regiment the process, always keeping lines of communication open, and following established methodologies and procedures as determined by a set of policies set forth by a given fund board.

In the current environment, if advisers are not supported in the right way with a diligent administrator, they may feel as if they are operating in a vacuum – which is likely a scenario that will produce less than optimal outcomes for shareholders and may result in valuation efforts that do not comply with the aforementioned policies. Advisers should look to a fund administrator that is equipped with the knowledge and discipline to properly support them in a crisis, and keeps the adviser on point regarding methodology to make sure it contains measured and managed components appropriate in a volatile market.

Private Holding Methodology

Fair valuation for private notes or other private holdings should be a very regimented process. First, a Fair Valuation Committee (FVC), with the parties to be included and operating parameters defined by trust policies, should come together to create a methodology and attempt to “prove the concept” with possible back testing. Once the FVC feels that it is on solid footing with the proposed methodology, it is enacted with results presented to the fund board for approval and on an ongoing basis to make sure there is a comfort level with how the methodology is functioning. The continued oversight at the board level allows the board to ask questions, provide comment and suggest changes to be taken back to the FVC for execution.

But in a volatile market, even more diligence may be required, with an assessment of how the methodology may be functioning daily and under duress. Questions may need to be asked of the methodology itself. For example, does the approved methodology capture all that it needs to in volatile market conditions? This is ideally reviewed within the FVC and the discussion memorialized with meeting minutes for later consumption by a fund board. Suffice to say that a dynamic methodology might require a dynamic approach from the FVC, meeting as needed and not holding to any pre-determined meeting schedules. Furthermore, with fund administrators and advisers, the major participants in FVC, along with fund boards working remotely, it’s even more important for lines of communication to remain open and active.

For a better understanding of the steps required to create a fair value methodology, see the information below:

Steps to Creating a Methodology

  1. Advisers should communicate that they are going to purchase a security position that requires valuation support, the creation of a fair valuation.

An FVC meeting must be convened and a methodology must be created and installed in lieu of a daily market price which may not be available. The entire process must be documented and memorialized within FVC minutes. In rare cases, advisers may have already purchased such a security position. In such a scenario, the FVC must quickly convene a meeting and come to a determination. Having advance notification of such purchases from advisers is critical and an obvious best practice.

  1. Gathering the fair valuation committee and resources.

Fair valuation resources could include the adviser, the administrator, a compliance officer, a third-party valuation expert, a fund auditor, and perhaps a representative from the company or position requiring a valuation, if available, to provide insight or commentary on what ‘moves the needle’ for that investment so it can be incorporated into the methodology.

  1. Creating an agreed-upon methodology and instituting the plan.

There can be two different kinds of methodologies – dynamic and static. A Dynamic methodology incorporates enough factors that support daily movement of the price for certain securities. A Static methodology may be more appropriate for short-term security holdings with fewer inputs overall and whose market value is less susceptible to normal market movement. Static methodologies will receive more scrutiny from fund boards and regulators and require proper memorialization with carefully prepared minutes.

  1. Ongoing measurement.

How often does the FVC get together to review results? Is there anything the team can use as a proxy currently in the market to be sure the methodology is working as expected? Were the dispositions of fair valued security positions close to the expected outcome? For example, if the security does not sell at the expected price, then the FVC can reassess the methodology to add or subtract components to ensure a better result with dispositions of similar holdings in future. A clear understanding of the methodology and recognition of current market trends are very important so quick adjustments can be made.

  1. Presenting results to the fund’s board of trustees.

The board is presented with minutes from every FVC meeting. Trustees need to see exactly how methodologies were formulated, all back-testing activities, and what conclusions were reached. Did the fund receive what it was expecting in the way of proceeds in a sale? This is referred to as disposal variance testing. Ultimately, the board is responsible for the methodology and results per the Investment Company Act of 1940 (‘40 Act). The goal for the fund board is to make sure the methodology is viable under any market condition.

Pricing Services in Coronavirus Market

Mutual funds and ETFs (“Funds”) may hold equities, derivatives, fixed income securities such as corporate bonds, more complex debt instruments such as asset backed securities, and other fixed income that may be distressed in some form or another. Funds will receive equity valuations derived from the stock market closing quote received at the end of each day. Fixed income securities as previously described are evaluated via pricing services like the Intercontinental Exchange (ICE), Bloomberg, Refinitiv, and others. Those services look at buy and sell activity of the bond or other similar issues along with other factors, then form and provide a daily evaluation.

In the coronavirus environment, there has been evidence of more significant volatility with certain fixed income evaluations from the aforementioned pricing services, ultimately resulting in larger than usual swings in value for shareholders of funds with such holdings. In such a market, it may be very important for the FVC to document conversations and observations the advisers may have if there is a feeling the pricing service is not reacting quickly enough to market conditions. There may be reason to consider a change from one approved pricing service to another and such a change should be carefully documented. Such a decision should not be taken lightly and there should be an expectation that a fund board will review such a change carefully.

Challenging Evaluations

Advisers may wish to challenge evaluations from pricing services. The fund administrator can support this process by submitting the challenge on behalf of the adviser, along with any evidence the adviser can provide to support the challenge and recording the outcome. The adviser does have leeway to submit a challenge directly as well. Either approach may be acceptable as the fund board can then be assured that the adviser is diligently viewing the marketplace and expertly overseeing the pricing service. The fund board may rely upon advisers to make the best decisions regarding price challenges because they are actively engaged daily and know their holdings best.

Advisers should not, however, limit their price challenges to cases where they believe the service is undervaluing the investment. If an adviser believes an evaluation for a fixed income security is too high, then such an evaluation should be challenged with the goal to see the price evaluated down. That is why disposal variance testing is so important. Did a security position sell for what it was expected to? Overseeing the efficacy of a pricing service is crucial with the up and down pricing spreads being witnessed in today’s volatile environment.

Under proposed new Securities and Exchange Commission (SEC) Rule 2a-5, advisers would follow a similar path as described above with the fund board delegating valuation responsibilities. The fund board retains oversight and it is expected that advisers, via the FVC, will continue to report regularly to the board on their efforts undertaken to support the best outcomes for securities valuation.


The careful crafting of valuation policies and procedures that allow for contributions from advisors, valuation experts, audit firms and other third parties, along with the efforts of a sound administrator will allow for expected outcomes in times of “normal” market volatility and be the strong foundation necessary for when markets are behaving with more volatility and uncertainty.   It is exactly during such times that an administrator can add value and make a difference for fund boards and ultimately for shareholders.

8359 UFS 6/4/2020

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