The CAO of Apollo Investment Corp. addresses internal valuation procedures, illiquid investments, working with third parties, and lessons learned.

March 06, 2019

Amit Joshi Apollo Investment CorpRecent examination findings and enforcement actions from the SEC’s Office of Compliance Inspections and Examinations (OCIE) has sparked a trend of increased scrutiny on fund valuation from regulators. With an audit background in alternative investments, and now as the Chief Accounting Officer (CAO), Controller Assistant Treasurer, and Vice President of Apollo Investment Corp., Amit Joshi has seen firsthand the various approaches fund companies take when valuing their investments. We recently spoke with Amit to discuss his perspective on best practices in portfolio valuation.

Can you discuss and comment on internal controls, policies, procedures, and best practices regarding valuation?

One of the most important aspects to consider for any fund company is the development of a valuation policy. I think people should spend a good amount of time thinking through their business as they draft their policy. Some of the things to think through include:

  • the kind of products the company offers
  • the frequency of the valuation (i.e., quarterly or annually)
  • what kind of investments are included
  • the liquidity of those investments

A valuation policy should clearly include detailed information on all those components.

In addition, a valuation policy should be detailed enough that it lays out the criteria and various scenarios and approaches of how the valuation will occur. For example, a company may approach a valuation using multiple broker quotes. Or, a company may use a single quote but also look at the pricing vendor. Or, if there isn’t a pricing vendor, then it may use an independent, third-party valuation firm and do a positive assurance of the full-fledged valuation. This information should all be included in the valuation policy.

Another example is with exchange-traded funds, which seem simple enough, but we have seen enforcement actions even with those types of funds. A valuation policy for exchange-traded investments should include what price to use, such as the last closing price. If the closing price is not available, then the next price alternative might be the traded price. If traded price is not available, then the next price alternative is a broker-dealer quote(s).

In those scenarios, it’s also very important to work closely with the deal professionals to understand how reliable the quote is and that the right approach is being used.

Can you speak to best practices as it relates to illiquid investments?

One of the best practices I’ve seen as it relates to illiquid investments is to create an internal risk rating system, which can be extremely helpful for determining the risk level of various investments. For example, a risk rating system may include a risk score from one to five where a score of one indicates that the fund is performing above expectations and five indicates it is performing below expectations. The watch list then helps the board of directors and senior management team identify where they should be spending more of their time.

Another best practice is to assess the various product types. Following the assessment, professionals should determine which valuation methodologies will be best for the investments, and then evaluate if multiple valuation approaches can be used. If multiple valuation approaches are used, then there needs to be a reconciliation of the value determined by those approaches.

Along with reconciling valuation methodologies, performing back-testing is very important. Back-testing helps professionals understand any significant differences between actual transaction price and fair value, which will help to assess the adequacy of the valuation process.

Professionals should also evaluate how often the underlying information of the portfolio company is obtained and how heavily it needs to be reviewed. Furthermore, back-testing helps in this case, too; one should perform back-testing on that underlying information to evaluate the authenticity of the information. In this regard, one of the ways to approach this would be to obtain audited financial statements when they become available and compare the significant input in these statements with the draft information that the portfolio company previously provided to document and reconcile the differences.

It’s important to ensure that the valuation approach and changes in significant input are properly documented. In general, documentation is key, but especially in the case of illiquid investments, which may have subjective assessments.

What are your thoughts about conducting valuations internally?

Valuation is a key area for a fund because it not only impacts the net asset value of the fund, but it also has an impact on the management and performance fees.

If the valuation is going to be conducted internally, it is important to have an independent valuation team for that fund. Deal professionals are dealing with the investment day-in and day-out, and there may be conflicts of interest because they are the ones who have made those investments. An independent valuation team includes members who are experts in valuation and are focused just on the valuation of the fund, so they can be truly independent. They can work with the deal professionals as the internal valuation gets drafted and also work with the third-party valuation firm to answer questions and independently verify the work.

Some companies do all their valuations internally and don’t send anything to a third-party valuation firm. Then, there are funds that do all their valuations externally through a third-party valuation firm. And, there are funds that might send 20%-25% of their portfolio every quarter to a third party, and then rotate among the investments so that the entire portfolio is eventually covered.

A fund company can be at any point in the spectrum, but what’s most important is the consideration of the portfolio’s overall risk level. For Level 3 investments, which consist of mostly illiquid, distressed investments, generally an independent valuation is something that can give more confidence to investors, the board, and senior management.

If a fund company is conducting an internal valuation, when should they start it?

It’s really based on the measurement date and when the company wants to close the books and issue financials. If it’s a quarterly valuation, the valuation can start a few weeks before the measurement date. Some public funds have a tight deadline, which can also play a role on when to start the valuation. In short, start as early as possible. 

Once the internal valuation team completes the valuation, there should be a meeting between the valuation team, deal team, and finance team, including the CFO, to share and discuss the updates. It’s very important that everyone in the meeting understands the business theme around that investment. They should focus on how the theme will influence the concluded price or mark and if the valuation methodology needs to change or valuation inputs need to be updated.

Also, even if a company starts the valuation process before the measurement date, any significant information that becomes available should be considered and the valuation should be updated to reflect the same. There should be a process that ensures all deal professionals evaluate any additional information if it becomes available closer to the measurement date.

How about best practices if a company decides to bring in a third-party valuation expert?

Many companies decide they want to outsource a component or all of the valuation to a third party. The most critical element when doing this is sharing all the documents with the third-party valuation experts who rely on this information to independently value these investments. In some cases, enforcement actions have been brought against companies when the valuation firm did not receive all of the required information.

Just like with an internal valuation, everyone needs to review the valuation reports to ensure they have captured the correct information in the process and that everyone agrees on the assumptions used. One should also check the calculation of these reports to avoid any mathematical errors.

In addition, it is important to ensure that all parties are aware of the timeline and can deliver the draft report and final report in a timely manner.

Can you talk a little bit about best practices in working with the board and valuation committee?

It’s important to have a meeting with the board and valuation committee as soon as possible because if the valuation changes, it will impact the entire financial statement. And, typically if it’s a public fund, there are only 40 or 60 days to report, so it’s a relatively short window to complete the valuation and get it approved by the board.

One of the best things I’ve found to work is to have a valuation package that can be used to update the board and valuation committee. This valuation package should include various analyses, focusing on investments that moved significantly, quarter-over-quarter variances, third-party and internal price variances, changes in valuation methodologies, broker quotes, stale pricing, back-testing, and a one-page summary valuation document for all the investments.

Can you talk a little bit about best practices in working with auditors?

It’s critical to treat the auditors like a partner, sharing information and communicating in a timely fashion. You want to avoid scenarios where you walk into the board meeting and the auditors come in and say, “We have found an issue.” That’s not a conversation you want to have with auditors or with your board at that point in time.

What we do, normally, is share our valuation material a week before the board meeting on valuation, and we give that timeline to our auditors to ensure that they have also completed their work before things goes to the board. We work with auditors to ensure everyone is on same page with timelines and adhere to those timelines.

Generally, before the valuation meeting even occurs, we have a separate discussion with the audit partner and the audit chair. This is to ensure we are all on the same page and to address any issues or challenges beforehand.

What’s your biggest lesson learned?

I come from an audit background, and on my second day of work, the partner on the project told me, “If it’s not documented, it’s not done.” That piece of advice has been helpful throughout my entire career even as I moved to an in-house role. If auditors or regulators walk in, if things are documented, we have evidence of how we performed the valuation.