Houlihan Lokey’s Hedge Fund Practice

Nimble, Thoughtful, Global, Independent Advice

HAMLIN LOVELL

Houlihan Lokey is a global boutique investment bank that aims to offer independent advice and does not burden clients with the balance sheet conflicts that plague some bulge bracket firms. “We put the client first and use intellectual rather than financial capital,” says Head of Houlihan Lokey’s Hedge Fund Coverage practice, Mark Goldman.

Houlihan Lokey has more than 1,200 people across 24 offices globally and takes pride in being nimble – both in acting for clients and when hiring staff. “Our restructuring group employs world class home-grown talent. We have also bought boutiques that have a complementary cultural fit. As a few examples, we just hired a co-head for our FIG group from Barclays and an oil and gas specialist from Deutsche Bank, and we acquired Black Stone IP to create our Tech+IP franchise,” says Goldman. Most recently, the firm announced that it has agreed to acquire Quayle Munro, an advisory firm which specialises in data and analytics, to establish a Data & Analytics Group in Corporate Finance.

Houlihan Lokey’s hedge fund practice grew from its financial restructuring franchise. It has broadened out into financial advisory (due diligence, fairness opinions, and valuations, where the firm has its roots), corporate finance, M&A, and capital markets. The growing focus spans the full life cycle for hedge fund managers of all sizes, from seeding, to mergers and acquisitions, sourcing deals, advice on quoted vehicles such as business development companies (BDCs) or permanent capital vehicles (PCVs), sourcing and disposing of illiquid securities, and fund liquidations. “We expanded our must-have relationship among creditors to other parts of our firm, growing our firm while continuing to focus on serving our clients,” says Goldman. Houlihan Lokey’s valuation practice – which we devote an extended profile to, see below – is busier than ever.

Houlihan Lokey is feeling the pulse of markets and catching the buzz of deal chatter all day long. A natural extension of this information flow is that Houlihan Lokey acts as an informal matchmaker and headhunter, helping core clients and friends move between firms and find key people. This leverages a powerful network. “Houlihan Lokey’s best and deepest relationships are with financial sponsors, multi-strat firms, hedge funds, and alternative providers of capital,” Goldman adds. In 2017, Houlihan Lokey’s Corporate Finance business was hired by financial sponsors 248 times (not including valuation work); currently works with more than 200 hedge funds; and is in touch with over 1,000 providers of alternative capital.

Corporate restructuring leader
Houlihan Lokey is ranked number one by the restructuring value of global distressed debt and bankruptcy deals it advises on and has advised on 12 of the largest 15 US restructurings between 2000 and 2017. “We are the largest and most active firm. We have offices across the US, Europe, Asia, the Middle East and now Australia, where an acquisition has moved us into pre-eminent position overnight. We also just opened an office in Dubai,” says Senior Managing Director and Co-Head of Houlihan Lokey’s Global Financial Restructuring practice, Eric Siegert.

“We have the deepest bench in terms of senior personnel and resources, drawn from different industry groups,” says Siegert, who has been with the firm for more than 30 years. This is not unusual. “Our 35 managing directors have an average tenure of 20 years or more,” he says.

“We pursue a collaborative approach between our restructuring personnel and seasoned Corporate Finance bankers in multiple industries, and we bring a very comprehensive solution to the table. Few others can offer that diversity,” he adds.

Houlihan Lokey vigorously represents both debtors and creditors – but of course not both at the same time. “We can be paid directly by funds, as we were in the Icelandic banks’ restructurings, but we are more often paid by companies, with fees approved by the bankruptcy courts,” explains Goldman. The firm has “an outsized market share on the creditor side, working with the same names deal after deal, with many repeat clients and much repeat business,” Siegert points out.

Houlihan works on both traditional and out-of-court restructurings. Creditor committees can be composed of hedge funds, private equity firms, insurance companies, and traditional asset managers of all sizes. “We work with the largest funds, such as Oaktree and Apollo, and we also work with hedge funds running under one billion,” says Siegert. Additionally, Houlihan has constant interaction and information flow with the broader creditor community, including some firms that are not on creditor committees, to keep them abreast of developments.

Houlihan takes pride in its independence. For court restructurings, such as Chapter 11 processes, there is a formal test of independence: the disinterested test, which requires affidavits to the court confirming that there are no conflicts. In an out-of-court context, Houlihan’s clients can take comfort that “there are no significant investments anywhere that could provide a conflict or taint our perspective in any way. Clients know with absolute certainty that we can provide independent advice on the facts and circumstances,” says Siegert, who has testified in bankruptcy court as an expert on valuation and financial restructuring matters.

Houlihan Lokey advises on liability management exercises such as pre-bankruptcy solutions that can avoid the need to go into bankruptcy. The industry focus follows whichever sectors are seeing stress and distress. Not so long ago, shipping was the main distressed sector. Lately, the firm has been involved heavily with the energy and retail sectors, which are seeing disruptive change. For instance, Houlihan Lokey has been hired by creditors of Toys “R” Us, which had debt owned by CLOs. In energy companies, the restructuring practice dovetails well with Houlihan Lokey’s illiquid financial assets group, which seeks out acquisition and divestment opportunities. “We have a daily active dialogue with credit managers and use that knowledge to grow other practices, such as capital raising, illiquid financial assets, valuation, capital markets, and M&A,” explains Goldman.

Seeding and capital raising
Houlihan Lokey has been exploring acquiring a firm to assist with capital raising for private equity and other alternative capital providers and is hopeful of making such an acquisition soon. This would be strategic and complementary to its existing businesses. Separate from raising money for managers, Houlihan Lokey has been involved in advising a variety of managers in various corporate transactions. This has included strategic M&A, unwinding struggling or failing funds, and unwinding seed deals as managers mature. The firm is currently “working with a prominent hedge fund manager who was seeded by a prominent allocator to repurchase the seed interest; we are also selling a multi-strat manager and advising a larger sovereign-backed entity looking to expand their GP capabilities,” says Goldman.

Illiquid financial assets
Houlihan Lokey makes markets in a variety of illiquid financial assets that appeal to a broad cross-section of hedge funds and alternative capital providers. The firm established the Illiquid Financial Assets practice in 2009 to take advantage of the growing flow in such assets from financial institutions and hedge funds. The firm is frequently retained to find markets forboth individual assets, portfolios of assets and sometimes entire funds.

“The IFA practice has a symbiotic relationship with the hedge fund coverage group,” says Managing Director and Co-Head of Houlihan Lokey’s Illiquid Financial Assets practice, Jeff Hammer. The IFA group was founded by Hammer and his Co-Head Paul Sanabria, both of whom moved to Houlihan Lokey from Bear Stearns where they had run the private equity secondary investment group as well as the private funds group. With the global financial crisis forcing wholesale liquidations of a wide variety of assets, Hammer and Sanabria saw an opportunity to leverage Houlihan’s franchise in valuation and restructuring as well as its frequent, favourable interactions with hedge funds. Houlihan had developed deep and strong relationships with a wide variety of hedge funds through their investments in distressed situations. The dialogue was continuous and productive. The Illiquid Financial Assets practice broadened the conversation and the IFA team went to work intermediating financial assets to and from financial institutions and hedge funds.

Over the years, hedge funds became increasingly central to the IFA business at Houlihan Lokey. Hammer states, “We determined pretty quickly we needed to spend a significant amount of time with hedge funds, especially special situation funds with longer-term, locked-up capital. The special sits funds have evolved into one of the most creative and flexible pools of capital on the planet. They consider investments in anything: life settlements, legal claims, pharmaceutical royalties, capital leases and even tax receivables.”

IFA has arranged many transactions with hedge funds over the years and finds needs to fill in good times as well as in bad. “We have carried out roughly 30 transactions involving hedge funds as sellers over the past nine years. We have arranged even more transactions with hedge funds as buyers. Some have been both buyers and sellers in the same basic time frame! It is a vibrant market,” says Hammer.

The IFA team’s sell-side practice focus is not restricted to hedge funds. “Hedge funds were our first clients but over time our client roster has expanded to include banks, insurers, sovereign wealth funds, pensions, endowments and family offices – all of who are also actively buying and selling illiquid assets,” says Hammer. The buyside for these assets also extends beyond hedge funds. “There are dedicated investment funds devoted to life settlements, pharmaceutical royalties, litigation finance and other discrete strategies in the illiquid markets.”

Asset and fund M&A
Roughly 50% of IFA’s transactions are asset transactions, which are priced through what Houlihan calls “Asset M&A”. The process typically takes 90-120 days and is called an M&A process because it is an auction process, similar to a corporate divestment. “For liquid assets you can phone brokers or trading desks, but for illiquids more work is involved,” says Hammer. “Secondary markets in the illiquid world lack transparency and standardised documentation. Most deals are heavily negotiated. None of these markets enjoys the efficiency of a central clearinghouse.”

In addition to Asset M&A, Houlihan’s IFA team executes ‘Fund M&A’ transactions. These transactions involve a change in status of a fund due to a variety of causes ranging from managerial disputes to team defections to investment performance to fraud. Roughly 20% of Houlihan’s activity here involves alleged fraud, including the Platinum Partners case; 30% relate to hedge funds that have restricted redemptions, for example Octavian, Plainfield Asset Management, Third Avenue; and the remainder are for healthy funds requiring re-positioning or re-branding.

Structuredsolutions
The IFA practice has a London-based team focusing on the de-leveraging of European banks. The group’s structuring capabilities are sought-after to assist banks in shedding non-performing assets in different jurisdictions in Europe, including Germany, Italy, Greece and Portugal. “We seek to develop structured solutions that do no harm to bank balance sheets,” explains Hammer. “The overhang of NPLs in Europe continues to be a looming problem for most Continental banks. We can solve this problem.” Hedge funds are often counterparts in these types of transactions.

Corporate finance, M&A
In a climate of increased focus on alternative lending strategies, Houlihan Lokey is sought after to advise BDCs on corporate activity. “We are probably more active in the BDC space than anyone else. We were retained to advise North Carolina-based BDC, Triangle Capital Corporation, on its strategic alternatives, and we recently advised Full Circle Capital Corporation on its merger into and with Great Elm Capital Corporation. We also advised Benefit Street Partners on its acquisition of Business Development Corporation of America as well as advising Fifth Street Asset Management on its sale to Oaktree,” enumerates Goldman.

Houlihan Lokey has been retained by a Middle Eastern entity that is seeking to invest in a global asset manager. The firm is also looking at strategic options for a multi-strategy hedge fund manager.

Goldman expects consolidation will continue throughout the alternative asset management industry, as “investors are more comfortable investing with larger, more stable managers.”

Permanent capital vehicles
Houlihan Lokey had a small role advising Ares on their IPO. It has also helped managers to raise assets through special purpose acquisition companies (SPACs) and assisted managers in establishing PCVs. Goldman sees great benefit in PCVs but also realises that there are sound reasons why very few hedge fund managers have set them up. “It is very hard, if not impossible, for an emerging manager to raise assets in a PCV. And when managers are riding high they may find that fees are higher on private funds than on PCVs. Only managers who are real business builders and want to monetise the value of the institution they have created will find it worthwhile. The best managers can choose between permanent and private vehicles or run both.” However, “there can be conflicts between public and private vehicles,” he cautions.

Valuation
Houlihan Lokey’s valuation practice provides full independent valuation and limited scope positive assurance in relation to Level 3 and increasingly Level 2 assets. This is designed to meet certain US and international accounting and financial reporting standards. For Level 2 assets, Houlihan Lokey can also confirm the reasonableness of broker quotes.

As valuation is a rapidly-evolving discipline which attracts growing attention from regulators, we interviewed Houlihan Lokey’s Portfolio Valuation and Fund Advisory Services practice head, Dr. Cindy Ma, for an extended profile of the valuation practice.

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Houlihan Lokey’s Valuation Practice
Independent valuation analysis for Level 2 and Level 3 assets

Houlihan Lokey’s Portfolio Valuation and Fund Advisory Services practice carries out valuation analysis of assets held by hedge funds, private equity funds, BDCs, and other investment advisors such as venture capital funds, mutual funds and real estate funds.

Drivers of growth
Multiple driversencourage, and sometimes compel, greater use of independent, third party valuation agents. Regulatory enforcement actions have highlighted a number of public cases, identifying issues with valuations of assets and/or sub-optimal valuation practices. Houlihan Lokey’s valuations have not been the subject of SEC enforcement actions, according to Ma.

The standard-setting body, the Standards Board for Alternative Investments (SBAI), (formerly called the Hedge Fund Standards Board (HFSB)), recommends the use of ‘an independent and competent third-party valuation service provider’. Whether or not they are SBAI signatories, institutional investors may require, or prefer, a valuation agent – at least for Level 3 assets (and increasingly for Level 2 assets as well) to avoid the perception of possible conflicts of interest where hedge fund managers, who are remunerated on the value of their fund assets, have the final say on valuation. Charging fees only upon realisation of illiquid assets does mitigate one potential conflict of interest, but it is usually only carried interest, or performance fees, that are disbursed in this way, while management fees also may be paid out based on unrealised valuations. Additionally, the possibility of using what may prove to be an inflated performance track record in order to raise assets can also be a contentious issue for regulators.

Secondary market activity in private equity interests, co-investments, side pockets, and sidecars can also prompt the need for a fresh valuation or a second opinion from valuation agents. This can be seen in the context of a general trend towards more transparency being provided to investors in multiple areas.

Regulations like Dodd-Frank and AIFMD can also encourage firms to seek independent valuation advice. For instance, a by-product of the risk retention rules for structured credit is that valuation agents need to confirm if structures meet the rules (eg for horizontal, vertical, and L-shaped risk retention in the US).

Other service providers may spur the use of valuation agents. For example, fund liquidators may need to retain a valuation agent (Houlihan Lokey was recently hired by the receiver of Platinum Partners).

The Public Company Accounting Oversight Board (PCAOB) is asking auditors to raise their game in ways that include carrying out deeper fair value analysis. Auditors welcome the engagement of third party valuation agents, according to Ma, who was formerly a partner at EY.

Responsibility and liability
Though multiple service providers – auditors, administrators, valuation agents, brokers, and pricing services – are involved in the valuation process, managers or general partners typically hold formal and ultimate responsibility – and liability – for the valuations of a fund’s investments. Some years ago, governing bodies, namely a board of directors, were found liable in a landmark case around Regions Morgan Keegan mutual funds, where Ma was hired by the SEC as an expert witness in a testifying role. Eight former directors of Regions Morgan Keegan open and closed end funds settled with the SEC and admitted that they had failed to properly oversee valuation.

Costs and benefits
A valuation agent adds a layer of costs, leading to the label ‘triple taxation’ whereby there are three levels of valuation-related overheads: managers’ internal resources, auditors and administrators, and valuation agents. Valuation agents charge fees on a per asset basis rather than fees related to the value of assets. Where valuation policies insist on a valuation agent for all Level 3 positions, this fixed cost may seem disproportionately or prohibitively high for small positions. Some valuation policies set a dollar threshold for using a valuation agent.

Apart from the need to demonstrate an independent valuation process, the benefits include the fact that experienced and well-resourced valuation agents may have special expertise in particular industries, asset classes, instruments, and strategies. This could complement knowledge within an asset manager, or in some cases it may fill in gaps in asset managers’ own valuation infrastructure. Houlihan Lokey has extensive experience in valuing a wide range of asset classes, including illiquid securities (including private equity, venture capital, loans, bonds, preferred stock, PIPEs, hybrids, peer-to-peer loans, and mortgage servicing rights); structured products (RMBS, CMBS, ABS, CDOs, CLOs); corporate derivatives; over-the-counter derivatives; and more esoteric bespoke products (including revenue share agreements, litigation rights, trade claims and bankruptcy claims, carried interest, and E&P or mineral rights). Houlihan Lokey argues that their valuation practice exploits constructive synergies with the firm’s other platforms. Capital markets and corporate finance platforms can provide real time market insight, for instance. Financial restructuring, transaction advisory, and strategic consulting units can also shed light on certain assets. Although the firm has implemented strong policies to identify and mitigate conflicts and avoid sharing confidential information, this cross-fertilisation of intelligence helps Houlihan Lokey to provide more well-rounded, timely, and accurate valuation advice.

External valuation providers may reduce the internal resources required by fund managers, relieving the burden on back offices, and freeing up portfolio managers to spend more time on alpha-generating activities. And a valuation agent may be able to expedite some aspects of audits, operational due diligence routines, and regulatory examinations. “A comprehensive valuation review carried out by a credible valuation agent who documents methodology and assumptions can provide answers which make the audit process easier and smoother and ultimately more efficient. If auditors or regulators have questions, Houlihan Lokey is the first line of defence,” explains Ma.

Different levels of bespoke service
Not all clients choose a comprehensive valuation review and costs vary according to several levels of service. The lightest service level from a third party valuation agent offers some comfort over broker quotes by providing Level 2 support to confirm the reasonableness of broker quotes. A limited scope ‘positive assurance’ service from a third party valuation agent reviews managers’ processes to determine if managers’ value conclusions are reasonable, without separately offering an independent conclusion of fair value. The more robust independent valuation service generates a thorough valuation analysis with the third party valuation agent defending each assumption (eg, cash flows, methodology, multiples, discount rates, capitalisation rates, comparable companies, etc.) and providing supporting material in order to offer an independent conclusion of fair value.

Roughly 60% of Houlihan Lokey’s clients request full independent valuations with 40% choosing positive assurance. Both the client and Houlihan Lokey are involved in determining the appropriate service. “If clients cannot produce a robust, empirically defensible valuation memorandum themselves, then it does not make sense for them to request positive assurance from a third party valuation agent as this positive assurance presupposes that the client has already prepared a supportable valuation,” explains Ma. Houlihan Lokey aims to add value, rather than replicating what its clients are already doing in house. It aims to tailor its offering to suit managers’ and investors’ needs. The frequency of third party valuations will depend on whether, and how often, they are required for events such as capital raising, redemptions, investor reporting, financial reporting, inter-fund transfers, and collateral valuations for asset-based lending.

In approximately 75% of cases, Houlihan Lokey is hired by a fund manager or general partner. Sometimes, it is retained by institutional investors or limited partners to carry out due diligence on asset managers or occasionally by fund administrators or fund lenders who need additional expertise or a fresh opinion.

The entity remunerating Houlihan Lokey depends on fund documents. “Often, third party valuations are an expense borne by the fund, but it can be charged to the manager. Where fund documents do not prescribe who pays, it is more likely to be the manager,” explains Ma.

GP and manager valuations
Ma also cites a natural extension of Houlihan Lokey’s hedge fund practice and valuation expertise: providing valuations of the alternative asset manager and GP entities that run the funds. She observes that the frequency of events driving the need for valuations of managers has increased – such as changes in senior members, raising new capital at the manager level, or the outright sale of an equity stake in the manager. However, she cautions that these valuation exercises are far from simple – “Complex structures used to incentivise performance while providing for tax efficiency call for an in-depth understanding of the industry and a rigorous analysis of the manager itself.” Furthermore, “there are a number of unique factors that should be considered that impact the risk profile and value determination. These include the investment focus of the manager, revenue stability, depth of management & key man risk, stability of fund returns, high water marks, AUM growth & withdraw rights, management compensation structure, and fund structure.” Ma cites that Houlihan Lokey advises a variety of institutional investors in valuing their minority interests in fund managers & GPs, as well as advising fund managers directly in valuing their manager and GP entities for a variety of purposes including equity compensation, admitting new partners, separation events, estate & gift tax, and succession planning.

Portfolio acquisition and divestiture services
Another extension of Houlihan Lokey’s experience and relationships with the hedge fund community has led to its involvement in a trend of illiquid portfolios (both distressed and performing financial assets) changing hands. Ma sees this trend growing as banks, insurance companies, and other regulated institutions seek to clean up their balance sheets and free up regulatory capital. Ma and her colleagues have been advising the natural buyers of these portfolios, which are often hedge funds and other institutional investors with matching investment mandates and broader discretion in their strategies. She observes that Houlihan Lokey is often brought into these situations because “the sales process for these portfolios can be both competitive and time constrained, requiring buyers to dedicate substantial resources to these efforts, often leading to internal disruptions and potentially high opportunity costs.” She refers to Houlihan Lokey’s ability to mobilise a deep bench of resources to provide real-time market insights as well as asset class and industry-specific expertise in support of a streamlined and efficient process.

Good valuation practices
Another service Houlihan Lokey offers to fund managers is advice on managers’ valuation processes, policies and procedures, benchmarking them against best practices. To highlight some key takeaways from Houlihan Lokey’s Portfolio Valuation Best Practices brochure, a sound valuation policy framework should be formally set out in a written document, defining the roles, responsibilities, and modus operandi of those involved with valuations, the valuationcommittee, and the governing body (which can be a board of directors, the general partner, managing member or trustee). Valuation manuals should also disclose any conflicts and how they are mitigated. Ideally the valuation process will be independent of the investment process. This can often be achieved through segregation of duties inside some asset managers.

For instance, valuation committees usually include the CEO, CFO, and COO, and could also receive input from investment professionals although they would not be expected to sit on the committee. Of course, in smaller firms, some individuals wear multiple hats, which can create challenges in terms of demonstrating segregation and forming valuation committees. Ma argues that “smaller firms may benefit from using a valuation agent and even outsourcing the valuation function.”

Bespoke not boilerplate manuals
Transparency protocols and documentation are important for stakeholders to gain comfort on valuation policies. SEC examiners and operational due diligence professionals are closely scrutinising dozens of manuals, including valuation policy documents, which must be customised to specific circumstances. Boilerplate language may not pass muster. “In the old days, policies and procedures in manuals looked similar as managers cut and pasted standard language. Now they must make sure that it actually reflects their infrastructure and operations,” says Ma. Just as lawyers advise that compliance manuals should be living, evolving documents, so too Ma suggests that “valuation policies and procedures should be reviewed frequently to reflect portfolio strategies and operations. If managers start trading a new asset class, they must revisit their protocols to make sure that methodologies and quality controls are clearly included in the procedures.” Consequently, “many clients are requesting reviews of their valuation manuals,” says Ma. It is vital to ensure that policies are consistently applied. “A gap between policies and actions is a big issue,” stresses Ma. Houlihan Lokey’s May 2017 brochure, A Valuation Road Map for Fund Executives, offers more guidance on governance, processes, controls, reporting, and documentation.

A nascent valuation profession
While valuation firms have existed for many decades, the concept of a dedicated valuation profession is nascent. Ma has been on the board of the International Valuation Standards Council (IVSC) for the past six years. “The aim of the IVSC is to provide a standard of guidance for business valuation and real estate valuation. It is still in the process of setting up a board for financial instruments,” she explained.

Professions often have self-regulatory bodies, which is also in the making for valuation professionals. “Six years ago, SEC Chief Accountant, Paul Beswick, expressed his concern with the valuation industry having no regulator, unlike the audit industry, which has the PCAOB, FASB, and ultimately the SEC,” Ma recalls. Whereas the audit of large firms and funds is dominated by the Big Four, Ma is of the opinion that “valuation firms are of many different shapes and sizes so in some situations, firms may not be rigorous enough for some purposes.” The aspiration to create a credible self-regulatory body is ultimately based on self-interest. “The valuation industry is concerned that if we do not do anything, regulators will catch up,” says Ma. The Certified in Entity and Intangible Valuations (CEIV) valuation credential for valuation professionals currently focuses on entity and intangible asset valuations for publicly traded US companies, but may be expanded to cover financial instruments, which may be relevant for the hedge fund industry and should be monitored.

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BrokerQuotes Focus
Under the fair value hierarchy (ASC 820 in US GAAP and IFRS 13 in IAS, which are very similar according to Ma), assets can be split into Level 1 (mark to market), Level 2 (mark to matrix) and Level 3 (mark to model). Until a few years ago, Houlihan Lokey’s valuation practice focused almost exclusively on Level 3 assets, which are often complex and illiquid. Over the last few years, and particularly the past 12 months, Houlihan Lokey has been getting more client requests for analytics and support on Level 2 assets, many of which may not be perceived as either complex or illiquid. (Very seldom are valuation agents asked to opine on Level 1 assets).

Level 2 assets are often valued with reference to quotes by various brokers who may make markets in the securities, and from a valuation perspective there are many detailed steps needed to conduct such valuations properly. In December 2017, Cindy Ma and her colleague Susanna O’Brien published a paper entitled Valuation Considerations for Broker-Quoted Positions, which provides a detailed discussion of multiple nuances and reviews several case studies of regulatory enforcement actions around sourcing quotes.

Quotes must be considered in the context of market liquidity and many other factors. “There is more scrutiny on evaluating broker quotes: managers are often asked whether they can actually execute at that quote, if the quote just accommodates a request but cannot be used to trade, how many parties are providing quotes, and whether they take the high, low, average, median, etc.,” explains Ma.

Grey areas between Level 2 and Level 3
The subjectivity and fluidity of classifications between Level 2 and Level 3 is one reason for engaging a valuation agent on Level 2 assets. Differences of opinion and methodology mean that the same asset could be classified as both Level 2 and Level 3 by different investment vehicles at the same point in time. And the same investment vehicle may move an asset between the Level 2 and Level 3 categories over time. “Securities can shift between categories, particularly in dislocated market conditions,” observes Ma. The ASC 820/IFRS 13 guidance on criteria for classifying assets is not especially prescriptive – and does not precisely define concepts such as ‘actively traded’ – but there is potential for assets with one or more quotes to end up as Level 3. Insufficient liquidity behind a quote can result in a quoted asset being categorised as Level 3. Liquidity is a multi-faceted concept, which can be defined across several dimensions, including tightness, immediacy, depth, breadth, and resilience.

Adjustments made to a Level 2 valuation that are deemed significant can also cause it to fall into the Level 3 category. And where quotes are non-binding, and based on indications rather than observable transactions, they are more likely to be Level 3 (per guidance from FASB ASC 820-10-35-54M).

Houlihan Lokey itself does not get involved in classifying assets as Level 2 or Level 3 but suggests that managers need to demonstrate robust and repeatable processes for classifying assets. A specific regulatory concern is that misstated asset classifications may also misrepresent the liquidity of the fund.

Sourcing of quotes
‘Sham quotes’ or ‘U-turn quotes’ provided by the manager are perhaps the most glaring and egregious abuse that can result in Level 3 assets being misclassified as Level 2. This allegedly occurred in the case of SEC vs Visium Asset Management, where manager Stefan Lumiere was fined $1 million and imprisoned for 18 months. In another enforcement action, SEC vs Alphabridge Capital Management, the manager ostensibly obtained quotes from registered broker dealers, but in fact the quotes were supplied to registered representatives of broker dealers by Alphabridge itself. When the auditor asked to speak to the registered representatives, Alphabridge allegedly forged their responses. This resulted in a fine of $5 million and civil penalties.

Quotes should be sourced independently of the front office, from broker dealers or pricing services, but obtaining quotes from a third party is not sufficient evidence for documenting a valuation analysis. Delegating or outsourcing the quote provision function to a third party does not relieve the manager of responsibility for ensuring that the quotes are consistent with accounting standards.

Pricing services
Given a historical lack of transparency in over-the-counter markets, certain companies have offered pricing services to market participants. Pricing services typically gather broker quotes, trade data, and other information from the market and, using automated processes, attempt to provide price indications even on securities that may not have a recent broker quote. Given the reliance on significant amounts of market data, these services tend to focus on providing price indications for large numbers of securities at relatively low cost. However, managers have found that using pricing services can have several shortcomings, and they tend to yield poor indications for securities that are relatively less active.

Pricing services do not remove subjectivity from the process. They may use different inputs and apply different weights to them. Therefore, managers (and/or valuation agents) should carry out due diligence on pricing services, which can include quite extensive ‘deep dives’ and price challenges. The Public Company Accounting Oversight Board (PCAOB)’s Pricing Sources Task Force, formed in 2011, recommends that managers need to determine whether pricing services are compliant with GAAP. Regulators and auditors are asking managers to corroborate and defend the prices used. Specifically, managers need to be cognisant of the sources and processes used; identify, document and test controls; and gather historical data on liquidity and pricing.

In the case of SEC vs Covenant Financial Services, bonds were sold in 2011 at prices that fell short of indicative quotes from a pricing service. This should have raised a red flag, but Covenant carried on using the service until early 2013, earning alleged excess fees of $400,000 as a consequence. Covenant’s omissions here were allegedly inconsistent with its audit, written valuation policy, private placement memorandum, and limited partnership agreement. Covenant paid a civil penalty.