SEBI’s standard approach, standardising valuation for AIFs

Dayita Kanodia | Executive, finserv@vinodkothari.com

So far, valuation of securities in terms of an Alternative Investment Fund (‘AIF’) was carried out in accordance with Regulation 23 of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’).

Regulation 23 provided AIFs with flexibility in adoption of valuation techniques or methodology for valuation of investment portfolios and the AIF managers were required to merely provide a description of the valuation procedure and of the methodology for valuing assets.. Also, the modalities relating to valuation of investment portfolio of the AIFs were not disclosed in the PPMs at the time of submission to SEBI and also were not reported to SEBI subsequently.

On January 06, 2023, SEBI issued a consultation paper on ‘Standardised approach to valuation of investment portfolio of Alternative Investment Funds’ (‘Consultation Paper on Valuation by AIFs’) which discussed the need for a standardised approach to valuation methodology along with other issues. SEBI had also conducted a survey of 150 managers of different categories of AIFs to understand, inter alia, the present valuation practices being followed.

Subsequently, vide an amendment dated June 21, 2023 SEBI has provided for a standardised approach with respect to the valuation of investment portfolio of AIFs. This standardised approach not only provides for the manner of valuation of AIF investments but also states the responsibility of the manager of an AIF with regard to this valuation in line with the Consultation Paper on Valuation by AIFs.

This article discusses the recent amendment in detail, including the provisions which have been put in place in the event of any material change in the methodology and approach for valuation of investments of schemes of AIFs.

Effective date and applicability

SEBI came out with this circular on June 21 2023 however the provisions of the same shall come into force with effect from November 01, 2023. However, all AIFs are requested to bring about the change in their valuation methodology in accordance with this circular at the earliest.

Existing approach to valuation by AIFs

Prior to the amendment, AIFs had the freedom of adopting various valuation methodologies for their investment portfolios. This flexibility would seem appropriate the AIFs invest in bespoke financial arrangements. For instance, the widely known ‘Discounted Cash Flow’ valuation methodology which is usually applied for valuing assets which genn erate a steady stream of cashflows might not fit into all the scenarios of investing by the AIFs and has its limitations, which would point AIF managers towards adopting a different approach.

Annexure A to the Consultation Paper on Valuation by AIFs highlighted the different valuation practices being followed by various managers as shown in the table below –

Valuation principle/methodology/standard	No. of schemes	Percentage
IPEV Guidelines	71	26.39%
Asset class based approach	59	21.93%
Market approach	52	19.47%
Income approach	46	17.10%
Cost based Approach	13	4.83%
International valuation standards	7	2.60%
Royal Institution   of   Chartered   Surveyors   (RICS) valuation standards	3	1.12%
Accrual basis approach	4	1.49%
Others	14	5.07%
Total	269	100%

Further, the survey observed that across 105 schemes of category III AIFs, valuation of investment in listed securities was done at the closing price quoted on the relevant stock exchange and valuation of listed securities was being carried out at cost or by discounted cash flow, sales multiple method, etc.

However, this led to a scenario where different valuation methodologies were adopted across the AIF landscape and there was no uniform practice being adopted.

The Consultation Paper on Valuation by AIFs highlighted the need for a standardised approach to valuation by stating that “A standardised approach with regard to valuation principles/methodology/standard for valuing investment portfolio is one of the steps to ensure fair disclosure of value of investment portfolio to the investors. It will also ensure that the valuation principles/methodologies/standards are uniform across the AIF industry and performance of a particular AIF as well as that of the AIF industry is benchmarked based on valuation carried out on uniform principle/methodology to reflect their performance in a fair manner.”

Standardised approach to valuation of investment portfolio of AIFs:

Previously, as stated in regulation 23(1), AIFs were required to carry out valuation of their investments  in a manner  specified by SEBI from time to time.

Accordingly, SEBI has specified the manner of valuation according to which, the securities whose valuation norms have already been prescribed under SEBI (Mutual Funds) Regulations, 1996 shall be valued as per the norms prescribed therein.

Valuation norms as per Mutual Fund Regulations

Valuation norms have been prescribed in the eighth schedule of the Mutual Funds Regulations, 1996^[1] (‘MF Regulations’) which provides for different principles to be followed while undertaking valuation of the investments. These principles inter alia include provisions stating valuation of investments to be done at fair value, identification of methodologies that will be used for valuation of each type of securities/assets held, periodic review of the valuation policies and the need for procedures to be in place to prevent incorrect valuation.

How are different securities valued ?

The valuation guidelines prescribed under these MF regulations provide for valuation of different types of securities depending on the nature of the same.

Traded and non traded securities

Traded securities other than money market and debt securities are required to be valued at the last quoted closing price on the stock exchange while the non traded securities are to be valued “in good faith” by the Asset Management Company(AMC) on the basis of appropriate valuation methods based on the principles approved by the Board of the AMC.

Further, certain principles are to be adhered to while valuing such securities in good faith by the AMC. These principles require the equity instruments to be valued on the basis of capitalization of earnings solely or in combination with the net asset value, using for the purposes of capitalization, the price or earning ratios of comparable traded securities and with an appropriate discount for lower liquidity.

Convertible securities

For convertible debentures and bonds, the non-convertible portion should be valued on the same basis as would be applicable to a debt instrument while for the convertible portion, the valuation should be done in the same way equity instruments are valued.

Rights shares

Until rights shares are traded they should be valued as no. of rights offered divided by the no. of original shares held multiplied by the difference between Ex rights price and rights offer price.

For e.g if 10 rights were offered while already holding 100 shares at a rights offer price of say, Rs. 20 and the Ex-rights price is determined to be Rs. 25 then the value of rights shall be – 10/100 *( 25-20 ) which is equal to 0.5.

However, in case a decision is made not to subscribe to the right shares but to renounce them and these renunciations are traded,  the renunciation value shall be taken into account.

Situation of other securities – how will they be valued ?

Valuations of securities not mentioned in the mutual fund regulations shall be carried out as per the valuation guidelines approved by the AIF Industry Association. This Industry Association should however, in terms of membership, represent at least 33% of the number of SEBI registered AIFs. Further, it is required to endorse appropriate valuation guidelines after considering the recommendations of the Alternative Investment Policy Advisory Committee (AIPAC)^[2] of SEBI.

Off late there has been a significant growth in the number of private debt funds in the industry. These funds invest in unique propositions, including hybrid instruments carrying features of both debt and equity. It will be interesting to see how the valuation of such instruments are standardised.

Responsibilities of AIF Manager            

As per  sub-regulation (5) and (6) of regulation 23 of AIF Regulations, the manager and KMP of the manager were required to ensure that the independent valuer computes and carries out valuation of investments of the scheme of the AIF in the manner specified by the Board and were also responsible for true and fair valuation of the investments of the scheme of the AIF.

Deviations and changes requiring disclosure

Now, after the amendment, in case there is a deviation of more than 20% between two consecutive valuations or a deviation of more than 33% in a financial year in respect of each asset class, the manager is obligated to inform the investors the reasons/factors for the same.  This may inter alia include changes in accounting policies, assumptions, valuation methodology and approach.

Material change – need for an exit option

Any change in the  methodology  and  approach  for  valuation  of investments of the scheme of AIF, shall be construed as material change significantly influencing the decision of the investor to continue to be invested in the scheme of the AIF. Accordingly, the fund is required to adhere to the provisions mentioned in the circular dated June 19, 2014^[3] which provides for giving an exit option to the unit holders not wanting to continue with their investment.

Such holders will be given at least one month for expressing their dissent.

A July 18 circular^[4] issued in the same year clarifies that any change in the fundamental attributes of the fund/scheme shall be construed as “material change”. However, exit option is not required to be given with respect to such material change if the AIF has the approval of at least 75% of the unit holders by value of their investment.

Independent Valuer – who is eligible?

SEBI has specified the eligibility criteria for being appointed as an independent valuer which requires such person not to be an associate or manager or sponsor or trustee of the AIF. He is further required to have an experience of 3 years and should hold membership of professional institutes such as ICAI,ICSI, ICMAI or CFA institute. However, if such valuer is a company, it has to be a holding or a subsidiary of a credit rating agency registered with SEBI. 

Reporting of valuation of investments to performance   benchmarking agencies

Manager of the fund is required to ensure that a specific timeframe for providing audited accounts is included as one of the terms in the subscription agreement with the investee company.

This is to enable AIFs to report valuation based on this audited data of investee companies to performance benchmarking agencies within 6 months. Such reporting will be done only after the audit of the books of accounts of the fund in accordance with the AIF regulations.           

Concluding remarks

This SEBI circular by providing for a standard methodology for the valuation of investments by AIF has attempted to clear several ambiguities. Also, by mandating the managers to provide an exit opportunity in case of a material deviation from the valuation methodology originally agreed up, the discretion powers of the managers have been cut down to a great extent.

This is likely to improve the investors’ confidence in AIFs, and therefore, deepen the penetration of the alternative investments in India’s capital market.          

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^[1] SEBI | Securities and Exchange Board of India (Mutual Funds) Regulations 1996 [Last amended on February 07, 2023]

^[2] The AIPAC advises SEBI on issues related to the further development of the alternative investment and startup ecosystem in India and any hurdles that might hinder the development of alternative investment industry under its purview.

^[3] SEBI | Guidelines on disclosures, reporting and clarifications under AIF Regulations

^[4] SEBI | Clarification and extension of deadline with respect to circular on Guidelines on disclosures, reporting and clarifications under AIF Regulations