CSSF feedback report on ESMA CSA on valuation

Further to the publication by ESMA of its report on the Common Supervisory Action (“CSA”) on valuation in May 2023 (“CSA on Valuation”), the CSSF published its own feedback report on 18 July 2023 based on the analysis of the Luxembourg-domiciled investment fund managers (“IFMs”) managing Luxembourg and foreign-domiciled undertakings for collective investment in transferable securities (“UCITS”)/open-ended alternative investment funds (“Report”).

In this Report, the CSSF highlights the key areas where shortcoming/vulnerabilities have been observed and provides recommendations to IFMs managing UCITS and/or open-ended/closed-ended alternative investment funds (“AIFs”).

1. Actions to be initiated by IFMs

The CSSF requires all IFMs managing UCITS and/or AIFs (i) to conduct a comprehensive assessment of their valuation framework in relation to the observations made by ESMA as well as in its Report and (ii) to take the necessary corrective measures by 31 December 2023.

In a nutshell, IFMs must review and update their valuation policies and procedures, notably in order to enhance governance around (i) the valuation framework and changes to it, (ii) the valuation methodology/model, and (iii) use of external service providers.

2. Brief summary of the CSSF recommendations

The review/update must notably cover the following points:

2.1 Appropriateness of valuation policies and procedures

Valuation policies and procedures must:

• be concise, centralised, well-established and covering all the types of assets managed and clearly allocating operational tasks and responsibilities for asset valuation;
• be regularly (at least on a yearly basis) reviewed and for which the senior management of the IFM has to approve any changes;
• outline how/when a change to the valuation policy, including a methodology, may be effected and in what circumstances this would be appropriate;
• provide for reporting to the senior management of the IFM to ensure timely remediation of shortcomings.

If valuation models are used:

• the valuation models (notably the data inputs, pricing/market data sources, assumptions, limitations, rationale for their use, etc.) must be regularly reviewed, at least on yearly basis and when required such as under stressed market conditions. They must be validated by persons who have appropriate knowledge and experience and who have not been involved in their development;
• the review and validation of the valuation models have to be properly documented.

2.2 Valuation under stressed market conditions

IFMs must consider the outcomes of the Liquidity Stress Testings (“LSTs”) in the context of valuation of assets under stressed market conditions.

The valuation policies and procedures must clearly:

• define the valuation method/methodology to be applied especially under stressed market conditions;
• establish the monitoring systems in place to determine the potential liquidity/valuation issues;
• set the conditions that would trigger the use of a different valuation model;
• map the cases where valuation uncertainty may trigger the use of liquidity management tools.

2.3 Independence of the valuation function

All IFMs must:

• verify and formalise in the valuation policies/procedures the independence of the valuation function, particularly from the portfolio management function;
• ensure that remuneration policies and/or valuation policies/procedures present the safeguards in terms of remuneration of the valuation staff to mitigate conflicting situations.

As outlined in the ESMA report on the CSA on Valuation, the conflict of interest situations also have to be managed where valuation-related functions are performed by third parties (including other group entities), especially if they perform multiple potentially conflicting functions on a delegation basis with fee structures linked to the net asset value (“NAV”).

2.4 Use of external valuers/data providers

In accordance with the applicable regulation and in line with the ESMA report on the CSA on Valuation, all IFMs must have in place valuation policies and procedures that:

• justify the criteria behind the selection of pricing sources;
• describe the controls performed on the prices of the assets in the portfolio, especially on less-liquid assets. As a reminder, the ESMA report on the CSA on Valuation notably emphasises that “it should be avoided to over-rely on the assessment made by external data providers, whose pricing methodologies and outputs should be challenged and regularly back tested in order to ensure their accuracy and robustness under all market conditions” and that “internal valuation models could be used to challenge the prices provided by the external data providers […].”

2.5 Early detection mechanisms for valuation errors and transparency to investors

The CSSF reminds all IFMs that formal remedial procedures have to be in place in the event of valuation errors and incorrect calculations of the NAV, ensuring that full investor compensation is triggered if the valuation/NAV errors cause harm to investors of the funds. The effectiveness and the correct application of these remedial procedures must be monitored, in particular during stressed market conditions.

On the transparency aspect, the CSSF requires all IFMs to ensure appropriate disclosures (i.e. in a clear, understandable, relevant, non-technical, non-general/boilerplate language) to the investors of the funds regarding the valuation policies and procedures, such as the governance arrangements, valuation methodologies and methods and their related changes and the valuation risks.

2.6 Focus on open-ended funds investing in private equity and real estate assets

The CSSF notes that the model review was not robust enough for a few IFMs, managing notably open-ended funds investing in unlisted equities and direct real estate. The CSSF therefore reminds IFMs that it expects them to:

• select the relevant methodologies/methods to value the assets with an appropriate level of justification and objectivity;
• have robust valuation policies/procedures in order to assess the reasonability and consistency of the models used (e.g. review of assumptions/financial models/input data and quality of the data; back testing) and to be able to take into account economic and asset specificities’ changes in the models;
• ensure the alignment between the funds’ investment strategy, liquidity profile and redemption policy.

2.7 Involvement of depositaries in the verification of the valuation framework of IFMs

In the context of the CSA on Valuation, the CSSF observed a general lack of involvement of depositaries in the verification of the valuation framework of IFMs.

The CSSF therefore reminds depositaries that they must control the valuation of the funds for which they act as depositary. In particular,

• as part of risk assessment and due diligences on IFMs, depositaries must ensure that:
  • the valuation process, policies and procedures are established in compliance with applicable UCITS and AIFs requirements as well as undertakings for collective investment’s rules (in particular for AIFs, Article 17 of the AIFM Law and implementing measures of Article 19 of the AIFM Level 1 Directive);
  • where applicable, as set out under Article 94.4 of the AIFM Level 2 Regulation, the appointment of external valuers by AIFMs comply with the aforementioned articles;
• as part of periodical controls, they shall ensure that valuation methodologies, as defined under IFMs valuation policies, are effectively implemented.

Concerning the IFMs, they must:

• ensure that the depositaries of the managed funds have access to the necessary information in order for them to perform their control pertaining to asset valuation according to applicable requirements;
• ensure that asset valuation is addressed as part of their review of depositaries’ performance of their contractual obligations.