What's in the rule?

The Securities and Exchange Commission (SEC) adopted rule 2a-5 under the Investment Company Act of 1940, which went into effect on March 8, 2021, with a compliance date of September 8, 2022. The rule provides guidance to registered investment advisors (RIA)<span/> and business development companies (BDC) to determine fair value of fund investments in good faith. The rule establishes requirements for fund boards' obligation to determine the fair value in good faith. As part of the rule, the fund's board may designate a "valuation designee", which could be the fund's investment adviser, for some or all of the fund's investments, as long as the valuation designee is subject to the board's oversight. In conjunction with Rule 2a-5, the committee also adopted rule 31a-4, which requires funds or their advisers to maintain appropriate documentation to support fair value determinations.

Below are the key considerations and requirements of the rule:

Periodically assess and manage valuation risks

The rule requires that funds assess periodically any material risks associated with determining the fair value of the fund's investments, including material conflicts of interest, and managing those identified valuation risks. Depending on the type of fund, the rule provides flexibility to determine whether certain sources and types of valuation risk should be weighed more heavily than others.

IHS Markit's pricing services can help clients with complying with these requirements. The pricing service incorporates established asset specific industry practices in determining valuations. Bid, mid and offer prices and additional analytics that are evaluated from relevant market sources can help alleviate valuation risks. Additionally, the pricing and reference data service provides detailed terms and conditions that can help funds identify characteristics of individual investments. Global teams utilize nimble technology with robust business continuity plans, which effectively mean that clients can expect continuous operation with minimal disruption.

Establish and Apply Fair Value Methodologies

The rule requires that the board or the valuation designee establish and apply fair value methodologies by:
(a) selecting and applying appropriate fair value methodologies,
(b) periodically reviewing the appropriateness and accuracy of the methodologies selected and making any necessary changes or adjustments, and
(c) monitor for circumstances that may necessitate the use of fair value.

IHS Markit's team of experts and evaluation staff are highly specialized in the asset classes that they evaluate. Pricing platforms for all asset classes are SOC 1 certified and inputs and thresholds are configurable to adapt to changing market conditions. With the help of these pricing platforms and streaming data for evaluating specific securities, evaluators can capture market movements in real-time. Most liquid securities are priced multiple times each day as new pricing information becomes available.

Test Fair Value Methodologies for Appropriateness and Accuracy

The rule will require the testing of the appropriateness and accuracy of the methodologies used to calculate fair value. This requirement is designed to help ensure that the selected fair value methodologies are appropriate and that adjustments to the methodologies are made where necessary. The rule provides flexibility to boards or valuation designees to:
(a) identify the testing methods to be used,
(b) determine the minimum frequency of testing depending on the circumstances of each fund, and
(c) use new, appropriate testing methods when applicable.

IHS Markit has several internal processes and checks in place to ensure that the quality of prices is validated before being distributed to customers. Our valuations are periodically compared to observed market trades to ensure that our methodologies are current for various market conditions. These results are documented and shared with our customers. Transparency metrics and input data on price files can help clients determine the appropriateness of sources used to evaluate securities.

Pricing Services

The rule will provide that determining fair value in good faith requires the oversight and evaluation of pricing services. Boards or valuation designees of funds that use pricing services will be required to establish a process for approving, monitoring, and evaluating each pricing service provider. The rule also requires that a process for initiating price challenges be established. Before deciding to use a pricing service, the fund's board or valuation designee is expected to consider factors such as valuation methods used, price challenge processes, and inputs used for pricing.

IHS Markit's evaluation processes are documented in frequently updated and comprehensive methodology documents. Customers may request due diligence meetings to understand our processes in detail and have any questions addressed by our team of experts. IHS Markit also has a price challenge process that clients can utilize. Customers can expect timely and descriptive responses after our evaluation staff reviews every single challenge. If clients wish to receive additional details about certain securities, deep dives can be performed on the securities in question. Frequently updated transparency metrics on price files provide details about inputs utilized for pricing.

Rule 31a-4

Rule 31a-4 will require funds or their advisers to maintain appropriate documentation to support fair value determinations. Records will be required to be maintained for six years, with the first two in an easily accessible place. Reports generated by valuation designees must include a specified list of the investments or investment types for which the valuation designee has been designated.

As part of our evaluated bond service, IHS Markit provides an array of reports for clients that can help them comply with the reporting requirement. Learn more about our service.

Posted 13 July 2021 by Krishna Shetty, Executive Director, Head of Americas Corporate and Sovereign Bonds Business Development, S&P Global Market Intelligence

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.