It has become more and more common for fund managers to leverage the expertise and reach of third-party pricing services (TPPS) to help provide pricing for non-exchange-traded debt and derivative products. Since 2011, when the Public Company Accounting Oversight Board’s (PCAOB) Pricing Sources Task Force was created, there has been a major push to raise awareness over one common theme: Although you can outsource the function of obtaining data and pricing, you cannot outsource the responsibility of determining the most appropriate fair value.
Over the past nine years, the SEC has raised awareness with fund managers regarding their responsibility for the monitoring and proper selection of the final price used for valuation as well as gaining the proper understanding of the TPPS and their expertise, specific methodologies, and inputs used in valuations. Directors are now asking specific questions as to the use of TPPS, and TPPS management teams are now prepared to, and have been, providing more transparency and support for their clients. Still, we believe it’s important to revisit some of the industry best practices as they relate to the use of TPPS.
First, disaggregate your portfolio into ‘buckets’To effectively apply some of the controls discussed below, you should first disaggregate your portfolio into various buckets, beginning with major “type” of investment (e.g., corporate, municipal, RMBS) and then disaggregating until you feel that there are buckets with sufficient differences to help with the controls discussed below. For example, if you are managing a portfolio of CLOs, disaggregating based on seniority/tranche, rating, and vintage will likely be necessary.
Develop strong procedures and controls
The SEC believes that funds using TPPS must have sufficient understanding of the information they receive from TPPS to evaluate whether the value complies with U.S. Generally Accepted Accounting Principles (GAAP). Management is also responsible for establishing internal controls to provide it with the information necessary to comply with GAAP. The following are procedures and controls to consider to fulfill your responsibilities and assess the reliability of the pricing provided and your understanding of the inputs and methodologies used by your TPPS. Be sure to document your steps.
The inclusion, frequency, depth, and breadth of the below procedures should depend on how significant the use of TPPS is to your portfolio and striking your monthly NAVs.
Establish a ‘challenge process’ to challenge valuations that appear unusual or unexpected. Being able to effectively challenge a valuation entails coming up with expectations of value and having acceptable thresholds for variances. These thresholds will vary based on the type of instrument and which sub-category bucket the instrument falls into. Expectations may be derived in many ways, including but not limited to interpreting current available market data on recent purchase or sale levels of similar securities; leveraging a secondary provider; or, for derivative instruments, reviewing the fair value from derivative counterparty statements.
Despite the results of the challenge process, the process should be documented and a challenge track record should be maintained. Securities with historical challenges should be flagged and tracked, and when they are eventually sold, document the transaction price compared to the most recent value provided by the TPPS to come full-circle on the challenge process. For example, if you sell a bond at a price significantly higher than a lower price you recently challenged but the TPPS did not accept and instead maintained the lower price, this should be communicated to your representative at the TPPS.
Perform deep dives into a sample of securities. This should be done at least annually, for a sample from each bucket. A deep dive should obtain further detail regarding the specific inputs used by the TPPS and the exact valuation methodology deployed for your selection. This shows that you are looking through the price to understand the inputs and methodologies used to determine the price. For example, did the TPPS use recent transactions for the security, recent transactions for similar securities (“matrix pricing”), or a model? If using a model, what significant inputs were used, and are they in line with market participant assumptions?
If available, obtain and review an independent auditor’s report on controls at the TPPS. This will give you an understanding of the controls in place. However, performing this step alone will not tell you anything about the accuracy of the valuations themselves.
Establish a system of ‘back-testing,’ which compares actual transaction prices to the most recent price provided by the TPPS. Actual transaction prices are the best estimate of fair value, so this step should be the foundation of your controls. This should be done on an ongoing basis. Any material variances should be explainable (market conditions, issuer specific news, etc.) and documented.
If there are repeated material unexplainable differences with your back-testing program, discuss them with your TPPS to understand and correct the issue. If they cannot be corrected, assess:
1. Should your acceptable variance be increased? i.e., if you have a 1% threshold for corporate bonds but only a 2% threshold for CLOs, perhaps the CLO threshold should be increased. The pricing thresholds should be evaluated throughout the year to determine the appropriate thresholds based on market activity. The process and decisions related to changing acceptable variances should be documented.
2. Are the valuations provided by this TPPS the best estimate of fair value? If not, what adjustments can be made to better reflect fair values? Note: Making an adjustment to a price provided on an over-the-counter (OTC) Level 2 instrument will likely push the instrument into a Level 3 fair value hierarchy classification. Although this may not be the most desirable outcome, the ultimate goal should be to determine the best estimate of fair value.
3. Should we continue with this TPPS, or should we discuss alternatives?
Use two vendors or obtain additional independent broker quotes where possible. Having a secondary TPPS or obtaining independent broker quotes to use as a “check” on the main source is ideal. This can also be a key input to help determine when to challenge your main provider. If a variance is above a tolerance level, challenge the main vendor. For derivative instruments, the counterparty’s fair value per your statements can be used as a good check and balance over the TPPS.
Have documentation summarizing your understanding of the methods, assumptions, and inputs used for each bucket of investments, as well as the expertise of the TPPS related to each bucket. Most TPPS have documentation regarding the inputs and methodologies per major type of investment. In addition to this, you can likely obtain information regarding the TPPS and their coverage, depth, and specific expertise for certain instruments. For example, one TPPS may be considered the “industry standard” for pricing bank debt while others may be experts in CLOs. Your understanding of these items should be documented and updated when applicable.
Special considerations for using third-party administrator pricing
Most of the above procedures are assuming you are obtaining valuations directly from the TPPS. If you are relying on a third-party administrator’s (TPA’s) pricing, the valuations should be looked at no differently – as if the TPA is an extension of the TPPS. In other words, you are still responsible for the valuation, despite leveraging their services. Some large TPAs use a variety of TPPS in the valuation process, and may give you the option of using one specific TPPS or an average of multiple TPPS. If you are obtaining valuations from your TPA, who is using valuations provided by TPPS, most of the aforementioned procedures would need to be adjusted with the following:
Obtain a pricing matrix that shows type of investment and which TPPS are used as the primary and secondary pricing sources. Document your review and understanding of this matrix. For example, you should document in your own files whether there is a primary source or whether there is a blend of various TPPS for each bucket of your portfolio.
Know what due diligence the TPA is performing on their TPPS. Ask your representative at the TPA whether they have a due diligence questionnaire or more specific documentation of their procedures and controls to test the accuracy of the valuations. For example, some large TPAs may have a formal back-testing or challenge protocol already in place. You can likely leverage this and document your review and understanding of this process to help with your documentation of your own procedures.
Know and understand the TPA’s official challenge process. Perhaps once per quarter or semi-annually you do a deep dive into that challenge process. This may entail speaking with management of the TPA’s valuation group to understand the process and inspect any reporting they have. If you have access to market data, a secondary pricing source, or recent trading activity, consider instituting a challenge process over the price provided by the TPA, rather than with the TPPS.
Obtain and review the independent auditor’s report on controls at the TPA. This should already be happening, but a specific focus should be on the valuation process as it relates to TPPS. Some SOC 1 reports address controls over the use of TPPS. As with TPPS SOC reports, doing this step in a vacuum is not sufficient, but it adds a lot to the big picture.
ConclusionPerforming and documenting the results of the above procedures will help auditors, directors, current and potential investors, and potential regulators understand the steps you are taking to understand the inputs and methodologies used by the TPPS and fulfill your fiduciary responsibility to determine the most appropriate fair value for your OTC debt and derivative positions.
Subject matter expertise
CPA, Partner, Leader- Financial Services Industry
CPA, Partner, Financial Services Industry Leader – South/West
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