Understanding SEC Rule 2a-5 and its requirements for valuations

As of September 2022, Registered Investment Advisers (RIAs) are required to comply with SEC Rule 2a-5, also known as the "Good Faith Determination of Fair Value," which sought to more robustly define the way funds approach asset valuations. The Rule furthers the SEC’s focus on transparency and accuracy of financial reporting. The key shift? It defines responsibilities for fund boards to ensure that valuations are determined in good faith.

So while valuations have always been a critical aspect of managing a portfolio, Rule 2a-5 adds new layers of accountability for Registered Investment Advisers (RIAs), formalizing standards that had previously been considered best practices by some. Furthermore, while Exempt Reporting Advisers (ERAs) are not covered by the Rule, some have begun adopting practices from Rule 2a-5 as part of their approach to valuation oversight.

What’s changed?

Defining board requirements for oversight of fair value determinations  

The Rule introduced specific requirements of the board of directors in order to determine the fair value of a fund’s investments. These requirements include: 1) periodically assessing and managing material risks associated with fair value determinations; 2) selecting, applying, and testing fair value methodologies; 3) testing for appropriateness and accuracy; and 4) overseeing and evaluating any pricing services used.

Additionally, Rule 2a-5 allows the board to assign responsibilities for determining fair value to a “valuation designee” (i.e., investment adviser often), subject to additional conditions and oversight requirements. Interestingly, the Rule specifically indicates that the valuation designee is expected to “reasonably segregate” the process of determining fair value from the portfolio management function. This could be read as encouraging funds to responsibly balance input from investors with that of the valuation designee to ensure that valuations are being assessed objectively, reducing the risk of conflicts of interest. By including independent third-party professionals, fund boards can further enhance balanced determination of fair value.

We take a look at each of the new requirements below:

Assessing and managing material risks

The Rule requires that funds assess potential risks that could arise when determining fair value for the fund’s investments, including conflicts of interest or market dislocations.

Applying fair valuation methodologies

The SEC now requires documented valuation methodologies that are to be applied across a fund. This is to make sure all assets are valued transparently and regularly reviewed.

- In order to apply fair value methodologies consistently, the board or valuation designee will have to specify the key inputs and assumptions used in generating fair value to each portfolio holding.
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- Boards or valuation designees must periodically review valuation methodologies for appropriateness and accuracy, making changes where necessary.

Aumni provides a hub for valuation-related data such as company capitalization and key performance indicators (KPIs), allowing you to easily update and maintain records. We also provide insight into historical trends.

Requirement for regular testing  

Fund boards or valuation designees are required to regularly test valuation approaches to ensure they remain suitable as market dynamics shift. The SEC requires ongoing validation; though did not specify a minimum frequency of testing.

Monitoring third-party pricing services  

If third-party pricing services are used, boards are responsible for overseeing the process for approving, monitoring, and evaluating the pricing service provider. For example, Aumni’s independent valuation partner, PricingDirect, is considered a third-party pricing service whose use could be specified in a fund’s valuation policy.

Preparing for compliance

To support compliance efforts, it’s helpful to establish a formal process for board oversight. This might include collaborating with boards to set up regular review meetings where valuation methods can be examined, approved, and documented.

Many of our customers have developed standardized valuation processes across portfolios, ensuring they reflect current market conditions. Periodic reviews may be scheduled to test and, if necessary, adjust these methods in response to evolving market trends.

Additionally, regular testing of valuation methods can help meet the Rule 2a-5 requirements. Setting up a testing schedule that incorporates scenario analyses and stress testing will ensure that valuation methodologies continue to perform effectively and stay aligned with market dynamics.
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