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The GIPS standards are based on the ethical principles of fair representation and full disclosure. Recalling how rates of return are calculated, it is almost trivially apparent that meaningful

performance measurement presupposes the validity of beginning and ending asset values. During the global financial crisis of 2008–2009, however, when market prices were unavailable for many hard-to-value securities, the investment industry and the accounting profession gave renewed attention to the issue of valuation. The International Accounting Standards Board (IASB), the Financial Accounting Standards Board (FASB), and others re-examined the notions of fair value and market value, and studied the problem of valuing assets in inactive markets. The GIPS Valuation Principles were developed in consideration of the work done by these

organizations. Effective 1 January 2011, the GIPS standards require firms to apply a fair value methodology following the definition and requirements we are about to summarize.

The Standards define fair value as the amount at which an investment could be

exchanged in a current arm’s length transaction between willing parties in which the parties each act knowledgeably and prudently. (In this context, the phrase “arm’s length” describes a

transaction in which the parties are unrelated and acting in their own interests.) The valuation must be determined using the objective, observable, unadjusted quoted market price for an identical investment in an active market on the measurement date if this price is available;58 otherwise, the valuation must reflect the firm’s best estimate of the market value. Fair value must include accrued income. (Provision II.A, Fair Value Definition.)

In spelling out valuation requirements, the GIPS standards restate provisions and, in some cases, clarify the applicability of provisions we have encountered before. For periods beginning on or after 1 January 2011, portfolios must be valued in accordance with the definition of fair value and the GIPS Valuation Principles (Provision I.A.2). Firms must comply with all applicable laws and regulations regarding the calculation and presentation of performance (Provision 0.A.2) and, if a compliant presentation conforms with laws and regulations that conflict with the requirements of the GIPS standards, firms must disclose and describe the conflict (Provision I.4.A.22). Accordingly, firms must comply with applicable laws and regulations relating to valuation, and when there is a conflict they must disclose it. Firms must document their policies and procedures and apply them consistently (Provision 0.A.5); this requirement entails documenting and adhering to their valuation policies, procedures,

methodologies, and hierarchy (and any changes to them). Firms must disclose that policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request (Provision I.4.A.12). For periods beginning on or after 1 January 2011, firms must disclose the use of subjective, unobservable inputs for valuing portfolio investments if the investments thus valued are material to the composite (Provision I.4.A.27), and they must disclose if a composite’s valuation hierarchy materially differs from the recommended hierarchy in the GIPS Valuation Principles (Provision I.4.A.28).

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We have referred several times to the Standards’ recommended valuation hierarchy, which firms should incorporate into their valuation policies and procedures on a composite- specific basis. Articulated in Section C of the GIPS Valuation Principles, it is a hierarchy in the strong sense that, if the inputs described at one stage are unavailable or inappropriate, then firms should proceed to the next stage. As we have seen, investments must be valued using objective, observable, unadjusted quoted market prices for identical investments in active markets on the measurement date. If such prices are unavailable or inappropriate, investments should be valued using, in descending order, the bases spelled out in Provision II.C.1:

1. Objective, observable quoted market prices for similar investments in active markets. 2. Quoted prices for identical or similar investments in markets that are not active. 3. Market-based inputs other than quoted prices that are observable for the investment. 4. Subjective, unobservable inputs.

The GIPS Valuation Principles clarify that inactive markets include those in which there are few transactions for the investment, the prices are not current, or price quotations vary substantially over time and/or between market makers. Unobservable inputs reflect the firm’s assumptions about the assumptions market participants would use in pricing the investment— assumptions about assumptions. They should be developed using the best information available in the circumstances.

Implementation (12)

Valuation Policies and Procedures. Firms may enter transactions involving a wide range of

financial instruments, including derivative securities, in many different markets. It is fitting, therefore, that the Standards not only require firms to document their valuation policies,

procedures, methodologies, and hierarchies but also recommend that the valuation hierarchies be composite-specific. Normally, for investment strategies that employ plain-vanilla securities trading in robust markets, quoted prices are readily available. Other composites, however, may represent strategies that materially make use of securities that trade infrequently in relatively illiquid markets where values must be imputed or estimated. Real estate and private equity are obvious examples, but valuing investments in swaps, options, and other derivatives that are tied to underlying securities uniquely issued by specific companies may prove problematic,

especially if the firm cannot refer to recent transactions in identical or similar assets. Implementing the GIPS standards offers firms an opportunity to re-examine their valuation policies, procedures, and methodologies and to define valuation hierarchies reflecting the characteristics of the securities held in each composite and the markets in which the composite strategy is executed. For assets that are valued using quantitative models, it is useful to list input factors such as discount rates and risk-adjusted cash flow projections and to review the basis for estimating them. Portfolio managers, security analysts, quantitative analysts, and traders should participate in these discussions. Once established, the valuation policies must be documented, followed consistently, and made available to prospective clients upon request.

The Standards also set forth additional requirements pertaining to real estate valuations. Recalling that real estate investments must have an external valuation (Provision I.6.A.4), the GIPS Valuation Principles further require that the external valuation process adhere to practices of the relevant valuation governing and standard-setting body (Provision II.B.10). The GIPS Valuation Principles also state that the firm must not use external valuations where the valuer’s or appraiser’s fee is contingent upon the appraised value (Provision II.B.11). Clearly, such

financial arrangements would incentivize the appraiser to inflate the asset’s value. The GIPS Valuation Principles proceed to restate other requirements, chiefly having to do with disclosures, that we considered in the section on real estate investing above. They also include, however, some additional recommendations. Although appraisal standards may allow for a range of estimated values, the Standards recommend that a single value be obtained from external valuers or appraisers because only one value is used in performance reporting (Provision II.C.6). It is also recommended that the external appraisal firm be rotated every three to five years (Provision II.C.7).

Similarly, the GIPS Valuation Principles restate private equity disclosure requirements that we discussed earlier and add another requirement: The valuation methodology selected must be the most appropriate for a particular investment based on the nature, facts, and circumstances of the investment (Provision II.B.17). There is also a recommendation having to do with private equity valuations that we have not previously discussed. The following considerations should be incorporated into the valuation process: (a) the quality and reliability of the data used in each methodology; (b) the comparability of enterprise or transaction data; (c) the stage of

development of the enterprise; and (d) any additional considerations unique to the enterprise (Provision II.C.12).

Fair representation means developing and adhering to policies and procedures designed to determine asset values as accurately as possible. Full disclosure means documenting those policies and providing the valuation-related information required by the GIPS standards—and, optimally, the recommended information as well—so that prospective investors can judge the reliability of reported performance.