AIF & PMS Portfolio Valuation: SEBI Guidelines & NAV Computation

1. Regulatory Framework for AIF and PMS Valuation

1.1 SEBI (Alternative Investment Funds) Regulations, 2012

The SEBI AIF Regulations establish the regulatory framework for AIFs in India. Key provisions relevant to valuation include:

• Regulation 23(1): Every AIF must have a comprehensive valuation policy, approved by the investment committee or board, and disclosed to investors in the placement memorandum.
• Regulation 23(2): The fund manager must ensure that the valuation of the fund’s investments is carried out by an independent valuer — defined as a person who is not an associate or related party of the fund manager or sponsor.
• Regulation 23(3): Category I and II AIFs must compute and disclose NAV at least quarterly. Category III AIFs must compute NAV at the frequency specified in the placement memorandum (typically daily or weekly for open-ended structures).
• SEBI Circular on Benchmarking and Valuation (2020): SEBI mandated performance benchmarking and standardised valuation norms for AIFs, requiring adherence to globally accepted valuation principles such as the International Private Equity and Venture Capital (IPEV) Valuation Guidelines.

1.2 SEBI (Portfolio Managers) Regulations, 2020

PMS providers are governed by the SEBI PMS Regulations, 2020, which prescribe:

• Monthly computation and disclosure of portfolio valuation to each client.
• Valuation of listed securities at market price (closing price on the recognised stock exchange).
• Valuation of unlisted securities in accordance with the norms prescribed by SEBI from time to time.
• Annual audit of client accounts by an independent auditor.

1.3 IBBI and Companies Act Requirements

Where AIFs invest in securities of companies undergoing resolution under the Insolvency and Bankruptcy Code, the valuation must comply with the IBBI framework. Additionally, for AIF structures registered as LLPs or trusts, the applicable accounting standards (Ind AS or Indian GAAP) govern the financial reporting of valuation.

2. AIF Categories and Valuation Frequency

3. The Fair Value Hierarchy

The fair value hierarchy, consistent with Ind AS 113 and the IPEV Guidelines, classifies valuation inputs into three levels:

3.1 Level 1: Quoted Prices in Active Markets

The most reliable valuation input. For listed equity securities, this is the closing price on the primary stock exchange (NSE or BSE) on the valuation date. For listed debt securities, this is the traded price or the yield-based valuation provided by CRISIL, ICRA, or other SEBI-approved credit rating agencies.

Applicability: All listed equity and debt securities that are actively traded. “Actively traded” means sufficient volume and frequency of transactions to provide reliable pricing.

3.2 Level 2: Observable Market Inputs (Other Than Quoted Prices)

Where Level 1 inputs are unavailable (e.g., thinly traded securities, OTC instruments), Level 2 inputs include:

• Quoted prices for identical or similar instruments in less active markets.
• Observable yield curves, credit spreads, and benchmark rates for fixed-income instruments.
• Prices from recent transactions in the same security (within a reasonable time frame).
• Market multiples derived from comparable publicly traded companies (used to value unlisted companies).

3.3 Level 3: Unobservable Inputs (Model-Based Valuation)

For illiquid, unlisted, and complex securities where no observable market data exists, the fund manager and independent valuer must use valuation models. Common approaches include:

• Discounted Cash Flow (DCF): Projects future cash flows and discounts them at an appropriate risk-adjusted rate.
• Comparable Company Multiples: Applies EV/EBITDA, P/E, or P/B multiples derived from comparable listed companies, with adjustments for illiquidity, size, and growth differences.
• Comparable Transaction Multiples: Uses multiples derived from recent M&A transactions involving similar companies.
• Net Asset Value (for real estate and asset-heavy funds): Values the underlying assets at fair value and deducts liabilities.
• Option Pricing Models: For convertible instruments, warrants, and structured securities with optionality.
• Last Round Pricing: The price at which the portfolio company last raised capital, adjusted for any material changes in the business since the last round.

4. NAV Computation: Step by Step

4.1 The NAV Formula

NAV per unit = (Total Fair Value of Assets – Total Liabilities) / Total Outstanding Units

4.2 Components of Total Assets

• Portfolio investments: Fair value of all equity, debt, hybrid, and derivative positions.
• Cash and cash equivalents: Bank balances, fixed deposits, liquid fund investments.
• Accrued income: Dividends declared but not received, interest accrued on debt instruments.
• Receivables: Amounts due from portfolio companies (e.g., sale proceeds pending settlement).
• Other assets: Prepaid expenses, tax refunds due, and other current assets.

4.3 Components of Total Liabilities

• Management fees payable: Accrued management fees owed to the fund manager.
• Performance fees / carried interest: Accrued performance fees based on unrealised and realised gains, subject to the waterfall structure.
• Operating expenses: Audit fees, legal fees, custodian charges, and administration costs.
• Borrowings: Any leverage drawn by the fund (common in Category III and some Category II AIFs).
• Tax provisions: Provision for capital gains tax, surcharge, and cess on unrealised gains (if applicable under the fund structure).

4.4 Worked Example — Category II PE Fund

Horizon Growth Fund (Category II AIF) has the following portfolio as on 31 March:

Liabilities: Management fees payable INR 0.50 Cr + Accrued expenses INR 0.20 Cr = INR 0.70 Cr

Net Assets: INR 100.50 – INR 0.70 = INR 99.80 Cr

Outstanding units: 70,00,000

NAV per unit: INR 99.80 Cr / 70,00,000 = INR 142.57

5. Valuation of Illiquid and Unlisted Securities

5.1 The Challenge

Category I and II AIFs hold the majority of their portfolios in unlisted, illiquid securities — start-ups, growth-stage companies, real estate projects, and structured debt instruments. Valuing these accurately is the single most significant challenge in AIF portfolio management. The absence of market prices means that valuation is inherently judgemental, requiring experienced professionals and robust processes.

5.2 IPEV Valuation Guidelines

SEBI has endorsed the International Private Equity and Venture Capital (IPEV) Valuation Guidelines as the benchmark for AIF valuations. The IPEV framework recommends:

• Primary objective: Estimate the fair value that market participants would agree upon in an arm’s length transaction.
• Calibration: At inception, the transaction price is the best indication of fair value. Subsequent valuations should “calibrate” to the entry transaction and adjust for material changes.
• Multiple techniques: Use more than one valuation technique where possible to triangulate fair value.
• Illiquidity discount: Where appropriate, apply a discount for lack of marketability (DLOM) to reflect the illiquid nature of unlisted securities.
• Down-rounds and impairments: Where a portfolio company raises a subsequent round at a lower valuation, the fund must adjust the carrying value — even if the fund’s own shares are not directly re-priced.

5.3 Valuation of Start-up Investments (Venture Capital)

Early-stage companies with no revenue or profits present unique valuation challenges. Common approaches include:

• Recent transaction price: The most recent funding round price, adjusted for time elapsed and material events.
• Milestone analysis: Adjusting value based on achievement (or failure to achieve) business milestones — product launch, revenue targets, regulatory approvals.
• Scorecard method: Comparing the start-up against a benchmark set of comparable start-ups on qualitative factors (team, market, technology) and adjusting a median pre-money valuation.
• Option pricing / probability-weighted expected return: Modelling multiple exit scenarios (IPO, M&A, liquidation) and weighting them by probability.

5.4 Valuation of Debt and Structured Instruments

For NCDs, structured obligations, and mezzanine instruments held by Category II AIFs:

• Performing instruments: Valued at amortised cost plus mark-to-market adjustment (based on yield curves and credit spreads of comparable instruments).
• Impaired / stressed instruments: Valued at the estimated recovery amount, considering collateral value, guarantor creditworthiness, and restructuring probability.
• Convertible instruments: Split into debt and equity components; valued using appropriate models for each component.

6. Role of the Independent Valuer

6.1 SEBI’s Independence Requirements

SEBI mandates that the valuation of AIF portfolios be performed or validated by an independent valuer who is not associated with the fund manager, sponsor, or any portfolio company. The independent valuer must:

• Have no financial interest in the fund or its investments.
• Be a qualified professional — typically a SEBI-registered merchant banker, Chartered Accountant, or IBBI-registered valuer.
• Provide a signed valuation report for each valuation date.

6.2 Our Role as Independent Valuers

At Virtual Auditor, we serve as independent valuers for several Category I and Category II AIFs. Our scope of work includes:

• Reviewing the fund manager’s valuation policy and methodology.
• Independently valuing each portfolio investment using the IPEV framework.
• Providing a quarterly valuation report with detailed methodology, assumptions, and sensitivity analysis.
• Supporting the fund’s auditor during the annual audit of NAV.

7. PMS Portfolio Valuation

7.1 PMS vs AIF: Key Differences in Valuation

PMS portfolios are typically invested in listed securities, making valuation simpler than AIFs. However, PMS providers also invest in unlisted securities, derivatives, and structured products, requiring more sophisticated valuation approaches.

• Listed equity: Closing price on the primary exchange.
• Listed debt: CRISIL/ICRA/CARE valuation or traded price.
• Unlisted securities: Fair value as per SEBI norms — typically NAV method or DCF.
• Derivatives: Mark-to-market based on exchange-published settlement prices (for exchange-traded derivatives) or model-based valuation (for OTC derivatives).

7.2 Client Reporting

PMS providers must furnish to each client a monthly portfolio statement showing the composition, value, and performance of the portfolio. The statement must include the valuation methodology for each security and the NAV computation.

8. Tax Implications of Portfolio Valuation

8.1 AIF Taxation Framework

AIFs are taxed based on their category:

• Category I and II: Pass-through taxation — income (other than business income) is taxed in the hands of the investors, not the fund. The fund deducts tax at source on income distributed to investors.
• Category III: Taxed at the fund level. The choice between trust taxation and company taxation affects the applicable rates.

The NAV computation directly affects investor entry/exit pricing and the tax implications of redemptions. An overstated NAV results in higher capital gains for the exiting investor; an understated NAV disadvantages remaining investors.

8.2 PMS Taxation

PMS clients are taxed individually on the capital gains and income arising from their portfolio. Each transaction (buy/sell) in the PMS portfolio is a taxable event for the client. The valuation of the portfolio does not directly create a taxable event (unrealised gains are not taxed), but it affects the computation of performance fees and management fees.

9. Audit and Compliance Requirements

9.1 Annual Audit of AIFs

All AIFs must have their accounts audited annually by an independent auditor. The auditor must verify the NAV computation, the valuation methodology, the independence of the valuer, and the accuracy of investor reporting. The audit report must specifically comment on the compliance of the valuation with SEBI guidelines and the fund’s stated valuation policy.

9.2 SEBI Reporting

AIFs must file quarterly reports with SEBI disclosing portfolio composition, NAV, leverage, investor details, and compliance status. PMS providers file quarterly compliance reports and annual audited accounts with SEBI.

10. Common Valuation Pitfalls

• Stale valuations: Using the last-round price for an extended period without adjusting for material changes in the portfolio company’s business, market conditions, or comparable valuations.
• Inconsistent methodology: Applying different valuation methods to similar securities across reporting periods without justification.
• Ignoring impairment: Reluctance to write down portfolio investments that have clearly deteriorated, leading to overstated NAVs.
• Excessive illiquidity discount: Applying a blanket DLOM without security-specific analysis can understate NAV and disadvantage exiting investors.
• Insufficient documentation: Failure to document valuation assumptions, sources of inputs, and the rationale for the chosen methodology creates audit and regulatory risk.
• Conflict of interest: Fund managers performing their own valuations without independent validation — a direct violation of SEBI’s independence requirement.

Frequently Asked Questions (FAQs)

Q1. Can an AIF use cost as the fair value of an unlisted investment?

Cost (transaction price) is the best indicator of fair value at the time of investment. For subsequent valuation dates, cost can be used as a proxy for fair value only if there have been no material changes in the portfolio company or market conditions. If material changes have occurred (positive or negative), the valuation must be adjusted. Using cost indefinitely without reassessment is not acceptable under the IPEV framework.

Q2. What is the typical illiquidity discount (DLOM) applied to unlisted securities?

The DLOM varies based on the nature of the security, the expected time to exit, and the availability of buyers. In Indian practice, DLOMs typically range from 10% to 30%. For pre-IPO companies with a clear listing timeline, the discount is at the lower end. For early-stage companies with uncertain exit timelines, the discount can be higher. The discount must be justified and documented.

Q3. How often must PMS clients receive portfolio valuation statements?

Under SEBI PMS Regulations, 2020, PMS providers must furnish monthly portfolio statements to each client. The statement must include the valuation of each security, the total portfolio value, cash balances, and performance metrics.

Q4. Does SEBI prescribe specific valuation models for derivatives in Category III AIFs?

SEBI does not prescribe specific models but requires that the valuation methodology be disclosed in the placement memorandum and applied consistently. For exchange-traded derivatives, settlement prices published by the exchange are used. For OTC derivatives, Black-Scholes, Monte Carlo, or binomial models are commonly used, with inputs calibrated to observable market data.

Q5. Can an AIF invest in securities of its own sponsor or manager?

SEBI AIF Regulations restrict investments in associates and group companies of the fund manager. Where such investments are permitted (under specific conditions), the valuation must be performed by an independent valuer with no connection to either the fund or the investee entity, ensuring arm’s length pricing.

Q6. What happens if the independent valuer disagrees with the fund manager’s valuation?

The independent valuer’s assessment takes precedence for NAV reporting purposes. If there is a material disagreement, the fund manager must either accept the independent valuer’s estimate or provide compelling evidence to justify an alternative value. The disagreement and its resolution must be documented and disclosed to the fund’s auditor.

For independent portfolio valuation services for AIFs and PMS, contact Virtual Auditor.

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