When President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Act”) on July 21, 2010, it was the most sweeping change to financial regulation in the United States since the Great Depression. Among other things, the Act created the Financial Stability Oversight Council, whose role is to identify and respond to emerging risks that may pose a threat to the U.S. financial system. Members of the Council will include the Secretary of the Treasury, the Federal Reserve Board and SEC administrators.
The Act also affects all federal financial regulatory agencies and almost every aspect of the nation’s financial services industry.
“Many organizations outside the financial services industry can benefit from implementing best practices specified in the Dodd-Frank Act,” says Jim Martin, CMA, CIA, CFE, managing director of Cendrowski Corporate Advisors. “However, the Act does not address some key concerns that may remain with today’s executives and investors. One such concern is the valuation of illiquid assets.”
Smart Business spoke with Martin about the Dodd-Frank Act, how it will affect both companies and industry, and the valuation of illiquid assets.
Who does the Act affect?
The Act applies to all public, nonbank financial companies, as well as larger public bank holding companies. However, the Act’s implications can and should be used as best practices in other types of organizations. For example, private companies can benefit by implementing risk management processes in the same vein as those discussed in the Act.
One of the provisions of the Dodd-Frank Act is the establishment of a systemic regulator to analyze financial marketwide risks. However, no organization, including those outside of the financial industry, should analyze risks in a vacuum. Companies often place significant attention on analyzing unique risks associated with their organizations. It is also important to consider the impact of industry and systemic risks and the way an organization might capitalize on the opportunities presented by those risks. Risk management processes should consider plans of action in the event that a business’s competitor falters and how the organization is prepared to capitalize on such an event. Systemic risks should also be scrutinized by an organization’s risk management process, as these may also present potential opportunities for value creation if successfully mitigated.
What ramifications will the Act have for holders of illiquid assets?
In its current form, the Act encourages that various derivative securities be traded through exchanges or clearinghouses. However, other forms of illiquid assets are not discussed in the Act. It does not discuss how valuation issues in private placement, private equity and venture capital fund transactions can be mitigated, though many investors, including corporate and public pension funds, endowments and insurance companies, hold these assets. Financial accounting standards have been implemented requiring these assets to be marked to market on a periodic basis; however, this is difficult and the Act provides no assistance. Valuation theory is premised on liquid markets and has significant difficulty dealing with illiquidity. The theory assumes an investor wishes to maximize return while minimizing risk over a single period. While this period could be lengthy, the key issue is that valuation theory assumes away liquidity risk, leaving an estimate of this quantity up to a valuation professional.
Overall, while increased transparency through more liquid trading is a laudable goal, it will be interesting to see what significant procedural changes occur.
Can you elaborate on the valuation issues you mentioned?
Assets are often valued through a market or income approach. In the market approach, an analyst might look at comparable transactions or at the trading multiples of public companies. This becomes difficult as the number of comparable transactions and comparable companies decreases. For instance, many venture capital funds struggle to find such comparable companies upon which to base a valuation an idea may be so new and radical that nothing similar has preceded it.
With respect to the income approach, much of today’s valuation theory is based upon the principle that all investors hold an identical and diversified market, or ‘risky’ portfolio. This is not the case on either front, as investors each hold different portfolios. Moreover, when the values of different asset classes move in virtual lock step with one another, how can you be diversified?
Heuristic methods have developed over the years, modifying underlying valuation theory, but these were not originally a component of the theory. The valuation tools that we have developed over the past 50 years are invaluable, but they are also difficult to directly apply to some areas of modern markets and speak little to the assessment of systematic risks outside of the sensitivity of a particular asset to such risks.
How should companies and investors respond to today’s risky environment?
As we mentioned in last month’s article and complementary insert, risk management is a continuous, recurring process. Irrespective of the environment in which a company participates, risk managers should focus on four primary areas of risk: strategic, operational, process and compliance risks. The latter element was explicitly specified as a requirement in the Dodd-Frank Act. Risks pertaining to each of these areas must be frequently elaborated and analyzed by members from all levels of the organization. Companies should also focus on the risks associated with their illiquid asset holdings to ensure they are not overexposed to risks associated with these assets.
For more information on the specifics of risk management process implementation, visit www.cca-advisors.com/risk-assessment.html.