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NAREIM DIALOGUES SPRING 2018 33 Operating Guidelines, From 1.0 to 3.0 Operating guidelines include processes that can or should be used in any type of market—whether now or the next downturn—in a wide variety of scenarios, such as: • When a new investment strategy or new fund is launched • When a change in valuation frequency or financial reporting will occur • When a new process and/or system is implemented Operating guidelines become even more crucial when confronting challenges, such as: • Valuing quarter-end or year-end off-market deals • Valuing nonperforming loans at the end of the financial reporting process Times of change often shine a light on the investment managers that have strong policies in place, which have been implemented in a way that helps prepare for change. For many firms, operating guidelines serve as a living tool and are regularly reviewed and improved. Institutional investors also generally want institutional-grade operating and reporting systems from their partners. While some investors will overlook weaknesses in this area if an investment manager has a long track record of superior performance, evaluating systems and instituting best practices can improve an already good relationship—helping investment managers avoid future problems. Accordingly, the majority of successful real estate firms—from private equity shops to real estate operators and advisory firms—employ a consistent behind-the-scenes tool: operating guidelines. These are a set of working documents comprising a firm's operational and investment strategies in a way that allows potential partners and investors to quickly and comprehensively understand a firm. For companies already using operating guidelines, it may be time to revise and update these documents due to fair value reporting changes as well as other institutional investment, finance, and accounting changes. WHAT TO INCLUDE Once a company chooses which reporting standards and approaches it wants to use, it's important to codify them in its operating guidelines. These can include the following: • A statement of objectives or an overview of process points and timing that specifies how each process is handled—providing checks and balances as well as a system that can be referred to in the event of staff changes or other disruptions • Business plans for the company and key business lines • Quarterly or mid-year forecasting • Asset-management reporting practices • Valuation processes for properties and investments—especially if a company is operating under net-asset value reporting • Development of a valuation committee with assigned roles and responsibilities • Disposition or acquisition processes, including steps for solicited and unsolicited transactions Many entities have a full version of their operating guidelines for internal use as well as a high-level or summary version for investors, partners, or even the SEC if they're a registered investment advisor. TIMING Timing is essential no matter if valuations are prepared internally or by external parties. Company resources and financial reporting deadlines need to match the timing and execution of three key items: • Valuations • Reviews • Approvals Why Update & Retool Operating Guidelines? Investors, investment managers, and operators often find the process of developing or updating guidelines does more than expected, shining a light on existing inefficiencies or uncovering small problems before they become big ones. Examples are shared below. CFO FOR A FAMILY OFFICE WITH $2 BILLION IN ASSETS UNDER MANAGEMENT "The policies formed the bedrock for our operations around valuations and financial reporting and allowed us to have tangible guidelines that we could build and expand on, and that we can share with stakeholders", said the CFO. Although the company sees itself as nimble and has an entrepreneurial culture, it also has a deep focus on compliance and risk management. Well-researched and updated operating guidelines are part of management's approach. One component of the revised operating guidelines was the incorporation of a comprehensive, yet concise, dashboard presenting the main inputs and assumptions in the quarterly valuations. COO OF A $1 BILLION PRIVATE-EQUITY FUND "The policies gave us the framework we needed at a critical time in our growth cycle, and the development of a related fair value liquidation model allowed us to focus on our core skills, such as acquisitions and asset management," according to the COO. "The operating guidelines also increased transparency for our investors and played a role in our capital raises." For this company, documenting the process of projecting asset-management fees based on potential deal flow to determine the resulting net-asset values gave management and potential investors significant additional clarity. ©iStock.com/Rawpixel