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FUNDS ACCOUNTING: hard to handle

picture_frameNicholas Pratt examines the role that fund accountants can play in generating more certainty in the valuations process


Oscar Wilde once defined a cynic as someone that knows the price of everything and the value of nothing. He could easily have defined some fund managers in a similar way over the last few years – except with one small difference. For those managers that have persisted with illiquid and hard-to-value assets, many have found they know neither the price nor the value of anything.

Hard-to-value assets remain a feature of the market yet there is far more awareness of the uncertainty involved and more attention is being paid to the valuations process. The valuation challenge essentially comes from the lack of liquidity around certain instruments. For a contract that will take 20 years to mature, this lack of liquidity or inherent complexity creates year after year of uncertainty for the trading manager.

To date there are three methods used to derive an asset’s value. The first of these is to take a historical value – for example, how much did you pay when you first acquired the asset and how is its value likely to have changed since then. This simple approach has been made more complex by the credit crisis and consequent volatility throwing a large spanner into the valuation process works.

The second method is to mark to market – that is to say, how much would the asset be worth if you tried to sell it today. This is generally the favoured approach, but the illiquid nature of these hard-to-value assets makes it very difficult to derive a true mark-to-market price because it is so hard to find a potential buyer.

The third approach for valuations is to mark to model, where managers will be reliant on quantitative models to price their assets – models which can be either developed internally or via third parties but which are always open to some element of interpretation and subject to far more regulatory oversight. 

And this is where the fund accountants come in. They are playing an increasingly important role in validating or certifying the models used by managers – a development that is in part driven by regulators’ desire to see more independence, rigour and transparency injected into the valuations process. “Fund accountants are making it harder for managers to use their own models because they are going deeper and deeper into how they work,” says Fred Ponzo, managing partner at Grey Spark Partners, a UK-based consultant.

Guessing game
The modelling world has been a minefield of mathematical engineering in recent years but fortunately most fund accountants have a very low threshold towards financial wizardry, says Ponzo. “There can only be so much mathematical wizardry that can go on and there are some assets that cannot be accurately priced,” says Ponzo.

“It is a fool’s gold to believe that innovation in quantitative analysis and modelling will be able to fill that gap in pricing. There will always be some guesswork involved and the simpler the model, the more transparent that guesswork will be to the outside world. A more sophisticated model may be marginally more accurate, but it will be less understandable to other investors and they will shy away.”

According to Paul Everitt, managing director of Fund Corporation, a Guernsey-based administrator, the biggest change among fund accountants has not been an increased effort to get these complex valuations right but an increased awareness of the risk of getting them wrong. Fund accountants have therefore begun to question whether they have the appetite for providing the price for these hard-to-value assets.

If they are going to put their head on the block, then they should charge a high price for it, but the standard approach is to rely increasingly on external valuation sources for the more complex assets. “My general impression is that the larger the organisation, the more risk averse it has become, which is why we are seeing so many move away from the responsibility of providing a risky price.”

There is nevertheless an important role that fund accountants can play in validating any valuations made or acquired by fund managers, says Everitt. “Fund accountants see a number of different situations with different fund managers and valuations so they can provide an industry view to each situation. They can also introduce some rigour into the process by assessing the level of risk a manager is willing to take, implementing a pricing policy based on that appetite and then ensuring that policy is adhered to when the valuations are made.”

Susan Ebenston, head of global fund services at JP Morgan Securities Services, also stresses the validation role that fund accountants now play in the valuations process. “When it comes to pricing, this means providing alternative valuations to the asset manager’s own – be it from the counterparty or from external and independent providers, including creating one themselves.”

And while the mathematical models employed by valuation specialists are becoming increasingly sophisticated, Ebenston stresses that from a fund accountant’s perspective, the underlying methodology used for valuations is the critical element in the pricing process.

“You have to be methodical rather than mathematical. The calculation formula has to be repeatable and independent and agreed beforehand with the asset manager – that cannot be stressed enough.”

The key difference in valuing hard-to-value assets is that the accountant has to engage directly with the asset manager, says Olivier Laurent, director of alternative investments product management at RBC Dexia. “With simple instruments, the fund accountant can get all the market data from the likes of Bloomberg and simply add it to the system and calculate the P&L and all of this can be done independently from the asset manager. But with hard-to-value assets it is completely different, particularly in the regulated domiciles where at least two sources of valuations are required for hard-to-value instruments and OTC derivatives.”

For many fund accountants it has been a tremendous change, says Laurent, particularly in the relationship between fund accountants and asset managers when it comes to discussing the inevitable discrepancies that arise in the valuations process. “Depending on the complexity of the instruments, we define the threshold for any differences in our valuation and that of the asset manager. For example, with a swap anytime the threshold is two basis points, but with an illiquid credit default swap or an OTC derivative, this threshold can rise to 100 basis points.”

Sometimes the discrepancy can be easily explained by different cut-offs on the market data used or a variation in the parameters used, says Laurent. “We still want to have a smooth accounting process and do not want to have to debate these differences on a daily basis when there may be very valid reasons for the variations. When we have hard-to-value assets, it is important to assess the importance of this asset in calculating the overall net asset value of a portfolio and to decide what controls should be put in place.

“This is the primary role of the fund accountant – to ensure consistency in the overall net asset value of the portfolio rather than concentrating on the daily differences in the valuation of specific assets. For example, you need to have a huge difference in the valuation of an OTC derivative before it has an impact on the overall net asset value so sometimes we realise that we should spend more time focusing on the valuation of illiquid bonds and emerging market assets rather than daily differences with OTC derivatives.”

The current scepticism towards complex assets is very much a result of the financial crisis, admits Ponzo, but this does not mean it is wrong or merely temporary. “I think it is a wake-up call more than a transient mood of the moment. There is a realisation that complexity does not always mean higher returns and while we may see more complexity in the future, it will be in a much more controlled and transparent way.”

Manager responsibility
Of course, if a manager has their pricing models and valuations approved by a fund accountant, this will go a great way towards assuaging any investor concerns. However, JP Morgan’s Ebenston emphasises that notwithstanding the regulatory changes and the increased role of the fund accountants as a validation agent, the ultimate responsibility for pricing assets still rests with the asset manager. “The fund managers may be delegating more functions and services to fund accountants but that does not mean that they can delegate their responsibilities. As fund accountants, our main role is to do what we are contracted to do well and to follow instructions. We never make investment decisions.”

This is not to say, however, that accountants will meekly go along with the strategies employed by managers and the valuations they provide. Ebenston says that accountants are setting themselves more stringent guidelines and paying more attention to the old adage that if you cannot price an asset, then it should not be invested in – particularly when it comes to regulated and Ucits funds. There has also been greater discussion between the asset managers and their fund accountants when it comes to any discrepancies that may emerge over an asset’s value.

“The tone of the conversations has changed because there is now more transparency,” says Ebenston. However, this has not stopped JP Morgan walking away from some relationships where the asset managers have not demonstrated a willingness to treat hard-to-value assets with the attention they merit. But is this principled approach likely to have much effect on these asset managers or will they simply find a more acquiescent accountant that is willing to go along with their investment plans?

“The last two years has been a period of growing pains and while some asset managers will find new accountants, others will struggle, particularly if they are looking to establish regulated or Ucits funds or if they want to attract any institutional investors,” says Ebenston. “I think the pre-Madoff days of non-professional accountants and opaque pricing policies are gone and the introduction of Ucits IV and Ucits V will not allow the industry to go back there.”

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