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Magazine Issues » June 2012

INSIDE VIEW: No room for inflated valuations

BaloonAmong the long list of due diligence checks, investors must not lose sight of how hedge funds value their investments. Joshua M Barlow, of PAAMCO, explains how to assess a fund's approach to this.

Valuation used to be one of the hottest topics in hedge fund operations. Over the past few years, as events unfolded with Lehman Brothers, Madoff, the financial crisis and various insider trading cases, other issues have appeared at the forefront, including counterparty risk, corporate governance, confirmation of assets, third-party service providers, and insider trading.

While this latest collection of hot topics is, of course, vital to consider when investing in hedge funds, the valuation/ pricing of securities held by hedge funds remains as crucially important an issue as ever. And it should continue to be a clear top priority for operational analysis of hedge fund investments.

Valuation critical
Valuation is critical because of the role it plays in how an investment manager is compensated and incentivised. Hedge fund managers are compensated with a management fee, which is typically between 50 to 200 basis points of the assets being managed, as well as a performance fee (on an annual basis). Performance fees

vary, and can be negotiated, but most hedge fund managers have a stated fee of 20% per annum. The valuation of the securities in the fund drives the returns, which then determines management and performance fees.

Inflated valuations diminish the actual value of remaining clients’ investments, as investors departing the fund will be overpaid for their positions in the fund. Thus, despite the many items vying for an operational due diligence team’s time, valuation remains of central importance. There are three primary issues to consider when assessing the valuation of hedge fund securities: documentation, consistency and, independence.

Every hedge fund manager should have a detailed valuation policy that covers and explains the valuation process for each security the fund may trade. This policy is more than the language found under valuation in the fund’s private placement memorandum or in the firm’s compliance manual. It should be a comprehensive document detailing – by security type – the primary valuation sources, secondary sources, process for pricing overrides, role of the valuation committee, and role of the administrator.

In addition, the documentation should not just relate to a written policy about how a fund values each security, but also cover the actual work being done at each interval. Furthermore, all managers should maintain records showing how they price each security every month.

The valuation process and sources need to be consistent each month, not least to mitigate concerns that a hedge fund manager may be smoothing returns. This means using valuation levels that show lower highs and higher lows for returns on assets. Hedge fund managers may use subjective valuation sources to accomplish smoothing or lower volatility of returns. 

Managers should not use broker quotes one month and choose to use an Interactive Data Corporation (IDC) pricing feed the next. Managers should not choose to use the average of three broker quotes one month and the next month choose the broker quote they feel is the most accurate. The procedures and principles need to be clear, and consistently applied.

The valuation process should be independent from the portfolio management of the fund. At most hedge funds, this means that the chief operations officer or chief financial officer will head the valuation process. In most cases, hedge funds should have a valuation committee, which may have some representation from portfolio management, but which should be controlled by non-portfolio management personnel. Administrators and independent fund directors can be important in creating independence in the valuation process.  

improving industry
The good news is that the hedge fund industry has made considerable strides in adhering to these three principles, and tools for robust pricing practices are improving. Pricing service feeds such as Bloomberg, Reuters, IDC and Markit have become more comprehensive.

Administrators are improving their expertise in this area, being empowered by managers to do more, and becoming more willing to take a stronger role in the process. Third-party valuation consultants are creating more detailed reports and taking a clearer stand on prices. Finally, because managers are improving their internal processes, they are less likely to be tempted to apply less objective pricing criteria.   

The most important step for the investor in all of this is to test the manager and his/her valuation policy. Before committing capital and at regular intervals thereafter, the investor should evaluate each of their managers on the three criteria of documentation, consistency of process and independence.

Using the valuation policy, the investor or their representative should select a few month-ends and test each security type traded by the manager, requiring  that the manager shows how he/she has priced each security.

Are they following agreed and regimented policies? What is the documentation support for the prices used? Is the process consistent month to month? Is there proper independence from portfolio management? 

Despite receiving decreased attention from investors since 2008, effective securities valuation remains a critical aspect of the operational assessment of a hedge fund manager. In the crowded “space” of issues requiring attention, investors must be careful not to lose focus on robustly testing this important aspect of hedge fund evaluation. While other issues have generated most of the heat in recent years, valuation should still be a hot topic.

Joshua M Barlow is associate director at Pacific Alternative Asset Management Company

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