A growing necessity for hedge fund valuation

WEST PALM BEACH, FL (HEDGECO.NET) – Valuation is fast becoming a critical issue, one few hedge fund managers can afford to ignore. in a recent speech, SEC commissioner Roel Campos said, “to avoid dilution and unfairness, valuation numbers must be accurate and unbiased. a key element of monitoring the risk of hedge funds is to understand the valuation used by said funds and counterparties to the funds.”

Institutional investors need, and want, better information. the Employee Retirement income Employee Retirement income Security act requires decision-makers to demon­strate prudence, loyalty and care, something they cannot do without having a solid understanding of a hedge fund’s valuation process, whether outsourced or handled in-house. leverage via the use of deriva­tives is another factor. According to US Department of labor guidance, when a pension plan is, “invest­ing in a pooled fund, which is managed by a party other than the plan fiduciary who has chosen the fund, then that plan fiduciary should obtain, among other things, sufficient information to determine the pooled fund’s strategy”.

Liquidity is another compelling factor for certain institutional investors, made more acute by research which shows that some hedge funds have as much as 50% of their money tied up in relatively illiq­uid assets, in part, some argue, to avoid having to register their managers. Critics counter that not all positions should be valued, and that doing so would jeopardise the asset allocation decision that led to investing in relatively illiquid holdings in the first place.

Additional numbers of service providers, wary of their mount­ing liability if they unquestion­ingly rely on valuation numbers from their hedge fund clients, urge better procedures. liability insurance underwriters feel the pinch and are passing along the cost to clients. Wendy Dowd, global underwriting manager for Chubb Group of insurance Companies, offers, “the hedge fund valuation issue is sig­nificant. We’ve paid out several claims tied to valuation issues and this is one of the key areas of risk we have identified in our underwriting of hedge funds. the primary concern is a lack of process, followed by a lack of independence. If hedge funds aren’t more proactive about putting a good valuation process in place, they are exposing themselves to significant liability risk.”

Last, but not least, traders themselves acknowledge the importance of valuation as part of effective task management with respect to asset allocation, rebal­ancing, risk control, determination of fees earned and monitoring of trading limits.

Hiring an independent and certified appraiser can go a long way to improving things, especially when accreditation itself entails satisfying rigorous education and experiential requirements. Courts and regulatory bodies are increasingly turning away experts on valuation matters unless their cre­dentials include some type of specialised valuation training. Visitors to the website of the National association of Certified Valuation analysts can compare some of the more popular business valua­tion designations. the Chartered Financial analyst curriculum includes valuation in many of its mod­ules and countless university programmes provide instruction about the valuation of derivatives, private company equity and distressed debt.

Valuation is a broad topic, one that would be impossible to tackle in one sitting. However, even an overview would be incomplete by not mention­ing model risk. often defined as the risk of using an inappropriate model or incorrectly applying an otherwise good model, model risk can be costly. A poor choice of model leads to incomplete or inaccu­rate numbers, which in turn leads to incorrect asset allocation, mistakes in hedging or trade rebalanc­ing and so on. Paying close attention to everything model-related is time well spent. Even if a model works today, it may not be relevant or correct under vastly different market circumstances.

Investors, regulators, insurance underwriters, auditors and compliance officers want to know many things. Does a hedge fund have a good handle on valuation? are independent appraisers being used to provide assessments of fair market value? Is the current policy in need of revision and who makes the review and revise decisions? Will an investor be told how much of a hedge fund’s portfolio is not valued on a regular basis, thereby affecting reported portfolio performance? How are asset valuations reflected in the fees charged by the hedge fund?

The list is long. one thing is certain. Hedge fund valuation is the topic du jour. It is not going away. to the contrary, everyone has a stake in the game.

Susan M. Mangiero
www.pensionriskmatters.com

This article first appeared in HFM Week, a source of weekly news and features on the hedge fund industry. For more information on the publication or to subscribe visit www.hfmweek.com

Susan M. Mangiero is a CFA charter-holder, accredited valuation analyst and certified financial risk manager. As managing member of Business Valuation Analytics, Mangiero provides valuation, risk management and litigation support services to pension trustees, regulators, audit and compliance firms, hedge fund professionals and attorneys. She is founder of the pension blog, Pension Risk Matters (www.pensionriskmatters.com), and author of Risk Management for Pensions, Endowments and Foundations.

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