CompliancePlus ConsultingCompliance Consulting • Funds Consulting Regulatory Consulting • Compliance Training Asset Valuation: Issues and solutions The significance of asset valuation Asset valuation has always been a thorny issue for hedge funds. Not uncommonly, hedge funds hold a considerable amount of illiquid assets which are notoriously difficult to valuate. Investors and regulatory bodies are also concerned with the fact that some assets may be valued by the fund managers directly. Conflicts of interest arise and the credibility of such valuation is called into question. As the hedge fund industry continues its expansion, a number of overseas regulatory bodies and professional organizations have looked into the valuation problem and highlighted its significance. In the United Kingdom, the Financial Services Authority (FSA) in its Discussion Paper entitled “Hedge Funds: A Discussion of Risk and Regulatory Engagement” (Discussion Paper 05/4, June 2005, “The Discussion Paper”) identifies valuation weakness as a key potential risk of hedge funds: “Valuation weaknesses; Weaknesses in asset valuation methodologies and processes related to skill shortages and conflicts of interest are creating significant potential for ill-informed investment decisions and detriment to market confidence.” (The Discussion Paper at P.6) The FSA further elaborates its concern: There are a considerable number of operational risks inherent in the valuation of hedge fund assets which may affect investors’ ability to accurately assess hedge fund manager performance (and therefore take informed investment decisions). This might have implications for price formation in hedge fund shares and the markets more generally, and therefore market quality. (The Discussion Paper at P.48, paragraph 3.87) In the United States, the President’s Working Group on Financial Markets has formed the Asset Managers’ Committee (AMC), a private sector committee comprising of institutional alternative asset managers, with a view to prepare best practice guidelines for hedge fund managers. The AMC, in its Best Practices for the Hedge Fund Industry (15 Jan 2009, “AMC Best Practice”) also identifies valuation as one of the key areas where the introduction of best practice can reduce risk and protect investors: “Valuation: Robust valuation procedures that call for a segregation of responsibilities, thorough written policies, oversight and other measures for the valuation of assets, including a specific focus on hard-to-value assets…” (AMC Best Practice at P.III) Apart from these regulatory bodies, the Alternative Investment Management Association (AIMA) and the International Organization of Securities Commissions (IOSCO) are also CompliancePlus Consulting Limited 801, Two Exchange Square, 8 Connaught Place, Central, Hong Kong Tel: (852)3487 6903 www.complianceplus.hk Page 1 of 4 CompliancePlus Consulting Compliance Consulting • Funds Consulting Regulatory Consulting • Compliance Training aware of the valuation issues and have issued relevant guidelines after extensive consultation. In Hong Kong, the Securities and Futures Commission (SFC) was also involved in the preparation of the IOSCO’s guideline. In the SFC’s Press Release: IOSCO Principles for the Valuation of Hedge Fund Portfolios (14 Mar 2007, at http://www.sfc.hk/sfcPressRelease/EN/sfcOpenDocServlet?docno=07PR35), Mr. Wheatley expressed that the issue “warrants the close attention of the market”. In light of the importance of this issue, this research article seeks to outline the problems relating to asset valuation, and to outline the solutions adopted by various regulatory bodies and professional organizations. In summary, the asset valuation problem can be further boiled down to (i) the governance of the hedge funds, (ii) the asset valuation methodology and system, especially when the asset is hard-to-value and illiquid, (iii) potential conflicts of interest, and (iv) transparency and investors’ protection. Governance As AIMA pointed out in its Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry (April 2005), the management organ of the hedge fund is accountable for preparing accurate asset valuation information. Although the actual calculation can be delegated to employees or other parties, the responsibility remains with the management body, and therefore the management ought to maintain overall control. An important question arises here: what kind of control should the management exercise? Another problem relates to asset valuation error. In The Discussion Paper, the FSA pointed out that in some jurisdictions the investors may not be compensated for calculation error committed by the hedge funds. A variety of solutions have been offered by the aforementioned regulatory and professional bodies. The American AMC in its Best Practice recommends hedge funds to establish: “A governance mechanism, such as a Valuation Committee or other responsible body; this body should have ultimate responsibility for (i) establishing and reviewing compliance with the Manager’s valuation policies and (ii) providing consistent and objective oversight and implementation of the Manager’s valuation policies and procedures…” (AMC Best Practice at 14) AIMA also issued the AIMA’s Guide to Sound Practices for Hedge Fund Valuation (Mar 2007, “AIMA’s Sound Practices”), and recommends that a Valuation Policy Document outlining the valuation practices, processes and controls would be approved and reviewed by the governing organ after consulting relevant stakeholders. Important decisions such as the use of a pricing model and deviation from adopted pricing policies must be approved by the governing body. CompliancePlus Consulting Limited 801, Two Exchange Square, 8 Connaught Place, Central, Hong Kong Tel: (852)3487 6903 www.complianceplus.hk Page 2 of 4 CompliancePlus Consulting Compliance Consulting • Funds Consulting Regulatory Consulting • Compliance Training Valuation policies As to the valuation policies, AMC suggests that the policies ought to be documented, and guidelines to evaluate exceptions as well as compliance guidelines should be issued. The IOSCO’s Principles for the Valuation of Hedge Fund Portfolios (“The Principles”), which is supported by the FSA, recommends that the policies have to state the valuation methodology, which has to be consistently applied. The policies have to be reviewed regularly. AIMA suggests in its Sound Practices that the policies must specify the role of each party in the valuation process, the price sources for each asset type and provide resolution procedure when it comes to exceptions. A hierarchy of price sources and the tolerance levels for variances between the sources must be stated in the policies. Hard-to-value assets A recurring issue for hedge fund valuation is the valuation of illiquid and hard-to-value assets. Hedge funds often invest in illiquid assets and ascertaining their “market value” or “fair value” is inherently difficult. As the FSA pointed out in The Discussion Paper, not uncommonly these assets are valued by the managers themselves, and even if valuation is performed by third party administrators, the administrator places heavy reliance on the managers’ valuation. This valuation difficulty is further complicated by the potential conflicts of interest. Nevertheless, it is generally recognized that in such instance the hedge fund managers are in a better position to value the assets, and thus the various best practices issued focus on the valuation procedure rather than prohibiting fund managers from performing asset valuation. For instance, the AIMA’s Sound Practices suggests that in some situations the hedge fund managers are the best candidates to value a certain piece of asset, in which case the managers should provide supporting information to the valuation service provider. The AMC’s Best Practice contains a full section devoted to this issue. In summary, the hedge funds should inform the investors that such investment may be made in the PPM. Valuation should usually be done or reviewed by a competent and independent party, although for hard-to-value assets properly controlled internal calculation is also acceptable. Nevertheless, the potential conflicts must be addressed by the valuation policies and procedures. To this end, the Best Practice provides: “To mitigate these conflicts, valuation policies and procedures should address the circumstances in which the Manager may rely upon models, the required support and documentation when using a model and the manner and frequency of reviewing models. In particular, any material exceptions or unusual situations arising in the context of a pricing model (e.g., the creation of a unique pricing model for a particular asset) should be documented and reviewed by the Valuation Committee.” (AMC’s Best Practice at P.20) Independence As noted above, in some circumstances the valuation is provided by the hedge CompliancePlus Consulting Limited 801, Two Exchange Square, 8 Connaught Place, Central, Hong Kong Tel: (852)3487 6903 www.complianceplus.hk Page 3 of 4 CompliancePlus Consulting Compliance Consulting • Funds Consulting Regulatory Consulting • Compliance Training managers themselves. Since their remuneration is usually linked to the performance of the fund, conflicts of interest arise. The best practices adopt two board approaches to tackle the problems. The first approach is to encourage independent valuation or duty segregation. For example, the AIMA’s Sound Practices provides that the parties involved in the investment affairs ought to be separated from the parties who perform the valuation. Nevertheless, the first approach may be unrealistic since in some circumstances the investment managers are more capable to value an asset. This is recognized by the AMC. The second approach thus arises to minimize the potential conflicts and control managers’ discretion when the managers are in the best position to value the assts. For instance, the AMC’s Best Practices provides: “In the event that portfolio management personnel do not believe that the valuation of an investment is appropriate, a Manager should have in place policies that seek to mitigate any conflict between portfolio management personnel and valuation personnel. For example, the Manager may develop a process for portfolio management personnel to “challenge” the determinations of valuation personnel in which the ultimate decision as to the appropriate price for a “challenged asset” would be made by participants in the Valuation Committee after consideration of pricing support provided by valuation personnel and input from the applicable portfolio management personnel.” (AMC’s Best Practices at P.17) The IOSCO’s Principles is also apposite here. The Principles provide that the valuation policies should be independently applied and reviewed to an appropriate extent. Individual valuation, particularly valuation influenced by the fund managers should be reviewed with a certain level of independence. The funds ought to conduct initial and periodic due diligence on the independent parties that provide valuation services. Transparency Ultimately, the valuation calculated has to be communicated to the end users, i.e. the investors. To this end, the AIMA’s Sound Practices sets out the relevant principles. The PPM should name the party responsible for the valuation, and material involvement of the fund managers in portfolio position pricing ought to be disclosed. NAV reports should be given to investors directly by the administrator (if any), and NAV reports prepared by hedge fund managers have to be qualified as such. Conclusion One must of course note that the above best practices are not the “silver bullet” that solves all the problems. They are not “one-size-fit-all” solutions, as AIMA warned in its Sound Practices. Nevertheless, these general principles are still useful to Hong Kong hedge funds. Moreover, to achieve better asset valuation, hedge funds are not the only actor. Other market actors, such as investment banks and administrators, also play significant roles. Ultimately, the SFC and the government should look into the matter. As Mr. Wheatley said, the issue no doubt deserves closer examination. 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