Asset Pricing and Fund Valuation Practices in the Hedge Fund ...

ASSET PRICING AND FUND VALUATION PRACTICES IN THE HEDGE FUND INDUSTRY

ASSET PRICING AND FUND VALUATION PRACTICES IN THE

HEDGE FUND INDUSTRY

By the Alternative Investment Management Association

Presented by

May 31, 2005

Toronto

ASSET PRICING AND FUND VALUATION PRACTICES IN THE HEDGE FUND INDUSTRYASSET PRICING AND FUND VALUATION PRACTICES IN THE HEDGE FUND INDUSTRY

Raj Kothari, PricewaterhouseCoopers Stacy Hammett, PricewaterhouseCoopersDerek Hatoum, PricewaterhouseCoopers


OVERVIEW


What were the drivers of this research?

• There is an increasing range of hard-to-value securities within hedge fund portfolios

• There is increased focus on the issues of pricing and valuation, from regulators, investors and managers


Study Objectives

• To assess the issues relating to pricing and valuation from a broad range of viewpoints

• To summarise concerns

• To make recommendations for enhancing existing practices and procedures


Approach

• Detailed questionnaire circulated globally

• Respondents: hedge fund managers, fund of funds managers, investors, administrators, prime brokers and custodians, accounting firms and auditors

• Collection and analysis of data


Key Facts

• Hedge fund industry is less than 5% of global fund industry

• Approx $1trn under management in hedge funds at end 2004

• Approx 80% of all assets are within ‘easy-to-value’ strategies

• Continuing maturity and sophistication of approach

• General understanding of potential issues and solutions


KEY FINDINGS


Key Findings

• 73% of manager respondents employ an independent administrator

• There are different perceptions as to who is responsible for the NAV calculation process

• Hard-to-value instruments are not as prevalent as generally believed

• Managers and service providers have differing views on which assets are hard-to-value

• There is a general desire to enhance valuation practices and procedures


24

5

31

24

48

31

24

33

38

16

10

0

11

5

0

0% 20% 40% 60% 80% 100%

Managers

Investors

Service Providers

Very important Important Moderate

Not important Less

How important is the issue of valuation for the hedge fund industry?

Service providers and managers appear to be more immediately concerned about the issue of valuation., though half of all respondents see this as an important issue


26

20

18

0 5 10 15 20 25 30

Pricing sources

Pricing illiquid

instruments

Independence

What are the most important pricing and valuation issues?

Pricing sources and illiquid assets are the most important issues


14

20

13

0 5 10 15 20 25

Hedge Fund

Managers

Investors

Service

Providers

What percentage of the hedge fund portfolio do hard-to-value assets represent?


0 5 10 15 20 25 30 35 40 45

Complex derivatives

MBS/ABS

Distressed debt

Private placement

Credit default swaps

% responses

Total Managers Service Providers

Which instruments do you find most difficult to value?

Some mismatch:

-MBS/ABS of no concern to managers yet yes to 19% of service providers

-- credit default swaps are an issue for 17% of managers yet only 3% of service providers


19

9

7

69

86

57

8

2

14

0

2

21

0% 20% 40% 60% 80% 100%

Americas

Europe

Asia-Pacific

Manager Administrator Prime Broker

Bank/Custodian Other

Who performs the NAV calculation?

- 93% of administrators are fully independent from the manager

- More than 80% of respondents believe that the fund’s administrator and auditor understand how to price hard-to-value instruments


RECOMMENDATIONS


Recommendations on Governance

• A summary of practical and workable pricing and valuation practices and procedures should be documented, approved by the board of directors, trustee or general partner of the fund and reviewed on a regular basis.

• The NAV of the fund should be produced by parties independent of the investment team / the investment manager.

• The offering document should explicitly describe the potential limitations of valuation and pricing practices.


Recommendations on Governance

• Oversight of the entire valuation process and, in particular, resolution of pricing issues associated with “hard-to-price” illiquid positions and exotic instruments is the ultimate responsibility of the board of directors, trustee or general partner of the fund.

• There should be adequate disclose of any material involvement by the investment manager in the pricing of underlying portfolio positions or otherwise in the calculation, determination or production of the NAV.


Recommendations on Transparency

• The pricing and valuation policy should be formalised in advance of the fund’s launch and should be adequately described in the fund’s offering document, including a practical escalation or resolution procedure for the management of exceptions.

• The pricing and valuation policy should explicitly clarify the role of each party in the valuation process.

• The pricing and valuation policy should incorporate appropriate controls.

• Price sources for routine pricing should be identifed with the details of the pricing and valuation policy document.


Recommendations on Procedures, Processes and Systems

• Where necessary, NAV calculations should be subject to appropriate checks and balances to ensure any actual or potential conflict of interest is appropriately managed.

• The industry recognises that in certain instances the investment manager has the best insight with respect to the valuation of particular instruments. Where prices are provided or sourced by the investment manager, the administrator should be provided, where possible, with supporting information by the investment manager.


Recommendations on Procedures, Processes and Systems

• The administrator should use reasonable endeavours to consistently

apply any pricing policy, unless there is good reason not to do so.

• NAV reports should be addressed directly to investors by the

administrator, where an administrator is used.

• Where practical and appropriate, a second price should be sought for hard-to-value instruments/illiquid positions where there is readily available market data.

• Practices described in the pricing and valuation policy for a particular fund must be capable of practical implementation by the relevant service providers (such as the fund’s administrator).


Recommendations on Pricing Models

• The use of pricing models or determination methods should be approved by the board of directors, trustee or general partner of the fund.

• Where practical and appropriate, pricing models or determination methods should typically be used for illiquid of hard-to-value securities, where an independent source is not available or where it appears that it may not be reliable.


Recommendations on Pricing Models

• The decision to use a pricing model rather than a market price should be properly justified by back-testing in normal market conditions and applying appropriate stress tests to identify model weaknesses.

• Internal valuation methods should be appropriate tested and, where possible and appropriate, independently reviewed and verified.

• Underlying data used in pricing model-based calculations should be formally reviewed and approved.


Next steps

• Industry and investor feedback

• On-going development of recommendations

• Inclusion of these recommendations in Guides to Sound Practices

• Continue to monitor issues and developments

• Revisit the topic periodically


ASSET PRICING AND FUND VALUATION PRACTICES IN THE

HEDGE FUND INDUSTRY

By the Alternative Investment Management Association

Presented by

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