Valuations: The Hot Topic
As more traditional investors and fund managers invest with hedge funds, the issue of valuations has become increasingly critical. The aggregate performance of hedge funds over the past ten years has been consistently positive and uncorrelated to the underlying state of the markets. Because of this, the industry is increasingly attracting investments from mainstream asset managers. These managers have to cope with the fact that hedge funds are free to use instruments and strategies not generally open to the traditional asset management market: for example, going short, taking massive positions, leverage and investing in illiquid instruments. Hedge funds are increasingly using complex over-the-counter (OTC) instruments such as derivatives as an efficient way of gaining exposure to a market or of exploiting ever more complex arbitrage opportunities. Are they valuing such positions correctly?
In its report last year on the hedge fund industry,1 the US Securities and Exchange Commission (SEC) found that valuation was one of the most critical investor concerns about hedge funds. According to Edhec’s Risk and Asset Management Research Centre,2 over half of hedge fund collapses have been due to a failure of operational processes, notably pricing and NAV calculation procedures. At both the Lipper and Beacon Hill funds, the managers mismarked their portfolios and inflated the NAVs, with no independent NAV check by the administrators. Similarly, at Manhattan Investments, the manager had concealed about $400 million of losses before the fund collapsed. Paul Atkins, SEC commissioner, stated in June 2004 that over the past five years there had been 46 enforcement actions against hedge fund managers that defrauded investors.
Significantly, it had been a traditional practice in the US for funds to value their own positions since there has, so far, been no regulatory requirement for this to be done independently. But institutional investors or a Fund of Hedge Funds (FoHF) are no longer prepared to accept selfvaluation.
They require more transparency and independence in the valuation process, to give them better reassurance that a fund’s NAV is being marked at a level that is reasonably close to the value at which they can redeem. A good summary of valuation issues that investors might consider can be found at www.iafe.org.3
Ultimately it is the hedge fund’s board that is responsible for checking that there are adequate procedures in place to ensure that the fund and its ositions are being properly valued. The first step towards more independent valuations was the appointment of administrators to produce the books and records. This has been much more common in Europe, where there has always been much more of a division of responsibilities, than in the US. But although an administrator may have assumed responsibility for determining the NAV, both the fund’s board and the administrator itself still have to be satisfied that it can be done accurately and independently.
When hedge funds are investing in exchange traded instruments such as equities, it is fairly easy to establish the value. Marking to market against market-quoted prices is straightforward. With illiquid investments and OTC derivatives, this is a more difficult exercise. By their nature, they are not generally traded and there is no market quote.
Different Approaches
There are four principal approaches being adopted for producing independent valuations of such positions.
• A simple method for an illiquid position is to value it at cost, or the lower of cost and market, but this is really appropriate only for a highly illiquid investment such as a private equity position. Such a position would be valued at cost until there is a valid benchmark trade to indicate the market value. The manager would tend to notify the administrator of the details of such investments, with a note on how the manager himself has determined the value: the administrator must verify the basis for any changes.
• Hedge funds or their administrators can go back to the counterparty (such as the Prime Broker or Executing Broker) with whom the trade was carried out initially, and ask for a valuation. The valuation may be either a “midmarket” value or a “close-out” value, at which that counterparty would (in principle) buy back the position.
The counterparty will value all these positions anyway, as part of its own risk management of its exposure to the fund and for its collateral management operations.
This approach is often used where firms do not have the capability to model positions independently. For example, the counterparty may have the best bespoke model for valuing a highly complex trade that it has structured, which a fund or administrator cannot easily replicate.
But the approach has its limitations. It is a laborious and unrewarding process for all parties involved, and valuations can take days to be produced and delivered. It is not always clear how the counterparty produces valuations: even a “close-out” value may be very different from the price quoted for actually unwinding the position. A fund with more than one broker, and a FoHF looking at valuations across a number of funds, will undoubtedly face inconsistent valuations for the same risk.
• Thirdly, the approach generally used for more common OTC derivative instruments is to produce a fair market value (or mark-to-model value) using standard valuation models. In this case, the key focus is on the independent check of the model inputs, especially the market rates.
Most common OTC instruments can be valued using proprietary or third party software so long as the underlying structural dynamics of the trade, such as the cash flows and trigger events, can be captured and modelled accurately, and the required current market rates can be sourced. For example, the value of an existing credit default swap position would be updated by applying today’s credit default swap spread curve and expected recovery rates for the reference entity, along with today’s interest rates, and recalculating the expected cash flows of the position over its life in the light of today’s data.
Just as an investor would not want to rely on the manager’s view of the NAV of his or her position, so it is rare for a valuation to depend on using the manager’s own models. It might happen with highly structured trades where the manager’s model correctly reflects the complex dynamics of those trades, but it requires rigorous independent controls. The model would need to be run independently by a third party such as the fund’s administrator, with independent sourcing of the market data. And this model would need sign-off from a third party such as the fund’s auditors that it produces reasonably correct fair value results for any given market data inputs.
More commonly, a third party responsible for determining or checking valuations will want to have independent software models, either ones it has developed itself or ones available from third-party software firms such as Lombard Risk that specialise in software to handle derivatives and complex trades.
Finding good market data to update the models can also be difficult with these sorts of instruments. Usually a number of sources will need to be used, including Reuters, Bloomberg, firms such as Lombard Risk that specialise in data for particular markets, and brokers. Collecting market data from a number of sources can be a laborious and difficult exercise.
• A fourth method, which is emerging in the market, is for the valuation process to be handled by a specialist firm such as Lombard Risk that has the models and software to provide valuations and risk measurement on derivative portfolios. Increasingly, positions and portfolios are being sent to such firms to produce independent and consistent updated valuations and risk measurement.
Again, this approach is used now where funds, FoHFs or administrators do not have the capability to model positions independently and consistently. It is also used where such firms need results daily through an efficient operational process.
The limitation with this approach, as with any outsourcing, is the dependence on the capabilities of the firm handling the process and the extent to which the processes, models and output are transparent and verifiable. This needs careful assessment before adopting this approach.
Credit Market Developments Highlight the Issues
There is increasing interest by hedge funds in credit as an asset class, and credit is becoming a strategy in its own right. This is because of the inefficiencies in the credit market and the arbitrage opportunities that hedge funds can exploit.
As well as traditional long-short positioning and taking positions in structured credit products such as CDOs, funds are arbitraging many of the fundamental components of the market. The range of instruments available is multiplying rapidly as techniques learned from the interest rate markets are applied in the credit markets. There are also arbitrage opportunities between equity and credit (capital structure arbitrage), exploiting relative value differences in these markets.
Since this is a new market, there are limited tools available for valuing such positions. This is an area where we at Lombard Risk have seen particular demand for assistance.
Regulatory Perspective
The SEC’s controversial proposal in 2004 that fund managers should be registered was their response to the growth of fraud cases by fund managers, to abuses in the mutual fund business and to the expected growth of hedge fund products aimed at less sophisticated investors.
Until now, the SEC had largely left the market to sort itself out. The spectacular collapse of Long Term Capital Management in 1998 and the significant investor losses did not lead to increased regulation of the hedge fund market. Institutional investors had only themselves to blame for investing in a fund with inadequate risk management and controls.
There are more chances of losses and casualties now, as interest rate rises and market conditions are combined with tighter collateral haircut requirements from brokers, to squeeze a market that has leveraged itself using cheap money. And the SEC’s previous view is holding true. The industry is already very focused on improving the way it operates. Investors, especially the more recent entrants such as the mainstream institutional investors and FoHFs, have been driving the need for better operational controls and compliance procedures, especially focusing now on the issue of valuations.
They have a lot at stake. They may be prepared to invest a lot in the skills of the hedge fund manager. But they will insist on a level of compliance structure to ensure that the books and records are based on independent assessments of the value of his or her positions. Put bluntly, if a particular manager they have invested in has a losing strategy, they don’t want that manager to be the one reducing his or her own results.
The industry will continue to drive these improvements ahead of the requirements of the regulators. The hedge fund market will continue to be focused on the issue of valuations until the mainstream investors and FoHFs are confident that the information available on hedge fund valuations, across all asset classes, is consistent, accurate and transparent.
CHRISTOPHER ROSE
LOMBARD
1 Implications of the Growth of Hedge Funds, Staff Report to the US Securities and Exchange Commission, September 2003.
2 Managing Hedge Funds’ Operational Risks, Edhec Risk and Asset Management Research Centre, 2004.
3 Valuation Concepts for Investment Companies and Financial Institutions and Their Stakeholders, International Association of Financial Engineers
Investor Risk Committee, June 2004.
Entry Filed under: Asset Management, Hedge Fund Strategy