Closing the Gaps

Can hedge funds and investors move closer on valuation?

ARTHUR TULLY, ERNST & YOUNG

Investors are expressing more clearly than ever before what they want from their hedge fund managers on issues ranging from governance and succession to fees. However, managers, either because of practical constraints or differing views, are not always able to meet those expectations. In the right doses, this friction is healthy. The key to the sector’s continued maturation is understanding where differences lie and working to overcome them.

Ernst & Young’s annual global hedge fund survey focused on identifying differences of opinion between managers and investors, in the hope that a better comprehension of the differences will lead to solutions. One of the most salient topics to emerge from the survey is valuation. Investors say they have more faith in valuations calculated by a third party than by managers. Managers, on the other hand, suggest that third-party firms may lack the expertise to value some complex assets. Other issues appearing on the radar in this survey were governance (particularly board independence), succession planning and fees.

Valuation: finding common ground
Valuation has become a topic of conversation because some managers and investors disagree on who can provide the most accurate information. The survey shows that 74% of investors believe it’s important to completely outsource valuation to an independent third-party administrator. In fact, 74% also believe independent valuation to be the main benefit of using administrators in the first place.

Perhaps not surprisingly, some managers don’t feel the same way. While most managers now outsource valuation, 55% say they do it not to increase accuracy, but to comply with investor wishes. In fact, 71% of managers say that fully outsourcing valuations actually carries risks. It is worth noting that managers and investors both feel that administrators are not very effective at dealing with difficult-to-value and Level 3 assets.

Says one manager in the survey: “Often the administrator has limited access to fully understand the management of that asset whereas internally we may have taken considerable time to model frameworks on the Level 3 asset.”

Some investors believe boards can play an important role in this process. The survey shows that one-third of investors feel the board of directors should have ultimate responsibility for reviewing and approving a fund’s net asset value (NAV), compared with just 9% of managers who say this is the case. Giving boards more oversight doesn’t necessarily solve the problem, however. A substantial minority of investors (36%) worries that the board is beholden to the managers and not able to guarantee a truly independent view.

The rise of shadowing
The majority of the largest hedge funds that outsource valuation to administrators perform robust shadowing procedures. The survey shows that 84% of managers now shadow administrators who calculate and issue NAV. This process of repeating the work done by administrators and keeping separate records is increasingly viewed by managers as a necessity, not a luxury, to mitigate the risk of error.

Says one manager: “We have to have our own records. We can’t rely on third parties.”

The vast majority (76%) of investors also believe that shadowing is important. This duplication of effort is an expensive business proposition, one that’s unique to the hedge fund industry and not necessarily viable over the long term. However, questions exist as to investors’ willingness to pay for such services. Only one-third of investors believe it is appropriate to pass on shadowing costs to the fund.

Opportunities for solutions
These are not trivial differences. Investors and managers still have plenty of work to do to find middle ground. Fortunately, some earlyprogress toward agreement has already begun.

Administrators, for example, have begun to supplement their resources by hiring professionals capable of dealing with Level 2 and 3 assets. There is a growing awareness of the need to subcontract such work to the growing sector of specialized valuation firms.

Hedge funds have been able, in some cases, to pass on the costs of shadowing to their funds, after gaining approval from major investors. Looking ahead, some hedge funds will likely need to re-examine their shadowing processes and develop a control environment that taps into the administrators’ strengths, while compensating for the administrators’ shortcomings.

Valuation best practices
While progress has begun on reconciling manager and investor views regarding valuation, lasting solutions will doubtlessly require time and effort.

In the meantime, there are several steps that managers can take to help bridge the gaps.

1. Valuation committee: It makes sense for funds, especially those with difficult-to-value assets, to establish valuation committees. It is important that committee members have sufficient expertise with Level 2 and 3 assets and that they are strong enough to defend the interests of investors while working well with managers.

2. Policies and procedures: In order to give investors additional comfort and minimize regulatory risk, funds should have clear and comprehensive valuation procedures and policies in place. The chief compliance officer should monitor that managers are consistently applying the policies, which is especially important because the SEC looks closely at consistency when investigating valuation practices.

3. SAS 70 (SSAE 16): Managers can help bolster investors’ confidence in the valuation process by examining their policies and procedures via SAS 70 audits. Some large funds have already begun to do this. SAS 70 audits might well give investors additional comfort around a manager’s valuation, risk management and operational processes.

Valuation cropped up many times in the survey, but managers and investors also voiced their opinions on other areas – some of which touch on valuation – such as governance, succession planning and fees.

Governance was of particular interest as it reflects managers’ and investors’ divergent views on the role of boards. It’s worth noting that while most hedge funds outside of North America have boards of directors, less than 15% of domestic funds use them.

As for funds that do have boards, many investors question the directors’ authority. Most investors (about 80%), for example, believe boards do not have enough power and knowledge to challenge the decisions of the management team. As one investor responding to the survey puts it: “Generally, a board is capable, but not close enough to the details of the operations — and as a result, the governance structure breaks down.”

Investors also wonder about boards’ accountability. Only 38% of investors say that the board is accountable to the fund and its investors, compared with 75% of managers who believe the same.Nevertheless, investors still want boards to become more involved, with many saying they want directors to be responsible for key areas, including investment guideline compliance (45%) and setting overall risk policies and thresholds (38%). This does not agree with managers’ views of board responsibilities. Most managers say they are the ones responsible for compliance with investment guidelines (69%) and for establishing overall risk and policy thresholds (72%).

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Succession planning was another area that showed disagreement among managers and investors. In fact, managers underestimate just how important a succession strategy is to their clients (see Fig.1). While two-thirds of investors say that having a well-articulated succession plan is important to their confidence in the fund, less than half of managers say that such a plan is important to retaining investors. Moreover, less than half of managers say they have a well-developed succession strategy.

There are also some differences in perception around this topic, because there is no clear agreement on where investors’ loyalty lies – with the founders, the solidity of the firm or individual portfolio managers.

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Nevertheless, succession is a very important topic now, as the hedge fund sector matures. In the past, hedge funds have relied on the investment prowess of their founding principals to attract and retain capital. As these firms increasingly institutionalize, they must think about the need to prove to investors that they can ensure a smooth transition to the next generation of leadership. As the industry matures, key man risk has emerged as a crucial factor that affects investors’ choices.

Fees and expenses continue to be a focal point for managers and investors. For funds, heightened regulation and investor scrutiny are raising the costs of compliance, regulatory reporting and other processes. The result has been margin compression, and, in the view of investors, reduced transparency on how their fees are spent. Investors express reservations about the management fee in particular, saying it is not clear enough which expenses it covers.

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That said, there are many fees that hedge funds currently do not charge their investors for, which investors say they would not mind paying. For example, 67% of investors say they would pay for regulatory examinations, although only 27% of funds currently pass on those costs. More than 40% of investors say they would not mind paying for trader compensation, although only 9% of funds currently pass on those costs.

It is also worth noting that fee and margin pressures are causing more managers to offer discounts for significant volume. More than twice as many hedge fund managers now say they charge graduated fees for larger mandates as compared to the previous year.

Final thoughts
It is encouraging to see that the hedge fund industry overall remains healthy, despite the volatility caused by recent financial crises. Investors added $70 billion of net new capital to hedge funds in 2011, bringing total assets under management to $2.01 trillion. For the industry to continue to expand, it behooves managers and investors to find more common ground. There is no doubt that investors are becoming more demanding. The survey suggests that managers who can shift their realities and show a commitment to clear valuation processes, independent boards, the strategic use of administrators and savvy management of fund expenses stand a better chance of being more successful.