Understanding the composition of a hedge fund portfolio and evaluating controls over the month end valuation process forms a key part of any operational due diligence review.

Many investors, however, are at opposite extremes when they perform due diligence in this area. Some investors are satisfied with simply knowing what is in Level 1, 2 and 3 from an administrator’s “Transparency Report” while others spend an enormous amount of time trying to obtain position-level transparency to tick and tie prices back to their own pricing sources.

Due to the variety of strategies and instruments traded, and the different levels of transparency provided by hedge fund managers and administrators, the way in which portfolio information is disclosed can vary tremendously.

In order to identify the inherent level of valuation risk within a portfolio, an investor should consider the most appropriate breakdown of valuation pricing sources and obtain sufficient transparency as to the types of securities traded. Once this is done, a more risk-based approach can be used to perform due diligence on the manager’s month end pricing process and, separately, the fund administrator’s independent price verification procedures.

Managers and administrators commonly only provide investors with the ASC 820 percentages for the aggregate portfolio (i.e., not separating assets and liabilities as shown in the audited financial statements). In order to assess valuation risk, and more specifically the materiality of Level 2 and Level 3 positions, it is important to understand how this aggregate portfolio is presented. Common approaches include: (a) the sum of the absolute market/fair values of each position in the portfolio (i.e., “gross portfolio”), and (b) the aggregate net portfolio (offsetting the fair values of assets and liabilities within the same ASC 820 level).

It is important to clarify the approach further because some managers may base the portfolio breakdown on aggregate risk exposure (which considers notional values and can lead to significant differences over fair value disclosures, especially in respect of derivative instruments), or the total number of positions in the portfolio (which is misleading for obvious reasons).

More often than not, the portfolio is presented using the gross portfolio method. Generally, this approach, when compared to the other approaches outlined above, is a more accurate proxy for assessing valuation risk. As illustrated in Table 1, the net portfolio approach can result in negative percentages that are difficult to interpret.

However, looking at a portfolio on a net, rather than gross, basis can be more appropriate in certain specific circumstances, for instance, in the case of a multi-strategy fund. As illustrated in Table 2, a multi-strategy fund which undertakes a sub-strategy that employs significant leverage (such as statistical arbitrage or relative value) could result in the gross portfolio metrics being skewed in favour of the more liquid strategies. In the example below, the gross portfolio disclosure effectively exaggerates the importance of the highly leveraged, highly liquid statistical arbitrage strategy (disclosed under Level 1) and effectively masks the relative proportion of Level 2 and Level 3 instruments in the portfolio.

Investors should be watchful of cash balances being included in the Level 1 category, as this can skew the metrics. It is also important to consider whether the information provided encompasses all trading activity. Although all trading typically takes place in one entity (generally the master fund), a portion of the portfolio may be invested in side pockets, the feeder fund, an intermediate fund, other affiliated funds, and/or special purpose vehicles. Portfolio metrics must incorporate (on a look through basis) all such investments.

The ASC 820 fair value measurements and disclosures presented in the audited financial statements provide some transparency into the level of valuation risk within the portfolio by segregating the portfolio by pricing source (i.e. sources as defined by Level 1, 2 and 3) and by breaking out assets and liabilities separately. From an operational due diligence perspective, this information is helpful, but not comprehensive. Investors should understand the underlying types of securities that are typically traded within these categories. For example, a thorough duediligence review should obtain information on the portion of Level 2 securities where prices are derived from underlying listed securities or highly liquid markets (such as contracts for difference or FX forwards) and that portion of Level 2 securities that are priced from dealer quotes which could be subject to manipulation based on the selection process.

Once an investor obtains a clear understanding of the materiality and type of securities held within Level 1, 2 and 3, a risk-based review should be conducted on the people, processes and systems in place within the manager and administrator’s organisations, respectively, to value the portfolio at each dealing date.

A comprehensive valuation policy is required for a fund with a material portion of Level 2 and 3 securities. The policy should identify the responsibilities of staff involved in the valuation process and outline security-specific pricing sources and methodologies. Where multiple sources of prices are obtained for the same type of security, the valuation policy should clearly identify the preferred hierarchy of pricing sources. For any portion of the portfolio priced using broker quotes, the policy should also outline criteria to evaluate the quality of such quotes and the elimination of any outliers, in order to minimise any quote selection bias. Factors that should be evaluated in respect of broker quotes during the monthly valuation process include whether the pricing sources are appropriate for a particular type of security, how actively each quote provider transacts in the instrument, whether pricing sources are consistent or change from month to month, the range of quotes received, etc.

For Level 3 assets, the manager should outline a robust internal review process for model-priced investments. Any non-standard models used to price derivative instruments should be subject to annual review by an independent valuation agent. Additionally, at a minimum, all material Level 3 positions should be subject to valuation on a positive assurance basis by an independent third party valuation agent at least semi-annually. Any pricing overrides by front office staff should be clearly documented and made available for review by senior staff. The valuation policy must also specify escalation and control procedures where there are price discrepancies between the manager and administrator. A periodic review of the valuation policy is warranted, particularly when new types of securities are traded or when market conditions undergo drastic shifts.

A robust valuation policy is only as effective as the people that are responsible for implementing it. Therefore, it is imperative that back office professionals involved in the pricing process are adequately qualified and experienced, relative to the complexity of the instruments traded. Additionally, a manager that trades in Level 2 and 3 securities should establish a valuation committee. Appropriate consideration should be given to the people who are appointed as members, those that should attend but abstain from voting, the voting process, and the depth of review and discussion by committee members. The frequency and scope of the review process undertaken by the valuation committee should be clearly defined, and minutes of meetings taken to adequately document discussions and conclusions. Any deviations from the established criteria within a valuation policy should be documented by back office staff and reviewed by the manager’s valuation committee before the month end NAV is finalised. Valuation meeting minutes with related support should also be shared with the independent administrator and the fund’s auditors.

External to the manager organisation, a full-service administrator plays a crucial role in pricing, or verifying the prices of, the portfolio that forms the basis of the dealing NAV. When evaluating the robustness of the administrator’s price verification procedures, investors should consider the extent of the administrator’s valuation expertise in the particular investment strategy (using strategy level assets under administration as one measure, for instance), the ability to independently source dealer quotes, the quote selection and review process, procedures to identify erroneous prices, materiality thresholds that trigger a price challenge (although this is generally not disclosed), and the extent to which monthly analytical review procedures (for example monthly pricing flux analysis) have been implemented. Given the nature of securities held in Level 3, it is unrealistic in many instances to expect an administrator to be able to verify the manager-ºassigned fair values.

However, the administrator should review the pricing models and inputs to ensure that they are reasonable and administrator staff, possibly in a specialist unit, should be qualified to perform these reviews. Any change in fair valuation methodology should be adequately substantiated and documented. The manager should also facilitate the direct distribution of independent third party valuation agent reports to the administrator so that the administrator can monitor the frequency of instances where the manager’s mark is outside the valuation range provided by the independent valuation agent. In order to ensure that the fair values reflect net realisable values (albeit on an ex-post basis), the administrator should also perform a comparison of month-end fair values to subsequent disposals.

Lastly, robust pricing systems implemented by both the manager and administrator, where appropriate, can also decrease operational risks in the valuation process. In particular, the automation of processes to capture prices from external sources, systematised data aggregation and selection processes, automated alert/exception reporting mechanisms and the function of an audit trail decrease the risk of errors going unnoticed.

In most cases, understanding the various facets of valuation in isolation using a ‘check-the-box’ approach is not sufficient. Investors should take a risk-based approach and focus their due diligence review on understanding how securities traded in the portfolio are priced, to determine where material valuation risk typically exists. This evaluation requires a multi-faceted assessment of quantitative and qualitative factors underlying valuation practices and control mechanisms implemented by both the manager and the fund’s administrator. In our experience, this is a more effective and efficient approach to due diligence.