IOSCO

Principles for the Valuation of Hedge Fund Portfolios

MICHEL PRADA, CHAIRMAN, IOSCO TECHNICAL COMMITTEE

Last November, IOSCO published its “Principles for the Valuation of Hedge Fund Portfolios” which brought its work, begun in this field in February 2006, to a successful conclusion. The report provides 9 high level principles which can be consistently utilised by all hedge funds worldwide in order to control their valuation process for financial instruments within their investment portfolios.

These principles were developed through a combination of the input of experts from the global hedge fund industry and the high quality responses received to the public consultation organised by IOSCO from March to June 2007. IOSCO’s objective in undertaking this open dialogue with the industry was to harness the practical insight of experienced hedge fund managers and service providers and thus create valuation principles which were a practical operational tool for market practitioners. To this end, working sessions were organised in Washington DC and in London with industry representatives (including administrators, auditors, fund of fund managers, hedge fund managers, prime brokers and valuation service agents) in order to discuss and address the issues related to the valuation of hedge fund portfolios. This commitment by industry experts, which was highly appreciated within IOSCO, proved to be crucial in the principles’ final development.

The public consultation could also be described as successful with IOSCO actually receiving 15 submissions from interested parties. While the respondents made some observations about the consultation proposals, they also generally supported its findings. It is worth noting that IOSCO’s Standing Committee 3, which is in charge of the regulation of market intermediaries, was also consulted on the report. Finally, the consultation report was presented to the Financial Stability Forum during its March 2007 session which addressed the general topic of hedge funds.

Reasons for development of principles

There were a number of key issues that prompted IOSCO to consider developing the valuation principles. Firstly, the increasing importance and role of hedge funds in global capital markets was considered. It was acknowledged that not only did hedge funds provide substantial liquidity in all asset classes throughout the world, they also represented important sources of investment diversification for institutional and sophisticated investors, and of product innovation.

Secondly, it was noted that the specific nature of certain hedge funds’ strategies, which involve exposure to illiquid, complex or highly structured financial instruments, may make it quite difficult to obtain an appropriate valuation. It should be stressed that the question of the valuation of complex or illiquid financial instruments is by no means unique to hedge funds.

Finally, consideration was given to the central role of the valuation of the financial instruments employed or used by hedge funds, and to the potential conflicts of interest that may arise when a manager takes an active role in the valuation process. It was observed that in some cases, the manager may have both the incentive and the ability to influence the valuation of the financial instruments held by the hedge fund in ways that do not fairly reflect their value, thus to the detriment of investors.

All these reasons prompted IOSCO to develop a single set of valuation principles that are applicable across a wide range of jurisdictions and hedge fund business models.

Aims of the Valuation Principles

The chief aim of the valuation principles adopted and recommended by IOSCO is to seek to ensure that hedge funds’ financial instruments are appropriately valued and, in particular, that these values are not distorted to the disadvantage of fund investors. The valuation principles were actually designed to strengthen the hedge fund valuation process with a view to mitigating conflicts of interests and therefore enhancing investor protection. Specifically, the key foundations of the principles relate to the elaboration and implementation of comprehensive written valuation policies and pricing procedures, and to the independence of the valuation process and of its monitoring. Needless to say, the valuation policies and pricing procedures will have to be reviewed periodically to ensure their continued appropriateness.

As regards the implementation of the valuation principles, it should be noted that, while the principles apply to all hedge fund structures across a wide range of jurisdictions, their implementation should nonetheless take into consideration the funds’ size, structure and the nature of their operations. It should be pointed out that the principles are mainly addressed to hedge funds’ managers, governing bodies and other service providers involved in the valuation process. Nevertheless, they may also be useful to investors particularly institutional and sophisticated individual investors as well as their representatives. As a matter of fact, and notwithstanding the implementation of the valuation principles by hedge funds, it is important to note that hedge fund investors will still need to carry out due diligence before and during their investment.

Finally, it should be stressed that the principles do not purport to address the issues faced by hedge funds that relate indirectly to portfolio valuation including, among others, the timely disclosure of the hedge fund’s net asset value, the valuation of the hedge fund portfolio as a whole (as opposed to the valuation of particular financial instruments), the valuation of investments in other funds held by a fund of hedge funds, and the compliance with applicable accounting principles. These issues were beyond the scope of the valuation report, however IOSCO does not exclude the possibility of considering them in the future.

Conclusion

IOSCO believes that the valuation principles will become, in practice, a useful tool in the hands of market practitioners worldwide. Not only does IOSCO consider that the principles will be helpful to hedge funds’ governing bodies, managers, service providers, unit holders/shareholders, prospective investors, but it also believes that the principles will also form a point of reference for financial research providers and rating agencies. IOSCO is confident that investors will ultimately benefit from the principles provided they are duly followed by hedge funds.

Interestingly, the market events of last summer have emphasised the importance of having coherent valuation policies and pricing procedures in the asset management world. They have further confirmed the need for having a set of clear principles in the area and the relevance of the said principles.

It will therefore be interesting to consider in the forthcoming months how the industry has reacted to the valuation principles as recommended by IOSCO. Not surprisingly, the market’s first reactions appear very positive and supportive.


Biology

MICHEL PRADA

Michel Prada is the current Chairman of IOSCO’s Technical Committee and the Chairman of France’s Autorité des Marches Financiers (AMF). He was appointed Chairman of the AMF in November 2003 having been Inspecteur Général des Finances since October 2002. He was reappointed as Chairman of IOSCO’s Technical Committee in October 2005 having previously occupied the position from September 1998 to May 2000. He was Chairman of the Executive Committee of the International Organisation of Securities Commission (IOSCO) from September 1996 to September 1998.