Valuations

Dealing with the thorny issue of valuations

JEROME DE LAVENERE LUSSAN, MANAGING PARTNER, LAVEN PARTNERS

The problems surrounding hedge fund valuations are not new and have already been taken up by organisations including AIMA, the Hedge Fund Working Group and the International Organisation of Securities Commissions Organisation (IOSCO). Much has been written to standardise industry practices yet the resulting principles are not having the required impact and need to be expanded to include some practical solutions. If the issues are not remedied it puts the reputation of the hedge fund industry at risk and could lead to political interference, including more laws and regulations.

New laws are not needed. It is well recognised that part of the problem is conflict of interest and legal responsibility. It is sometimes hard to value certain assets and often it is in the interest of managers and administrators responsible for NAVs to value them up rather than down, as their remuneration relates to assets under management.

Loss of confidence in the valuation process

It is contractually hard to determine who assumes responsibility when valuations go wrong, which means investors cannot trust the valuations provided. The industry should be more proactive and agree lines of responsibility for accurate valuations – if no one is responsible nothing will change. We propose that the industry adopts a standard agreement which incorporates the main principles for reliable valuations and includes legal liability for managers and administrators.

A major point which has been neglected is that the contractual responsibility for asset valuation is effectively nil. Investors look for an independent administrator as part of their due diligence. Unfortunately, few go as far as checking the weak provisions in contracts between the fund and the administrator. Investors must be encouraged to question these contracts which seek to lay responsibility for the valuation of assets with the managers or custodians when it should lie with the ‘independent’ administrator.

The administrator’s liability must also be contained since it can be very hard to value certain assets. All of this can be managed by the adoption of an agreement for administration services that would predefine potential negligence and incorporate the main principles for reliable solutions.

Adopting a LOVA

Our suggested solution is the adoption of a master agreement (let’s call it the Liability and Objective Valuation Agreement or LOVA) setting out an approach to asset valuation in line with agreed principles and introducing a degree of legal responsibility which administrators can accept (and notably insure).

The LOVA should be worked on and approved by an association of industry participants which must include investors, bankers, managers, insurers, lawyers and price providers. Funds and administrators could either adopt the LOVA as part of existing contracts or use it as a new agreement. Investors would finally have something objective to rely on and could easily check if a manager has adopted the agreement. Banks and other asset managers who value their funds internally could also adopt part of the LOVA and at least investors could check whether its standards are followed and may be able to start to influence things.

The LOVA is based on the premise that the industry can properly self regulate without waiting for investors or politicians to help it change. We have chosen the principles set out by IOSCO, one of the most objective and well known organisations, as the basis for our approach and suggest some clauses (in italics) or comments which would be included in the LOVA:

1. Comprehensive, documented policies and procedures for the valuation of financial instruments

“The Administrator shall have written procedures (the Procedures) for the valuation of assets. Its relevant personnel shall be competent and independent as the Administrator shall reasonably assess. The Administrator shall seek to exercise reasonable controls over the selection of valuation inputs sources and methodologies which shall not be limited to the Custodian or Manager and which shall include two independent sources from the agreed list set out in the Appendix. The Administrator shall have valuation processes in relation to adjustments for liquidity and or size of relevant positions”

This clause is the most important and seeks to pass some responsibility onto the administrator. The administrator should use two independent sources of pricing, even for hard to value assets. The Appendix mentioned (which can be updated from time to time) would include names of industry-approved independent pricing providers.

2. The policies should identify methodologies for valuing all financial instruments held or employed by the hedge fund

“The Procedures will set out the methodology to be used for each financial instrument, which include inputs, models and the selection criteria for pricing and market data sources.”

The industry could create a standard ‘valuation manual’ which could refer to specific types of hard-to-value financial instruments/securities and relate these to specific strategies such as distressed debt, emerging markets and mortgage backed-securities.

3. The financial instruments held or employed by hedge funds should be consistently valued according to the procedures

“The Procedures shall include a mechanism which enables the monitoring of the Administrator and the application of the Procedures by the Manager and relevant information and documents shall be made available to the Manager on reasonable notice.”

Fund managers should check that the procedures are being adhered to by the administrators. This could be done as part of an auditor’s report but the downside of such an approach would be costs. The review of the manager would also implicate their responsibility and thereby offer further comfort to investors.

4. The policies and procedures should be reviewed periodically to seek to ensure their continued appropriateness

There is a need to ensure the consistency of valuation sources and rules over time and the valuation manual would be regularly updated.

5. The policies should seek to ensure that an appropriate level of independent review is undertaken of the individual values, in particular of any valuation that is influenced by the manager

There is a need to ensure objectivity when assessing values obtained from external sources, the best way may be to have an agreed list of price providers.

6. A hedge fund’s policies and procedures should describe the process for handling and documenting price overrides, including the review of price overrides

This is complex and cannot be covered in detail in this article. It would be sensible to set out provisions whereby the parties can agree to override or deviate from a value given to a financial instrument. This is particularly relevant when at present a return to mark to market for some instruments is not deemed appropriate.

7. The arrangements in place for the valuation of the hedge fund’s investment portfolio should be transparent to investors

The adoption of the publicly available LOVA will guarantee clarity for investors and will make any fund that adopts it more transparent.

After all that has been written on valuations we believe that the simple yet complete approach promoted by the LOVA would quickly improve the industry’s standards and increase public confidence. Its clear, open and binding approach should result in a visible commitment from the industry to tackle one of its biggest problems, whilst maintaining its independence. The question is can it be done soon enough….?