Valuations: Not a Trivial Pursuit

GAM's Malcolm Paterson looks at a major source of operational risk

Malcolm Paterson, Operations Manager, Multi-Manager, GAM

On the surface, the back office and administrative aspects of hedge fund operations may be less exciting than the investment strategies and performance of the funds themselves but they represent one of the biggest risks associated with hedge fund investing and have certainly grabbed the headlines when hedge funds have collapsed. Those investors who are prepared to spend time ensuring that the operational processes of the hedge funds in which they are invested are sound may reap the rewards.

The facts speak for themselves. A 2003 survey by Capco of hedge fund failures found that some 54% of failed funds had identifiable operational issues and that half of all failures could be attributed to operational risk alone. Given that "operational risk" covers a wide range of issues, it is significant to note that by far the biggest category was the misrepresentation of fund investments, accounting for 41% of the issues in the study. This makes it clear that understanding anddealing with pricing issues in relation to hedge fund investments is crucial for investors to protect themselves from the negative effects of being associated with a hedge fund failure; both in terms of capital losses as well as damage to their reputation. In this piece, we seek to highlight areas where increased awareness by hedge fund investors may help them to manage the risks of mis-valuation in their portfolios.

What is fair value pricing and how does it affect my investment?

Hedge funds seek to provide 'fair value' pricing of the securities in their portfolios. This can be defined as the best estimate of the amount that the fund will receive on the sale, or pay on the purchase (to cover a short position), of each security at a given valuation point. The intention is to produce an "equitable" dealing price for the securities issued by the fund and therefore protect incoming, outgoing and ongoing investors in the fund.

The key issue for hedge fund investors is to ensure that funds in which they are invested, or are considering as a potential investment, are using fair and appropriate pricing procedures in a consistent manner in the valuation of their portfolios. This is fundamentally important as the value of these positions is used as a basis for determining the net asset value (NAV) of the fund, which in turn is used for subscriptions, redemptions and analysis of the performance of the fund.

In the case of liquid securities which are widely traded, fair and impartial valuations are relatively straightforward. There are independent pricing sources, such as IDC, Bloomberg or Reuters which, in turn, take their feeds from the relevant exchange on which that security is traded. This ensures minimal differences between the pricing feeds.

However, with the increasing complexity of instruments traded by hedge funds (many of which are not exchange-traded), securities may be more difficult to value as they may not be frequently traded or there simply may not be a readily accessible or available independent pricing source where prices can be obtained. Therefore, more care has to be incorporated into the pricing procedure.

A common approach to overcoming this issue is to use a range of quotes from brokers and market makers in order to find a mid-point or consensus valuation. However, this is not always possible – for example, an exotic OTC derivative may be very thinly traded, so may be priced by the manager using various (sometimes proprietary) mathematical models which are dependent on various inputs and assumptions.

This inherent difficulty in obtaining a fair valuation can easily become a catalyst for mis-valuation of a hedge fund's portfolio if the valuation process lacks robust internal procedures and management. Some consideration should be given to how often the manager takes a "reality-check" against the market-maker's determination of the value. In such cases, it should be borne in mind that there may be an inherent tendency for the market-maker to provide prices which protect its own book, so perhaps other questions that should be asked are: what tolerance is considered acceptable between the manager's price and the market-maker's price; what procedures are in place to both identify and escalate this; and who is involved in the final decision-making process on how to value such a position?

The origins of mis-valuations

Misleading or misrepresentative valuations for hedge funds typically arise as a result of the following factors:

  • Fraud or misrepresentation of securities in a portfolio
  • Mistakes in valuation
  • An inherent failure in the process or procedures applied to the valuation of the portfolio.

If a hedge fund manager or trader deliberately seeks to conceal losses or misrepresent the value of a holding (perhaps to enhance any incentive fee based on the performance of the fund), this would constitute fraud or misrepresentation. In other cases, a manager might inadvertently use an invalid price as a result of incorrectly identifying a security.

Mistakes in valuation – either accidental or intentional – can arise where the fund has used incorrect assumptions or where the valuation is not a "fair value" due to particular circumstances at that time. Take, for instance, a situation in which a manager holds a large proportion of a single convertible bond issue. Although prices may be readily available, the valuation may require adjustment in the form of a discount due to the size of the holding. The discount should reflect the practical reality of a manager trying to liquidate a position of such size that it would be likely to have an adverse effect on the market. A clear understanding of who is involved in the decision-making process is essential. Consistency of methodology is also vital to ensure that managers are not varying the type of price used to suit their own needs – for example, where quotes have been obtained from the same brokers week-in, week-out, then the brokers are not changed just because they are proving quotes that might suit a manager more. Appointment of a reputable third-party administrator may help in ensuring such consistency.

Mis-valuations can be systemic

In addition to these security-specific situations, errors in valuation can also occur due to inherent flaws in the valuation process which combine to cause a systemic mis-pricing of the portfolio. This problem might arise more commonly in OTC derivatives, convertible bonds, bank loans, asset and mortgage backed securities where valuations are often based on complex pricing models or limited counterparties in the market and where incorrect or inappropriate assumptions such as discount rates or exchange rates can lead to misleading valuations of a security.

Strategies at risk of mis-valuation

There is a higher risk of valuation errors in some hedge fund strategies. Strategies such as equity long/short have relatively lower valuation risk due to the fact that the securities they trade are generally liquid and prices are readily available. These have minimal variation between pricing sources since they derive their closing prices from the relevant principal exchange on which they are traded.

Among the instruments which may require more scrutiny are credit default swaps, convertible bonds, and other securities where broker quotes can vary widely, particularly for some issues where there is very limited liquidity. Other instruments include asset-backed securities (including mortgage backed securities), bank loans and distressed debt due.

Preventative measures

Steps can be taken to reduce the risks associated with the hedge fund valuation process. These include:

  • Implementing clearly-defined policies and procedures regarding the valuation of securities
  • Ensuring that the prices of securities are verified by an independent administrator
  • Segregating trading function from the middle/back office functions which are responsible for trade confirmation and portfolio pricing
  • Reviewing of valuations by independent directors and principals of the fund

The first point is particularly important. Any deviations from the established process or policy should be noted in writing and approved by the fund's board of directors or trustees, regardless of whether the fund has delegated the process of valuation to third parties, such as the fund administrator. Where there is no independent administrator appointed, the fund should seek independent verification that the manager is adhering to the valuation policies and procedures, such as a periodic audit by the fund's auditor.

Segregation of duties and the independence of back office functions have long been fundamental principles in the regulated fund world but are not always applied in all areas of hedge fund activity, particularly as many hedge funds are managed by "small shops". These principles require that the person who performs and checks the valuations shouldnot receive incentives tied to the level of the valuation or the manner in which the securities are traded. Ideally, this task should be undertaken regularly by an independent valuation agent who also recalculates the NAV, verifies the prices of the underlying portfolio securities and confirms independently that the securities in the portfolio exist. Typically this is undertaken by an independent fund administrator as part of the regular process of calculating the fund's NAV.

In addition to this, the directors or trustees of the fund should also review valuations. In particular, when fair value pricing has been used (i.e. when the manager has marked the position), there should be evidence to support the valuation which is reviewed and forms partof the fund's formal records. The way in which discrepancies or differences of opinion over valuations are dealt with can be indicative of how much or how little oversight there is of the valuation process and hence act as warning signals for potential problems in those funds trading less liquid securities. There are increasing numbers of third party service providers purveying independent pricing services for OTC derivatives and asset-backed securities, and although these may rely on proprietary or other models for their valuation, use of these third party providers may provide additional reassurance.

Conclusion

In summary, when investors are assessing hedge funds, their due diligence processes should seek to establish how the fund conducts pricing and particularly whether prices are independently verified. Pricing should be carried out either by an independent fund administrator or through a periodic audit of the valuations. Investors should ensure that they understand how the valuations for various securities are derived. This does not necessarily mean that the valuations will be "correct", but it does make it easier to identify how prices have been dealt with and to also identify valuation risks in situations where prices may be subject to adjustment or where there is manager subjectivity involved.

Consideration should also be given to infrastructure in terms of depth of resource, reporting lines, independent pricing committees, and segregation of duties as strength in such areas may reduce the risk that portfolio prices have been mis-stated.

Whilst the risk of mis-valuation can never betotally eliminated, consideration of some of the issues dealt with in this article and the adoption of robust due diligence and monitoring processes by hedge fund investors both prior to, and after investment, may be useful in managing some of the operational risks of hedge fund investment.