Institutional Investor's Alpha Magazine - April 2009 - (Page 61) ment, have always required independent valuation but say they now look over everything even more closely than before. “Even if a due diligence review approves the asset management process, the operational review has a right of veto,” notes Tracey Wiltcher, Nedgroup’s head of product investment management. At Credit Suisse’s fund-of-funds group, the mere presence of an outside administrator is not enough. “We are asking considerably more questions around the process that underlies fund valuation,” says Christopher Vaz, the group’s New York–based head of operational due diligence. Vaz reports seeing an increasing number of detailed valuation policies being adopted between funds and administrators. This heightened scrutiny is applied especially in instances involving illiquid assets. “In the case of the harder-to-value assets, we would expect to spend time with the administrator talking through how they are valuing assets so that we are fully satisfied with the approach,” Vaz explains. Although everybody seems to believe that external administrators have a role to play, there remains substantial disagreement over what that role should be. The London-based Alternative Investment Management Association has produced guidelines that explicitly recommend externally written valuations. The Washingtonbased Managed Funds Association, on the other hand, argues that “in certain instances the investment manager has the best insight with respect to the valuation of particular instruments.” However, two quasigovernmental groups, the Madrid-based International Organization of Securities Commissions and the U.S.-based President’s Working Group on Financial Markets, favor independent valuations. IOSCO recommends “an appropriate level of independent review,” and the U.S. group stipulates that “a fund should generally seek competent and independent review or generation of its final valuations.” Champions of third-party assessments argue that placing counterparty pricing at the core of a valuation model gives true mark-to-market values. This approach quotes prices at which — or close to which — a fund would be able to sell its assets if required. One drawback: When liquidity dries up, there may be no counterparties that can provide a market value. The manager-hosted model, which is likely to have more theoretical pricing, has at times been found severely wanting. Manager reliance on historical data pushed valuations rapidly out of line with reality when demand for asset-backed securities dried up during the financial crisis, sending valuations crashing at such hedge funds as the two Bear Stearns & Co. credit vehicles that collapsed in 2007. Most guidelines imply that the ideal valuation model will vary from fund to fund. Contrast, for example, a longshort equity fund investing almost entirely in exchangetraded stocks against an arbitrage strategy specializing in highly illiquid asset-backed securities. The former’s valuation is best rooted in mark-to-market standards; the latter is not as suited to such an approach, which is why it may be more important to require transparency rather than insist on independent valuation. Fund incorporation documents, in such cases, must clearly defi ne the methodology by which assets are valued. The fine print in cases in which third-party valuations are suitable should also guarantee an outside administrator’s access when market conditions do not favor the manager. “The key point is that the agreement endows the administrator with sufficient independence not to be pressured by the investment adviser when things get difficult,” explains Whitney Bower, a partner and administrator specialist at London-based private equity firm 3i Group, which has $14 billion in assets under management. “Unfortunately, that is not what happened in the Bear Stearns funds, which created huge valuation ranges between internal valuation and fair market value.” The potential price of shoddily drawn agreements has only lately become apparent. Many of the lawsuits pending against hedge funds and funds of hedge funds for their investments with Madoff may fall apart if it is shown that they had been informed that valuations were dependent on Madoff ’s in-house brokerage. The clamor for independent valuation may not sound a gloomy note for managers. “The growing importance of accurate valuations is increasingly clear to managers themselves,” argues Ian Headon, a vice president of hedge fund administration for Chicago-based investment management company Northern Trust Corp. “It can only be healthy because it encourages them to focus on the grow- “Independent administration is something that new investors are in a position to insist on.” — HANS HUFSCHMID, GLOBEOP FINANCIAL SERVICES ing importance of accurate valuation for managing counterparty risk.” Headon and others say that managers who are forced to be more transparent to keep their clients’ assets will inevitably deliver more accurate valuations. Jan Frogg, UBP’s Geneva-based head of alternative investments, acknowledges that some managers who resist independent asset valuation may well be justified. If the review of their valuation processes reveals that a combination of internal and external administration is both accurate and robust, then the redemptions may well be reversed, he says. But regardless of what UBP does, the shift of power from managers to investors provides a clear opportunity for valuation standards to be raised across the hedge fund industry. APRIL 2009 • INSTITUTIONAL INVESTOR’S ALPHA • 61
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