The first area I will cover is the recommendations on governance. An overriding theme, here as with other industries, is that the board of directors, the general partner or the trustees (as applicable) carry the ultimate fiduciary duty to the fund constituents, which includes the valuation process. I will refer to this governance body as the “board” during the rest of my presentation. One key to good governance is the documentation, codification and regular update of key fund valuation policies. These policies need to be known throughout the organization and be taken seriously from the top down. Another key is the segregation of duties. By eliminating entirely or severely limiting the involvement of the investment managers in the valuation process, inherent biases can be better managed. This generally means using an independent pricing group to value the fund’s assets. The board needs to assess and monitor the performance of the fund valuation group with respect to day to day valuation issues. Furthermore, the board must be confident that appropriate steps have been taken to value fairly and consistently those securities that are complex or hard to price. Its our experience in Canada that there is tremendous variation in the extent and role of boards in the valuation process.
ASSET PRICING AND FUND VALUATION PRACTICES IN THE HEDGE FUND INDUSTRY By the Alternative Investment Management Association Presented by May 31, 2005 Toronto
ASSET PRICING AND FUND VALUATION PRACTICES IN THE HEDGE FUND INDUSTRY Raj Kothari, PricewaterhouseCoopers Stacy Hammett, PricewaterhouseCoopers Derek Hatoum, PricewaterhouseCoopers
73% of manager respondents employ an independent administrator
There are different perceptions as to who is responsible for the NAV calculation process
Hard-to-value instruments are not as prevalent as generally believed
Managers and service providers have differing views on which assets are hard-to-value
There is a general desire to enhance valuation practices and procedures
How important is the issue of valuation for the hedge fund industry? Service providers and managers appear to be more immediately concerned about the issue of valuation., though half of all respondents see this as an important issue
What are the most important pricing and valuation issues? Pricing sources and illiquid assets are the most important issues
What percentage of the hedge fund portfolio do hard-to-value assets represent?
Which instruments do you find most difficult to value?
MBS/ABS of no concern to managers yet yes to 19% of service providers
- credit default swaps are an issue for 17% of managers yet only 3% of service providers
Who performs the NAV calculation? - 93% of administrators are fully independent from the manager - More than 80% of respondents believe that the fund’s administrator and auditor understand how to price hard-to-value instruments
A summary of practical and workable pricing and valuation practices and procedures should be documented, approved by the board of directors, trustee or general partner of the fund and reviewed on a regular basis.
The NAV of the fund should be produced by parties independent of the investment team / the investment manager.
The offering document should explicitly describe the potential limitations of valuation and pricing practices.
Oversight of the entire valuation process and, in particular, resolution of pricing issues associated with “hard-to-price” illiquid positions and exotic instruments is the ultimate responsibility of the board of directors, trustee or general partner of the fund.
There should be adequate disclose of any material involvement by the investment manager in the pricing of underlying portfolio positions or otherwise in the calculation, determination or production of the NAV.
The pricing and valuation policy should be formalised in advance of the fund’s launch and should be adequately described in the fund’s offering document, including a practical escalation or resolution procedure for the management of exceptions.
The pricing and valuation policy should explicitly clarify the role of each party in the valuation process.
The pricing and valuation policy should incorporate appropriate controls.
Price sources for routine pricing should be identifed with the details of the pricing and valuation policy document.
Recommendations on Procedures, Processes and Systems
Where necessary, NAV calculations should be subject to appropriate checks and balances to ensure any actual or potential conflict of interest is appropriately managed.
The industry recognises that in certain instances the investment manager has the best insight with respect to the valuation of particular instruments. Where prices are provided or sourced by the investment manager, the administrator should be provided, where possible, with supporting information by the investment manager.
The use of pricing models or determination methods should be approved by the board of directors, trustee or general partner of the fund.
Where practical and appropriate, pricing models or determination methods should typically be used for illiquid of hard-to-value securities, where an independent source is not available or where it appears that it may not be reliable.
The decision to use a pricing model rather than a market price should be properly justified by back-testing in normal market conditions and applying appropriate stress tests to identify model weaknesses.
Internal valuation methods should be appropriate tested and, where possible and appropriate, independently reviewed and verified.
Underlying data used in pricing model-based calculations should be formally reviewed and approved.