Hedge Fund Valuation Standards: Evolution, not Revolution
The Bank of New York Mellon Corporation, Kinetic Partners
The demand for alternative investments such as hedge funds is increasing dramatically. Institutional and retail investors alike are attracted to the investment opportunities offered by hedge funds and the prospects of higher returns, compared to traditional investment funds. However, in times of tighter credit and market volatility, all that glitters is most certainly not gold. It is becoming ever harder to generate alpha or, from an investor’s perspective, to pick a fund which will generate genuine alpha. The myriad of hedge fund managers, ranging from small boutiques to substantial departments within large asset managers and global investment banks, presents investors with a wide variety in both the quality of investment management and, importantly, in operational controls infrastructures.
Naturally, the recent volatility in the markets and the ensuing credit squeeze has benefited some hedge fund managers and their funds while making many funds suffer poor performance. Recent fund failures have once more brought operational risk to the fore. Some participants are arguing for increased regulation while others for self-regulation, by the promotion of sound or good practice. It was in this atmosphere that, in October 2007, the 14 leading European-based managers formed the Hedge Fund Working Group (HFWG) and issued a consultation paper proposing industry best practice in a number of operational areas.
One of the most frequently cited topics in the operational risk arena is valuation. This is seen as the most important risk area by far, especially where illiquid, hard-to-value, esoteric investments are concerned. Several hedge fund scandals have surfaced over the last few years that have received public attention and resulted in losses to investors. The SEC has pursued around ten cases per year over the past five years against US-based managers accused of defrauding hedge fund investors or using the fund to defraud others. So far at least, the experience of fraud among US managed hedge funds has not spread to investors in UK managed hedge funds. To assist the hedge fund community, the Alternative Investment Management Association (AIMA) issued a Guide to Sound Practices for Hedge Fund Valuation (The AIMA Guide) in March 2007. Its recommendations cover governance, transparency, procedures and methodology, with the goal of assisting investors, fund managers, service providers and all interested parties in tackling this thorny issue.
This paper aims to gain an understanding of how the recommendations set out in The AIMA Guide have been received by the UK hedge fund community, and in particular, stakeholders involved in the valuation process.
This survey was conducted in the six months following the publication of The AIMA Guide. Participants consisted of UK-based hedge fund managers with assets under management (AUM) ranging from US$10 million to in excess of US$10 billion. The survey was conducted by way of questionnaire and follow-up interviews. In addition to hedge fund managers, our interviews included former regulators and other experienced professionals from the hedge fund sector.
Less Awareness than Expected
Considering the range of respondents, the findings of the survey are remarkably consistent. The survey demonstrated that more than half of the respondents had limited or no awareness of AIMA’s work in this area, despite very high levels of media coverage of the recommendations. While the remaining respondents agreed that some procedures and guidelines on hedge fund valuation are necessary, whether mandatory or otherwise, such formalised policies and procedures have been internally developed in parallel with the work of AIMA’s subcommittee in this area. Those managers whose valuation practices were consistent with the recommendations also demonstrated a high degree of robust internal governance in other operational areas.
Figure 1: Awareness of AIMA Recommendations – Are you aware of the March 2007 AIMA recommendations on valuation?
Widespread Acceptance of Need for Improvement
Although not all respondents were aware of AIMA’s recommendations at the time of surveying, there was a general consensus that better governance of hedge fund valuation practice would be beneficial. As alternative investment products become more available to both retail and pension fund investors, so the reputation and financial risk to the industry of a valuation failure becomes more acute. Greater expectations about standards of operational risk controls from new classes of hedge fund investors, and pressure by regulatory forces to protect private investors from exposure to complex alternative products, is increasing the need for ever higher standards of operational risk control.
Figure 2: Necessity of guidance – Is guidance in this area necessary?
Recommendations are being Implemented but do They Make a Difference?
Almost two-thirds of the respondents have implemented one or more of the recommendations, in many cases through a wholly-independent process. Sound valuation practice is seen as a naturally-evolved feature of a well organised alternative asset management business whose interests must, de facto, be aligned with those of its investors. Encouragingly for proponents of the AIMA Guide, respondents felt that such a commonality of interests was essential to business success, and that the recommendations on valuation practice constitute common sense procedures which many already largely followed. Consequently, the large majority of respondents felt that their valuation risk remained unchanged following implementation of AIMA guidelines or their equivalent.
Figure 3: Valuation Risk following Implementation – Following implementation, does your valuation risk remain
The Valuation Policy Document is Heading for Universal Acceptance
A good example of a recommendation being implemented is the Valuation Policy Document (VPD). In our survey, 60% of the respondents confirmed that they utilise a VPD, with the remaining 40% professing a plan to introduce a VPD in the near future. This should be welcomed, provided that the VPD is of sufficient breadth and depth and that it is followed in practice. The VPD is “a summary of valuation practices, procedures and controls approved by the Governing Body”. As a key component in the dissemination of valuation data, a fund’s third-party administrator may find itself subject to the requirements and strictures of the VPD. The administrator’s role may vary from simple collation and compilation of figures to detailed calculation of values, triangulating the output of third-party valuation agencies in the case of harder-to-value investments. To minimise tension and misunderstanding, therefore, it is clearly vital that a fund’s administrators play a leading role in the development of the VPD.
If valuation of hedge fund assets is to be viewed with confidence by current and future investors, greater transparency and accountability can only be a good thing. The 2007 revision of AIMA’s pro-forma due diligence questionnaire for fund investors includes questions on operational risk management, including valuation. In a convergence of marketing and good governance, we consider it likely that a fund’s VPD will also be required reading for investors and funds of funds.
Furthermore, a review of the VPD, its comprehensiveness and quality, should become an essential part of the due diligence process.
The Good, the Sound and the Best
Our survey and subsequent interviews found that various industry bodies were confused about AIMA’s recommendations. There has been a promulgation of sound/best practice requirements and standards devised by various bodies such as IOSCO, AIMA, USA MFA, the FSA and others. These standards want to achieve good practice, sound practice, best practice or peer group comparisons, with AIMA being the most wide reaching. There is no accepted definition or terminology regarding, for example, best practice versus sound practice, which leads to confusion. Participants commented that AIMA is regarded as a trade association, thus the ability to impose standards is limited and not effective. That said a few participants supported specific regulation in this area, imposed on them by the statutory regulators.
As the graph below in Figure 4 illustrates, AIMA’s recommendations have yet to have a clear impact on the industry. If we analyse this further we may conclude that the guidelines have not sufficiently penetrated its target group or received the intended attention from the management of the hedge fund community. Could this be because AIMA’s remit is too far reaching? Or is it because there are too many alternative standards?
Recently, another group was formed to further the thoughts on good governance for hedge funds. The HFWG was created in October 2007 to articulate the view of the larger European hedge fund managers. Among its objectives, the HFWG is trying to persuade the hedge fund community to ensure that valuation best practice is a prerequisite for consideration as a top-tier alternative investment management company.
Figure 4: Awareness following Changes – Has your awareness of the valuation issues changed since AIMA’s publication?
Lack of Consensus on the Need for Regulatory Enforcement of Standards
There was no consensus regarding whether AIMA’s recommendations should be made mandatory by regulators. Respondents in favour of regulation felt that recommendations would increase industry confidence and result in more robust and better controls. They also expressed the view that the recommendations are more critically relevant for managers holding illiquid or hard to value instruments but that the whole universe of hedge fund managers should strive to operate to a set of industry standards.
Respondents against more regulation stated that AIMA does not have the jurisdiction to set binding rules and that the cost of implementation combined with existing mandatory projects such as MiFID and ICAAP could damage the attractiveness of the UK as a centre for investment managers. An argument in line with this was that regulators should not enforce recommendations from trade bodies. Some respondents were of the view that they should not be enforced and it is the responsibility of investors to do their own due diligence and that self verification is more effective than rules-based regime. Another argument against regulation was that due to the unique nature of individual funds a “one size fits all” regulatory regime on valuation would not be appropriate. What is agreed with the majority of respondents is that fund managers and investors must understand best practice and fund managers themselves should determine how that best practice should be implemented for their own funds.
Overall, both advocates and opponents of regulation seem to agree on the value of the recommendations as potential for setting an industry standard and promoting best practice.
Enforcing best practice through regulation has its own challenges. The biggest one might be that the funds are domiciled offshore and their offshore directors are largely governed by very ‘light touch’ regulation. The SEC currently has limited control over the industry as the majority of US managers are not regulated and in the UK, prescriptive regulation does not sit well with the FSA’s more principles-based approach. The FSA’s clearly expressed view is that detailed standards are best developed by industry bodies such as AIMA and the HFWG.
1. Too Many Standards?
It is fair to conclude that we are not facing a revolutionary move towards implementation of radical reforms in valuation practices. Furthermore, even in a perfect world where all participants in the marketplace adhere to the recommendations of industry bodies, comments by the respondents suggest that valuation risk will always be present. Bearing in mind the multitude of different strategies and complex products in place, it is not possible to set rigid standards that work for all scenarios. It is an inevitable function of the fundamental nature of hedge funds, where esoteric investment opportunities and derivative products are sought out, that valuation and its related risk will always be a topic of interest for investors.
While there was almost a 50/50 divide as to whether AIMA’s recommendations should or should not be enforced by regulators, the results and analysis above tell us that enforcing sound practice through regulation might not prevent the next market crisis. That said, respondents in favour of regulation believed that enforcement would increase industry confidence and the net effect would be a more robust and better controlled alternative investment industry. It would also focus managers’ attention and make them strive towards higher standards. The argument against regulation is of course that one regulator does not have the jurisdiction to set binding rules as most hedge funds exist in a multi-regulator environment and that if, for example, the FSA forced regulation in this area, it could severely damage the attractiveness of the UK as a centre for investment managers relative to other centres for investment management of alternative products.
2. Are Fund of Funds Robust Enough in Enforcing Standards?
Perhaps fund of hedge funds managers, as major asset allocators, are best placed to demand implementation of best practice governance and control regarding valuation procedures at hedge fund level and as they invest the bulk of institutional funds. The risk is that the fund of funds model acts as a blockage to investors really understanding valuation practices, since the investor relies solely on the due diligence undertaken by the fund of funds manager as intermediary. Consequently, when investors invest through funds of funds, they delegate the responsibility for due diligence and investment decision to the fund of funds manager and hence there is risk of an undue reliance on them undertaking proper due diligence before investing. Also, the incentive for investors to keep informed about best practice and actual procedures in place is eliminated. Thus they may not be able to recognise best practice or, more importantly, weak practice. The proof of the matter is when funds of funds withdraw investments from hedge funds where the primary reason for disinvestment is a lack of adequate control over the valuation process.
3. Robust Fund Governance – Time for a Governance Policy Document?
As is well known, the dispersed legal nature of hedge funds is driven by fiscal necessity. The legal position is that the Governing Body of the fund appoints all of its advisors, including service providers, the investment manager(s), administrator(s) and the prime broker(s). This has negative consequences though when things go wrong as the primary jurisdiction most likely is the Cayman Islands. The Cayman Islands Monetary Authority (CIMA) has a ‘light touch’ regulatory approach and does not direct industry standards through principles-based (or other) regulation. This inevitably leads to much time consuming and costly legal wrangling over loosely drafted documents such as Service Level Agreements. If industry bodies really want to make a difference in this situation then CIMA needs to engage with industry organisations in the same way as the FSA, and standards need to be set around fund governance, perhaps an overall Governance Policy Document (GPD) akin to the VPD.
Appendix – Bibliography
“Hedge Fund Standards: Final Report”
“Hedge Fund Standards: Consultation Paper”
Part 1: Approach to best practice in context
Part 2: The best practice standards
“Asset Pricing and Fund Valuation Practice in the Hedge Fund Industry”
“AIMA’s Guide to Sound Practices for Hedge Fund Valuation”
“Hedge Fund Operational Risk: Meeting the Demand for Higher Transparency and Best Practice”
The Bank of New York
The Bank of New York Mellon Corporation is a global financial services company focused on helping clients manage and service their financial assets, operating in 34 countries and serving more than 100 markets. The company is a leading provider of financial services for institutions, corporations and high-net-worth individuals, providing superior asset management and wealth management, asset servicing, issuer services, clearing services and treasury services through a worldwide client-focused team. Additional information is available at www.bnymellon.com
Kinetic Partners is a global professional services firm providing audit and assurance, tax, regulatory risk and compliance, and forensic services to the investment management industry. Launched in 2005 as a viable alternative to the ‘Big Four’ for clients wanting in-depth industry expertise, they are a true global partnership structure offering a seamless and bespoke service.Additional information is available at www.kinetic-partners.com