Valuation Becomes Tricky

While many hedge funds now have to register with the Securities and Exchange Commission, the SEC is still leaving funds to their own devices when it comes to valuing their portfolios.

That is not a source of comfort. Some organizations that have studied the valuation issue believe that it deserves more attention than it has received.

Last year the Managed Funds Association, a hedge fund trade group, released a report outlining hedge fund valuation best practices. Some fund administrators are also saying that they have become more vigilant in making sure that hedge funds comply with their own procedures.

The core issue is that hedge funds must take care to separate the valuation process from the fund management function, says Ed Hawthorne, managing principal at financial services consultancy Capco in New York.

In fact, according to a Capco research report released in 2003 but still current, valuation was a primary or contributing factor in 35 percent of the hedge fund failures studied. When fund managers are responsible for valuing their own portfolios, they can hide trading losses, inflate returns, or conceal misappropriated funds, Hawthorne says.

One key problem is that many hedge funds invest in instruments that aren't easily priced. Convertible bonds, for example, can be complex to value, and broker quotes can vary significantly for the same issue.

Emerging markets are another area in which different currencies can create valuation problems, or a lack of liquidity can impede price discovery.

Some hedge funds also invest in custom structures with particular banks. Each investment is unique and complicated, making it very difficult to appraise. "That's where the greatest problem lies," says Hawthorne.

Even straightforward equity investments may be difficult to value if a fund takes a highly concentrated position, which may move a market if it is sold outright. "When a hedge fund adviser has the ability to manipulate the value of the fund, it allows them to hide things," Hawthorne says. "We saw that as a contributing factor in many of the failures we studied."

One solution is to have the fund administrator take care of the valuation process. However, according to Boris Onefater, Deloitte & Touche's national hedge fund director, when it comes to the most illiquid of securities, such as projects designed specifically for the fund, the administrators have to come back to the manager to get the pricing, which can undermine the point of having an independent valuation.

Instead, Onefater recommends establishing a valuation committee for these cases, comprised of the fund manager, an administrator, a representative from the back office and another manager.

But this is not a one-size-fits-all solution. According to a 2005 PricewaterhouseCoopers report, only 37 percent of hedge funds have such a formalized pricing committee and nearly half have no plans to establish one.

There's a good reason for that, explains report co-author Eric Gronningsater, a director in the financial risk management practice of PricewaterhouseCoopers, because not all funds trade in illiquid securities. "If everything you do is in listed equities, then the judgment and pricing that you would get in a pricing committee would not be that helpful," he says. "For listed securities, there is no price determination to make at all. You can just automate the whole process. The review by someone independent from the traders to make sure that the prices are accurate is pretty mechanical."