Critical Issues for Hedge Funds
The State of Valuation | A Global Balancing Act | Hedge Funds Not Sold on Self-clearing | Capitalizing on the Demand for Valuation
The State of Valuation
June 4, 2007
Susan Mangiero, president and CEO of Trumbull, Conn.-based research and consulting firm Pension Governance, is a valuations and financial risk expert with over two decades of experience in capital markets. A frequent speaker on hedge fund and risk matters, and an accredited appraiser, Mangiero is the author of "Risk Management for Pensions, Endowments and Foundations" (John Wiley & Sons, 2005).
Before founding Pension Governance in 2005, she worked on trading desks at Bank of America, Bankers Trust and First National Bank of Chicago. Mangiero, who holds a PhD in finance from the University of Connecticut and an MBA from New York University, recently spoke with Securities Industry News compliance editor Carol E. Curtis about why valuation has become so important for hedge funds, and how the industry can satisfy investors and regulators that it is handling valuation properly.
How is "valuation" defined as it applies to hedge funds? Generally speaking, the term refers to the price at which informed, willing third-party financial buyers and sellers would transact. That said, there are different standards of value, so valuation must be clearly defined at the outset.
Why is valuation so important in this industry? Valuation numbers drive nearly every financial decision. Hedge fund managers need to know how to rebalance their portfolios, adjust risk management positions and report numbers to investors upon which they earn their fees. Valuation becomes especially important in the case of illiquid investments like private equity, distressed securities, emerging-market securities and complex derivatives. It is also an issue as more hedge funds go public. How else will you come up with a net asset value for the initial public offering, without a formal assessment?
Additionally, institutional investors are on the hook to understand how hedge funds value their holdings. The last thing pension fund, foundation or endowment fiduciaries want is a blowup that could have been prevented with a thorough vetting of the managers' valuation process. That includes assurance from the hedge fund managers that numbers are being provided by an independent third party.
What does that process entail? Selection of a proper valuation model is critical. Moreover, the value of an individual holding or portfolio of securities can, and often does, change over time. That's why it is so important to think of valuation as an ongoing process. This includes ongoing validation of valuation models, a review of source data and a check that valuation standards and practices are in use that are accepted by the industry.
What should institutional investors be asking about hedge fund valuations? In the aftermath of new regulations such as the Pension Protection Act of 2006, endowments, foundations and pension plans can ill afford to put money in alternative investments without asking tough questions. At a minimum, fiduciaries should ask for a copy of the hedge fund's valuation policy and procedures. If told that this information is proprietary, then an institutional investor should ask to meet with the person or persons responsible for establishing, implementing and adjusting valuation policies and procedures. General statements in the private placement memorandum that give full discretion to the hedge fund managers to value positions as they see fit are likely to be cold comfort for an institutional investor. Even if a hedge fund manager chooses not to have positions valued on an ongoing basis (and there could be legitimate reasons for that decision), an institutional investor needs to inquire about risk drivers. Has the hedge fund manager conducted any type of sensitivity analysis on identified qualitative and quantitative factors to identify likely impact (direction and magnitude) on portfolio value as one or more of the factors changes? Has the portfolio been stress-tested?
