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Critical Issues for Hedge Funds

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Capitalizing on the Demand for Valuation

June 4, 2007
By Katherine Heires

Among hedge fund operational priorities, the degree to which a fund is able to accurately price and report on its portfolio of investments is high on the list. "Reviewing hedge fund valuation practices is one of the biggest areas of focus in our work," says Reiko Nahum, founder of Amber Partners, a consulting firm with offices in London, New York and Bermuda that specializes in conducting assessments of operational practices at hedge funds and then providing certification to those funds that receive a passing grade.

An in-person assessment of valuation practices is a high priority in part, Nahum says, because this is an area particularly vulnerable to manipulation and misrepresentation by managers. Currently, 40 hedge funds have been reviewed and certified by Amber, information that is available for review free of charge by accredited hedge fund investors via a fund-specific password available for each manager at www.amberpartners.com. There, visitors can see the types of securities typically traded by a fund, the manager's pricing policy, its daily pricing process and what the administrator does to independently set securities prices at month-end.

According to Nahum, aside from certification, recent trends in hedge fund valuation include the growing use of valuation committees, particularly by larger funds, to assist in the pricing of illiquid or infrequently traded instruments as well as the proliferation of side pockets, which are portions of a hedge fund with different liquidity provisions--a kind of fund within a fund.

"Committees are becoming far more common," Nahum says, after being a relative rarity five years ago. Similarly, while the use of side pockets as an accounting treatment was rare in the 1980s, they are now common at funds that trade in many hard-to-price or illiquid investments. Nahum adds that if not properly executed, side pockets can result in serious accounting problems. "Because of the opportunities for abuse," she says, "managers need to establish formal policies and make their side-pocket practices very clear."

Accounting Specialists

Helping funds address such issues is the mission of Nahum's 18-month-old advisory firm. It is staffed with eight hedge-fund-savvy accountants including Nahum herself, a chartered accountant and former global head of operational risk due diligence at Geneva-based Union Bancaire Privee, one of the largest funds of hedge funds in the world.

Her team of reviewers, which has assessed over 600 funds, is often hired to review and, if appropriate, certify the operations of hedge funds around the globe. The demand has spawned a growing business where the competition now includes rating agencies Moody's and Standard & Poor's.

Although Amber's clients can be investors, they very often are the hedge funds themselves, which are increasingly eager to assure current and potential investors that they maintain best practices in valuation as well as management organization, fund structure, back-office processes, and independent oversight (administrator and service provider practices).

"Our biggest supporters are the pension funds, endowments, family offices and fund of funds groups that understand that, while they may do their own due diligence, more information from organizations such as ours can only be helpful to them," Nahum says. Plus, when the hedge fund pays for the review process with a goal of obtaining a third party's certification, "it's a no-brainer for them to get our reports, which are free for them," she adds.