Valuation of Hedge Fund Portfolios - IOSCO releases paper for public consultation
Briefing Note 029
14 March 2007
IOSCO has today published "Principles for the Valuation of Hedge Fund Portfolios". This outlines high level principles that should be utilized by hedge funds to control the valuation process when valuing financial instruments within their investment portfolios. Particular challenges arise when valuing illiquid or complex financial instruments and because of the central role that the hedge fund manager may have in contributing to valuations.
Why IOSCO undertook to write a paper on valuation principles
Due to the wide range of business structures adopted by hedge funds and the international mobility of capital, IOSCO believed it would be beneficial to promote a single set of valuation principles that are applicable across a wide range of jurisdictions and hedge fund business models.
The valuation of the investment portfolio of a hedge fund has a direct influence on the reported financial returns to investors. Additionally it determines the performance record of the fund, the price at which interests in the fund may be traded, and the remuneration of the hedge fund manager.
Issues associated with illiquid or complex financial instruments.
Investment strategies which involve exposure to illiquid or complex financial instruments can increase the challenges in obtaining an appropriate valuation. Examples are the lack of readily observable market prices in non-liquid markets and the use of models that rely on subjective data inputs. Additionally, the use of leverage will increase the impact of valuations used in the determination the Net Asset Value (NAV) of the fund.
The essential framework to facilitate appropriate valuations is the establishment and consistent application of documented valuation policies and procedures coupled with independent oversight by the hedge fund's Governing Body of the valuation process.
Conflicts of interest.
The manager of a hedge fund may exercise a significant amount of control and influence over valuations, both in contributing prices for valuing financial instruments and recommending the valuation policies and pricing procedures which document the valuation process. The actual or potential conflict arises because the interests of the hedge fund manager may not be aligned with existing or potential investors in the fund. Usually, the hedge fund manger is paid fees which are based on a combination of the value of the fund and on the performance of the fund over time. The ability of the fund manager to influence the reported valuation of the fund, to the detriment of investors entering or exiting the fund, may be mitigated, in part, by application of the Principles. These Principles recognise the valuable and necessary contribution a hedge fund manager can make to the valuation process, while outlining approaches which increase independence of the parties involved with valuations.
Independent oversight
Responsibility for independent oversight of the valuation process rests with the Governing Body. A number of practical measures are outlined which could be utilized by the Governing Body to increase independence in hedge fund valuation. Examples of structures which increase independence in the valuation process are the use of third party pricing services, independent reporting lines within the Manager and the establishment of a valuation committee.
Joint Industry – Regulator collaborative effort
IOSCO worked closely with expert practitioners in writing the Principles. Hedge funds contract with specialist service providers many of which play a critical role in the valuation process. Consequently, the expert industry group was comprised of administrators, auditors, fund of fund managers, hedge fund managers, prime brokers and valuation service agents. IOSCO is grateful for the time, effort and invaluable insight into the practical realities of all aspects of the valuation cycle delivered by the industry practitioners.
Application of the principles
The principles should be considered by investors when undertaking initial or ongoing due diligence. Investors have a direct interest in ascertaining the extent to which a hedge fund complies with the principles. Where the principles are adopted by hedge fund managers, it will strengthen the valuation process and enhance investor protection. The principles are applicable across a wide range of jurisdictions as well as a number of hedge fund and service provider structures and in cases are relevant to the interests of investors.
Your chance to comment
This paper is open for public consultation and IOSCO would welcome submissions from investors and all sectors of the financial community. The closing date is 21 June 2007.