Hedge fund valuations: An art or a science?
Olwyn Alexander of PricewaterhouseCoopers Dublin outlines the methods and benefits of consistent and accurate hedge fund valuations.
For the impressive success of the hedge fund industry to continue in a business where reputation is everything, consistent and accurate valuations are of paramount importance.
Hedge fund valuation issues are more far-reaching than for traditional mutual funds, and valuations range on a wide spectrum of quantitative/qualitative and objective/subjective factors.
In examining the issues and responsibilities in hedge fund valuations, this article will focus on three hotly debated areas: counterparty versus model valuations, liquidity, and stale prices.
Which is more appropriate and more reliable - counterparty quotations or model valuations for positions held? Both have positive and negative aspects, and both need to be considered in a valuation.
Counterparty valuations are model valuations, but with less transparency on the models and inputs being used as the counterparty is simply providing the final value.
Counterparty valuations raise concerns about reliability - whether it is provided by a knowledgeable trader or a more junior employee removed from daily trading activity and whether it is biased based on the counterparty desk's own position in the instrument.
Consistency of the models and inputs being used and the timeliness of the valuation quotes being provided is very important, with more and more hedge funds now seeking daily indicative NAVs.
However, as the counterparty is often the party with whom the position's valuation must be agreed and closed out ultimately, their valuations should not be ignored, but nor are they likely to be sufficient as the single source.
With model valuations, a standard industry model should be used whenever possible. If an in-house model is used, it should be independently tested, benchmarked and calibrated to industry accepted standards to ensure consistency of approach.
The source of inputs, their reliability and their consistency has to be assessed. Industry information is improving with the advent of consensus data, but there is still a good deal of subjectivity involved.
For example, is there sufficient historical information on recovery rates in the dot com industry to be reliable? There should be standards or guidelines for price overrides.
Finally, there is the issue of the black box - if the knowledge and understanding of the model is with one or two people can the valuation be assessed for reliability? This is where the combination of counterparty valuations and model valuations can highlight either errors or blatant misrepresentation and/or fraud by providing at least a benchmark to each other.
Liquidity is always an issue but particularly with certain strategies such as convertible bonds, CDOs, distressed debt and emerging markets. If a quoted market price is available, the use of liquidity discounts is actually inconsistent with most generally accepted accounting standards.
However, many practitioners believe that liquidity discounts are necessary to reflect true fair value. This has resulted in some funds having two NAVs - a trading NAV and a reporting (GAAP compliant) NAV.
The trading NAV incorporates liquidity discounts, considering the size of the position held versus both the total amount of the investment in issue and the average daily trading volume.
Some managers recognise that their purchase/sale of a large position can move the market and influence price, so using market value is not considered true "fair value" in these instances.
Taking liquidity to its extreme brings the issue of stale pricing. How old is stale? The SEC states that "if an exchange or market on which a security is traded does not open for an entire trading day, and no other market prices are available,
a security price is deemed 'not readily available' and requires the use of fair
This insight into the regulator's way of thinking may come to bear on hedge fund managers over time.
There does not appear to be a commonly accepted definition in the hedge fund industry, with many variations in different hedge fund managers' pricing policies.
It's not unusual to find the latest traded price being used as the default price, even though it can be up to three months old with no indicative valuations since the valuation point obtained! This is an area where some hedge funds could enhance procedures by addressing them in their pricing policies and implementing a mechanism for board approval and oversight.
So in the debate of art versus science, in the world of valuations, science is the valuation process and structure, while art allows the element of judgement and subjectivity to creep in.
Overall the valuation process should be as scientific as possible to enhance consistency and reduce the level of subjectivity. Certain instruments will always require some artistic flair, but as far as possible the pricing process should be documented and consistent to keep that artistic flair in check!
Hedge fund valuation is a complex area, posing many industry challenges. The starting point should be consensus on the definition of valuation with the next step pushing the valuation process to be as scientific as possible. The end goals are to minimise the areas of subjectivity and achieve consistency in an increasingly complex valuation environment.
This article was prepared by Olwyn Alexander, PricewaterhouseCoopers, Dublin (Tel: 3531 704 8719).
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