Valuation Best Practices
Hedge Fund Investment Portfolios
Two private-sector committees established by the President's Working Group on Financial Markets
("PWG") released best-practices guidance for the hedge fund industry on April 15, 2008. The Report of the Asset Managers' Committee (the "AMC report") is targeted at hedge fund managers, while the Report of the Investors' Committee (the "IC report") offers recommendations to hedge fund investors? The AMC and IC reports establish a set of key frameworks that aim to reduce systemic risk and promote transparency and protection for investors. This article will briefly discuss the motivation for a robust valuation framework as it applies to hedge funds before delving into the implementation of the valuation framework prescribed by the AMC and IC reports.
MOTIVATION
The global hedge fund industry has exhibited impressive growth in the last two decades. Assets under management have grown from $39 billion in 1990 to around $2 trillion by mid-2008.3 Unlike other investment vehicles, there is a substantial diversity in investment strategies adopted by individual firms within the hedge fund industry. Common hedge fund strategies may be classified as directional (e.g., equity long/short, managed futures, global macro, etc.), event driven (e.g., merger arbitrage, distressed security, etc.) or arbitrage (e.g., convertible arbitrage, fixed-income arbitrage, etc.). Regardless of the specific strategy employed, many hedge funds invest in securities and instruments that are difficult to value, either because they do not have an easily-identifiable market prices, or they are (temporarily) illiquid, or both.
Typically, a significant share of hedge fund manager compensation is tied to fund performance based on the ultimately realized value of the investment positions held by the fund. These compensation (incentive fee) arrangements align investor and manager interests and provide the requisite motivation for superlative manager performance. However, incentive fees can create conflicts of interest between managers and funds in the valuation of fund investments and presentation of fund performance. The conflicts are especially apparent for classes of investments that do not have easily-identifiable market prices. Further, liquidity of most classes of investments may be (temporarily) impaired by inclement market developments, which adds to the difficulty in valuing these investments.
Hedge fund managers need to dispel (the appearance of) conflicts of interest in the valuation of fund investments to gain investor confidence. Appropriate separation between fund management and investment valuation responsibilities, oversight of the entire valuation process, and a special focus on difficult-to-value investments are critical elements of a well-formulated valuation framework. In addition, a robust valuation framework is best complemented by adequate disclosures that discuss the critical elements of the valuation framework.