In the Post-Madoff world, the government and investors are going to be looking closer at how hedge funds operate and report information. Gone are the days of hedge fund secrecy and limited information supplied to the outside world. Investors will put increasing pressure on the government to for more reporting and controls on the hedge fund industry.
Asset valuation is one area that we feel is going to come under increased scrutiny. New regulations are already coming about, such as FAS 157, that require funds to mark illiquid assets to market, but at present funds are not under any regulation as to how they value their assets.
In our experience, many funds don’t use formal procedures for valuing assets – particularly fixed income and derivative products. They usually have an internal "pricing committee" who set guidelines on how the fund will value assets and will periodically reivew those values, but the whole process is done internally.
Many funds use averages of broker quotes to value assets. The fund will gather quotes from the marketplace, make their own judgment calls as to which brokers to eliminate from the equation (usually based on the broker’s relative volume in the issue), and calculate an average price using the remaining quotes. These valuations are usually created by the fund’s traders who are taking a position in these assets, possibly resulting in a biased valuation.
This manual process does not scale easily to the size of the fund. As the amount of positions that a fund owns increase, it becomes an increasingly manually intensive exercise. This situation may lead to manual error and “looser” internal guidelines as to how the valuations are calculated.
It is our view that regulation relating to hedge fund asset valuation procedures will start to move in the direction of mutual fund valuation procedures. Mutual Funds employ a very transparent process to strike a NAV for their investors.
Mutual funds elect a board of investors that guide the fund, among other things, on how to value assets held by the fund. Most mutual funds are required to value assets via a quote from a 3rd party vendor for an unbiased valuation and the board usually directs the fund on which vendor to use. These 3rd parties take the fund subjectivity out of the valuation and create more transparency for the investors.
Pricing Vendors use complex mathematical models to calculate what is known as an Evaluated Price. Similar to the way many hedge funds calculate asset prices, pricing vendors also use broker quotes in their models. The models also incorporate other inputs such as macroeconomic, sector and issuer level data as well as the specific terms and conditions of the individual assets in the model. These additional inputs remove current market anomalies from the current broker quotes yielding a fair and unbiased valuation.
Some might argue that hedge funds trade more exotic assets than mutual funds and that for some of these assets, no vendor exists that currently prices them. To this argument we propose a two pronged approach to the situation – 1) incorporating one or more pricing vendors to provide readily available valuations, and 2) developing a more robust system for gathering broker quotes and calculating prices for more assets where no pricing vendor exists.
FinServ has evaluated and or implemented both of these approaches for several of its clients.
Implementing a pricing vendor involves several steps:
- The fund’s portfolio is broken down into categories that the pricing vendors generally fall into (Bank Debt, CDS, Municipal Bonds, etc.)
- Vendors for each of the categories are identified and evaluated for cost and method of data transmission
- Remaining vendors are given the funds current population of securities to evaluate each vendor for breadth of market coverage, and sample historical prices are received from the vendor
- Historical prices are compared against the funds historical prices and reports are given to the traders for comparison and P&L impact analysis
- Once a vendor is selected, a script is created that extracts the desired asset population from the accounting system and electronically transmits this to the vendor. Another script is created that electronically receives the prices from the vendor and imports them into the accounting system
In the event that a price for an asset cannot be provided by any pricing vendor, we propose
developing a system that will facilitate the manual pricing process employed by the traders for
these assets. This system will do the following:
- Automate the collection of broker quotes
- Provide a repository for all broker quotes
- Automatically calculate the price based on the quotes and other assumptions entered by the trader
- Allow the trader to provide comments and proof as to why they are omitting a quote from the equation
- Provide an audit trail for any changes made in the system
- Automatically import prices to the fund accounting system
- Reporting that can provided to auditors
When a fund employs this two-pronged approach, it will give auditors and investors the valuation transparency that they will be looking for in future regulation.
This approach provides a more scalable automated process that will grow with the fund as well as providing an un-biased valuation that will more easily satisfy audits. It will also reduce errors and workload for the staff involved with valuations at the fund
FinServ Consulting is an independent experienced provider of business consulting, systems development and integration services to alternative asset management firms and their service providers, providing expert, tailored guidance in the design and implementation of business processes aligned with technology and systems.