Hedge Fund Asset Pricing Revisited: First; Communicate the Process. Then; Follow the Process. It’s That Easy.

People who know me know that I am way into process and control. Define the process. Test the process. Refine the process. Document the process. Communicate the process. Follow the process with rigor and collect data along the way to ensure that the process continues to be both accurate and stable. This is the way it’s done. Sounds easy, right? Easier said than done in practice (though why, I’m not too sure). Today’s Financial Times carried an article on one of my favorite subjects - valuation of complex hedge fund assets - which is really all about creating an effective, clearly communicated process and adhering to it with religious fervor. While reading the article I had this familiar feeling of deja vu. Where have I read about this illiquid asset valuation stuff before? Hmmm. Oh, that’s right. My blog, that’s where!

This is not a new issue by any stretch, but FT piece does provide a helpful reminder of how important this topic has become given the proliferation of complicated, over-the-counter derivatives such as CDOs, CDSs, TRSs, and other three-letter acronyms. It is only with clear and effective processes and policies that the continued, healthy institutionalization of the hedge fund business can continue apace. Otherwise, issues of trust and transparency will rear their ugly heads and the inevitable blow-ups will occur, ruining what represents a historic opportunity for the hedge fund industry to grow in a prudent, risk-controlled manner and to take its rightful place in the architecture of institutional portfolios as a core asset class. From the FT:

The valuation of hedge fund assets has risen from nowhere to become
a hot-button issue. How to value illiquid instruments is occupying
minds inside and outside the industry. On the inside, the Alternative
Investment Management Association in March published its Guide to Sound Practices for Hedge Fund Valuation. This followed the International Organisation of Securities Commissions releasing its Principles for the Valuation of Hedge Fund Portfolios.
The issue was even on the agenda of a meeting in April of the G7
advanced industrial nations where representatives of leading hedge
funds met deputy finance ministers.

This sudden focus is
recognition that valuation of the increasingly complex assets used by
hedge funds is a big issue for investors. Incorrect valuations can mean
investors pay too much for units in a fund, lose out when they sell, or
pay too much to managers in performance fees.

Pricing and
valuation is only a minor issue in equity long-short funds, where
standard mark-to-market techniques are sufficient. But there has been a
proliferation of sophisticated strategies in recent years that have
required advanced valuation techniques. These techniques are required
primarily for over-the-counter derivatives, which are illiquid and
therefore not easily priced. Instruments include collateralised debt
obligations, credit default swaps, total return swaps and mortgage
derivatives, all of which have grown enormously in popularity.

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Complex and illiquid issues are typically hand-priced, involving an
evaluator calling the desk of a broker-dealer that makes a market in
the security (ideally the primary dealer). Mortgage-related products
are often priced using models with analytical data and dealer quotes as
inputs. Vendors will often incorporate actual trade data into the
models and adjust the model prices in line with any visible trades in
the market. This process is clearly far from straightforward.

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Meanwhile, an Iosco committee including US, UK, French, German, Hong
Kong and Spanish regulators, as well as hedge funds and investors,
proposed nine principles of valuation. The main suggestions were that
hedge funds should draw up policies for valuing investments, ensure
they are used properly and applied as independently as possible.
Valuation methods should also be made clear to investors.

While there are no precise answers to the questions of complex derivative pricing, there can be a precise, clearly communicated process that is followed for valuing such instruments. And this is what will set hedge fund managers free. It is hard to get angry - much less get litigious - if someone tells you the process they are going to follow for handling a complicated problem that is carefully adhered to and logical on its face. No funny business. No single-data point valuation on which NAV and, therefore, compensation is based. Engage several dealers, maybe even rotate among a larger number to ensure fairness and independence, toss out the high and low, document all responses, repeat. To get a sense of how important I believe this issue to be, here are some thoughts I had written last July when discussing how poor illiquid asset valuation can skew NAV and cause a big, big problem for the industry:

But this issue - getting paid on NAV when NAV itself is highly
questionable - is a real problem. It looks bad. Real bad. The
implications extend beyond compensation. For instance, if you can’t
arrive at a fair value for an asset, a “thumb in the air” method is
used like book value minus an illiquidity haircut. This approach dear
friends, is not very scientific and is extremely prone to error. Beyond
error, once an approach is used for a particular asset that approach
tends to be used again and again and again. This has two potentially
adverse effects upon disclosure and compensation: (1) compensation may
be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated
since this asset, whose value invariably is moving up and down but
whose value is difficult to measure, is being valued in the same way
quarter after quarter after quarter. This is called autocorrelation.
This skews the analysis of fund returns and makes a fair comparision
across different firms and different strategies nearly impossible. Does
any of this sound good?

And if the industry doesn’t take steps to address this issue, my
sense is that the issue will be dealt with for them by constituencies
they’d rather not deal with (read: the SEC or Congress). It is just too
big a problem to be ignored, and the problem is growing every day as
more funds pile into less liquid assets for the reasons mentioned
above. One way to possibly deal with this is to create a fund with two
share classes - one which tracks the liquid assets (and therefore has a
calculable NAV) and another which captures the illiquid assets (which
does not have a readily calculable NAV). The liquid asset class could
attract performance compensation in the same way hedge funds are paid
today, which is generally quarterly. The illiquid asset class, however,
could be treated much the way private equity compensation is handled
today, based upon realization of the value of the illiquid investments.
A manager could then report two NAVs, one for each share class. This
would seem to restore the original intention of hedge fund compensation
model, while providing for a better matching of performance generation
and performance payment. This would also be a great PR move for the
industry, proactively dealing with an issue before it becomes a PR
nightmare.

For those who care, here are some posts I had written previously that also discuss the illiquid asset valuation issue:

• 07/21/2006: Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Firms begin?



• 08/04/2006: Side Pockets - Use or Abuse



• 12/26/2006: Hedge Fund Convergence: Strategy Versus Structure



• 04/30/2007: DE Shaw and Convergence: Putting the Issues on the Table

Sometimes getting the right answer is easy. And notwithstanding the complexity of the instruments at hand, the right answer to the valuation question is simple: clearly communicate and follow the process. End of story.

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COMMENT:

AUTHOR: howard Lindzon Associates

EMAIL: howard@lindzon.com

URL: http://www.howardlindzon.com

DATE: 05/28/2007 11:18:24 PM

transparency will come back in vogue as soon as volatility returns

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 05/29/2007 08:27:06 PM

I think transparency will come back when we enter a downturn/recession + we get some blow ups.

But you know what? It will be short lived. Happens all the time. 

Some one blow up = media make noise = senators looking for votes make ripples in an ocean (secretly collecting HF donations) = SEC investigating some Mobe and Jacobe Fund fraud = back to square one.

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3 years ago | view comments |  Hedge Funds