ASSET PRICING AND FUND VALUATION PRACTICES IN THE HEDGE FUND INDUSTRY

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ASSET PRICING AND FUND VALUATION PRACTICES IN THE
HEDGE FUND INDUSTRY
May 31, 2005 Toronto
By the Alternative Investment Management
Association
Presented by
PwC
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ASSET PRICING AND FUND VALUATION PRACTICES IN THE
HEDGE FUND INDUSTRY
Raj Kothari, PricewaterhouseCoopers Stacy
Hammett, PricewaterhouseCoopersDerek Hatoum,
PricewaterhouseCoopers
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OVERVIEW
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• What were the drivers of this research?
• There is an increasing range of hard-to-value
  securities within hedge fund portfolios
• There is increased focus on the issues of pricing
  and valuation, from regulators, investors and
  managers

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• Study Objectives
• To assess the issues relating to pricing and
  valuation from a broad range of viewpoints
• To summarise concerns
• To make recommendations for enhancing existing
  practices and procedures

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• Approach
• Detailed questionnaire circulated globally
• Respondents hedge fund managers, fund of funds
  managers, investors, administrators, prime
  brokers and custodians, accounting firms and
  auditors
• Collection and analysis of data

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• Key Facts
• Hedge fund industry is less than 5 of global
  fund industry
• Approx 1trn under management in hedge funds at
  end 2004
• Approx 80 of all assets are within
  easy-to-value strategies
• Continuing maturity and sophistication of
  approach
• General understanding of potential issues and
  solutions

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KEY FINDINGS
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• Key Findings
• 73 of manager respondents employ an independent
  administrator
• There are different perceptions as to who is
  responsible for the NAV calculation process
• Hard-to-value instruments are not as prevalent as
  generally believed
• Managers and service providers have differing
  views on which assets are hard-to-value
• There is a general desire to enhance valuation
  practices and procedures

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How important is the issue of valuation for the
hedge fund industry?
Service providers and managers appear to be more
immediately concerned about the issue of
valuation., though half of all respondents see
this as an important issue
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What are the most important pricing and valuation
issues?
Pricing sources and illiquid assets are the most
important issues
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What percentage of the hedge fund portfolio do
hard-to-value assets represent?
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Which instruments do you find most difficult to
value?

• Some mismatch
• MBS/ABS of no concern to managers yet yes to 19
  of service providers
• - credit default swaps are an issue for 17 of
  managers yet only 3 of service providers

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Who performs the NAV calculation?
- 93 of administrators are fully independent
from the manager - More than 80 of respondents
believe that the funds administrator and auditor
understand how to price hard-to-value instruments
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RECOMMENDATIONS
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• Recommendations on Governance
• A summary of practical and workable pricing and
  valuation practices and procedures should be
  documented, approved by the board of directors,
  trustee or general partner of the fund and
  reviewed on a regular basis.
• The NAV of the fund should be produced by parties
  independent of the investment team / the
  investment manager.
• The offering document should explicitly describe
  the potential limitations of valuation and
  pricing practices.

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• Recommendations on Governance
• Oversight of the entire valuation process and, in
  particular, resolution of pricing issues
  associated with hard-to-price illiquid
  positions and exotic instruments is the ultimate
  responsibility of the board of directors, trustee
  or general partner of the fund.
• There should be adequate disclose of any material
  involvement by the investment manager in the
  pricing of underlying portfolio positions or
  otherwise in the calculation, determination or
  production of the NAV.

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• Recommendations on Transparency
• The pricing and valuation policy should be
  formalised in advance of the funds launch and
  should be adequately described in the funds
  offering document, including a practical
  escalation or resolution procedure for the
  management of exceptions.
• The pricing and valuation policy should
  explicitly clarify the role of each party in the
  valuation process.
• The pricing and valuation policy should
  incorporate appropriate controls.
• Price sources for routine pricing should be
  identifed with the details of the pricing and
  valuation policy document.

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• Recommendations on Procedures, Processes and
  Systems
• Where necessary, NAV calculations should be
  subject to appropriate checks and balances to
  ensure any actual or potential conflict of
  interest is appropriately managed.
• The industry recognises that in certain instances
  the investment manager has the best insight with
  respect to the valuation of particular
  instruments. Where prices are provided or
  sourced by the investment manager, the
  administrator should be provided, where possible,
  with supporting information by the investment
  manager.

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• Recommendations on Procedures, Processes and
  Systems
• The administrator should use reasonable
  endeavours to consistently apply any pricing
  policy, unless there is good reason not to do so.
• NAV reports should be addressed directly to
  investors by the administrator, where an
  administrator is used.
• Where practical and appropriate, a second price
  should be sought for hard-to-value
  instruments/illiquid positions where there is
  readily available market data.
• Practices described in the pricing and valuation
  policy for a particular fund must be capable of
  practical implementation by the relevant service
  providers (such as the funds administrator).

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• Recommendations on Pricing Models
• The use of pricing models or determination
  methods should be approved by the board of
  directors, trustee or general partner of the
  fund.
• Where practical and appropriate, pricing models
  or determination methods should typically be used
  for illiquid of hard-to-value securities, where
  an independent source is not available or where
  it appears that it may not be reliable.

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• Recommendations on Pricing Models
• The decision to use a pricing model rather than a
  market price should be properly justified by
  back-testing in normal market conditions and
  applying appropriate stress tests to identify
  model weaknesses.
• Internal valuation methods should be appropriate
  tested and, where possible and appropriate,
  independently reviewed and verified.
• Underlying data used in pricing model-based
  calculations should be formally reviewed and
  approved.

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• Next steps
• Industry and investor feedback
• On-going development of recommendations
• Inclusion of these recommendations in Guides to
  Sound Practices
• Continue to monitor issues and developments
• Revisit the topic periodically

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ASSET PRICING AND FUND VALUATION PRACTICES IN THE
HEDGE FUND INDUSTRY
By the Alternative Investment Management
Association
Presented by
PwC