Sound Advice For Emerging Hedge Fund Managers - Part 3
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Transparency and Valuation
One of the key concerns faced by investors is the fund’s level of transparency. Over the past decade, investors have sought a higher degree of transparency. Transparency ensures that funds are making investments consistent with their investment mandate and helps monitor the performance of the fund and its respective holdings. Transparency needs have migrated from the investment / strategy side to all facets of the manager and hedge fund’s infrastructure. The need for transparency can include addressing regulatory guidelines, notification provisions, staff changes, counterparty exposures and valuations.
Investors will typically raise questions about transparency well before they put money into the fund and more often than not, investors will continue to seek transparency throughout the life-cycle of their investment. Assessing the degree of transparency typically commences during the investors’ diligence process. It is during this process that investors will begin to question the fund’s valuation policy. During their diligence review, investors want to understand who will be performing the investment valuations, who will be involved in the valuation process for each asset, if valuations will be performed in-house or by a third party, and whether a third party will be hired to opine on the valuation process. Ultimately the investors will want to know what party and/or parties will determine the final booked value. Additionally, investors will also seek to understand what guidelines will be set forth in determining the valuations of the underlying asset/investment, and how often the fund will value its portfolio.
In meeting the needs of the investors and in an effort to increase transparency, regardless of the size of a fund, it is best-in-practice to establish a valuation policy. The valuation policy should be continuously monitored, evaluated and revised to encompass all asset classes in which the fund invests or plans to invest. The methodologies recommended by the policy should conform to industry standards and strive to abide by guidelines suggested by industry governing bodies.
In establishing a valuation policy, a fund should first consider the standards set forth by accounting and government bodies such as the Financial Accounting Standards Board (“FASB”), International Accounting Standards Board (“IASB”), the Securities and Exchange Commission (“SEC”), and International Private Equity and Venture Capital Valuation Guidelines (“IPEV Guidelines”). All firms should strive to meet the Valuation Principles set forth by the International Organization of Securities Commissions (“IOSCO”).
Regardless of the size of one’s fund, it is imperative that a fund maintain the integrity of the policies set forth by industry experts and regulatory agencies, as failure to do so could lead to the termination of one’s fund or even punishment by law.
A component of the valuation policy should be for the fund to establish a valuation committee. As noted above, typically, the valuation committee oversees, reviews, and finalizes the valuations prepared for each of a fund’s investments. The valuation committee also monitors the frequency of valuation review which is defined within the valuation policy. The frequency of valuation can range from daily, monthly and/or quarterly and will depend on the asset class/underlying investment type. Depending on the size of the fund, it may be difficult to develop a large committee. However, regardless of size, specific personnel in both the front and back office should be identified to perform the functions of a valuation committee. Additionally, there should be a clear and documented understanding for who has the final authority in concluding on a value of an underlying asset/investment. It is recommended that this authority be an unbiased individual. Ultimately, the methodology employed in one’s concluded valuation should be consistent with the guidelines set forth in the valuation policy and in line with industry standards.
The valuation policy also describes the methodology and procedures by which the fund performs each of its valuations. The methodologies and procedures should have a consistent framework but typically vary depending on the type of investment/asset class. The policy states the valuation Fair Value hierarchy (i.e., defining Level I, Level II or Level III assets). The valuation policy should also identify and define the valuation approaches utilized in estimating a value for its investments (i.e. an Income Approach, a Market Comparable Company Approach, a Transaction Approach, and/or an Underlying Asset Approach). In employing such methodologies, it is recommended that funds seek the advice of a third-party consultant on hard-to-value and illiquid assets which are held by the fund.
Third-party valuation specialists have valuation expertise ensuring proper Fair Value guidelines are followed. Ultimately third party valuation specialists provide a level of assurance that the concluded asset values are reasonable.
As emerging hedge fund managers attempt to build out their infrastructure, they are faced with the challenge of choosing which functions to perform in-house and which functions to outsource. Apart from auditors, administrators, legal counsel, and prime brokers/custodians, there exists a wide variety of service providers which perform functions such as valuation, regulatory compliance support and consulting, IT network support, trading, accounting, and other functions. Of these, it is most common to see a smaller firm outsource its IT function altogether, and it is also quite common to see a smaller firm engage a compliance consultant. Firms must weigh the costs incurred when outsourcing versus the challenges faced when certain key processes are performed by a third party service provider. For example, what happens if the service provider decides it will no longer provide a certain service level or platform? How will the manager address staff turnover or system inefficiencies at the service provider level?
Compliance budgets may be nominal for smaller advisory firms. Outsourcing compliance functions provides firms with full compliance services, including but not limited to, assisting with regulatory filings, creating compliance documentation (including compliance manuals), creating compliance calendars, conducting mock audits, monitoring employee personal trading activity, and monitoring employee gifts and political contributions. Compliance consultants may provide a manager with software to streamline these processes. Compliance consultants may be used as a supplement to the compliance duties performed by the firm itself and by its external legal counsel.
Given the complexity of certain assets, funds may outsource a portion of their valuation function. Funds often engage a third-party valuation specialist to price illiquid assets in order to ensure that a fund’s NAV is calculated reasonably, independently, and without bias. Engaging a third-party valuation specialist is particularly important when illiquid assets represent a significant portion of a fund’s assets. Given the lack of pricing on illiquid assets, subjectivity is often required in the valuation of such assets.
Dependent on the size of the firm other functions may be outsourced including but not limited to, IT network support providers, IT data warehousing services, accounting services, and key personnel such as traders and CFOs. Investment managers should try to maintain as many functions as possible in-house to ensure internal controls are met. Ultimately, investment managers should focus on providing investors with transparency and implementing the best-in-practice guidelines noted above. In doing so, managers will require a healthy, balanced approach to insourcing and outsourcing certain functions.
Thus, in order to successfully grow an asset management firm to manage a single hedge fund or a group of hedge funds, it is imperative that the investment manager entity and the funds be properly structured. From time to time, the structure of the firm and funds should also be reviewed in order to ensure that the firm and funds comply with material changes to tax laws or regulatory developments. Moreover, in an effort to reduce operational risk, as well as to provide comfort to existing investors and prospective investors, the investment management firm must hire and retain suitable employees. Key employees must be empowered to develop and implement policies and procedures specifically tailored to the firm’s size and strategy including, in part, identifying and mitigating counterparty risk, ensuring that portfolios are properly valued, and maintaining a robust compliance program. A successful and sustainable fund will ensure that these essential characteristics are met and monitored.
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