Hedge Fund Valuation is a Big Deal for Pension Fiduciaries

As earlier stated, asset valuation is the cornerstone of investing. (See “Do You Really Know the Value of Your Portfolio?”)

The absence of good valuation numbers makes it virtually impossible to execute vital tasks:

1. Asset allocation

2. Risk management

3. Performance evaluation

4. Selection and comparison of managers …

(The discussion of what constitutes “good” numbers is left for another posting.)

Regulators and politicos are hardly alone in urging more prudence with respect to the valuation of certain positions. Industry groups have jumped into the fray, and some assert, it’s none too soon. The Private Equity Industry Guidelines Group posted valuation guidelines a few years ago. Its mission: “To promote increased reporting consistency and transparency while at the same time improving operating efficiency in the transfer of information among market participants by establishing a set of standard guidelines for the content, formatting and delivery of information.” The “MFA’s 2005 Sound Practices for Hedge Fund Managers” has a lot to say about valuation policies and procedures and is well worth a read.

So why is this important to pension fiduciaries? For one thing, countless fiduciaries are allocating monies to hedge funds. Second, a recent article offers that hedge funds could have as much as fifty percent of their money tied up in relatively illiquid assets, in part (some argue) to avoid having to register their managers.

According to U.S. SEC Commissioner Roel C. Campos, “To avoid dilution and unfairness, valuation numbers must be accurate and unbiased. A key element of monitoring the risk of hedge funds is to understand the valuation used by said funds and counterparties to the funds.”

Hiring an independent appraiser can go a long way to aiding this process, especially when accreditation itself entails satisfying rigorous education and experiential requirements. In fact, courts and regulatory bodies are increasingly turning away experts on valuation matters unless their credentials include specialized valuation training. (Note: As an Accredited Valuation Analyst and someone who has completed course and exam requirements for two other specialized valuation designations, I can attest to the rigor.)

With so much at stake, pension fiduciaries should be asking tough questions of their hedge fund managers (and/or consultants who recommend hedge fund managers).

1. Does the hedge fund rely on independent appraisers to provide assessments of fair market value?

2. Has a hedge fund established a proper valuation process?

3. How often are the valuations updated? *

4. Is each opinion of value well documented?

5. Are all terms and conditions of a particular economic interest specified and analyzed accordingly?

6. Does the hedge fund manager acknowledge how much of its portfolio is not valued on a regular basis, thereby affecting reported portfolio performance?

The list is long. One thing is certain. Hedge fund valuation is the topic “du jour”. Can a pension fiduciary afford to invest in a hedge fund, fund of funds, private equity fund, venture capital fund, commodity pool, derivatives fund and so on, without understanding whether, and to what extent, managers have considered various valuation issues?

* Not discussed here, there are those that assert that some positions should not be valued and that doing so would jeopardize the asset allocation decision that led to investing in relatively illiquid holdings in the first place. I welcome your comments regarding this point.