Alternative Investment Management Association
Olwyn Alexander, CFA
There has been much coverage, press and industry activity with respect to valuations in the hedge fund industry in the last number of years. Following the credit crunch and ensuing tightening of liquidity in the markets, the scrutiny has intensified since Summer 2007. Valuation is extremely challenging for certain investment types in the current environment.
To begin, it is useful to consider the importance of valuation. Certain “market myths” have developed, causing issues in the valuation process and there are challenges in how best to address these issues, which are outlined below. Looking to the future, there are new accounting standards on valuation which should improve consistency, measurement and transparency.
Importance of Valuation
Valuation is obviously important as it is intrinsic to the day-to-day transactions in a fund – subscriptions and redemptions being transacted at the correct value. Accurate valuation in a hedge fund context is also a key component of effective risk management, performance attribution and management and performance related fee calculations.
Hedge funds seek to generate alpha, so beta or market returns are not sufficient. Therefore, the tendency is to exploit market inefficiencies, so deviations from more standard, exchange traded investments are to be expected. There is a relentless push for enhanced returns and this has led to much greater sophistication and complexity of products being traded.
In the last nine to ten months the markets have delivered heavy losses and much volatility but most importantly have experienced bouts of extreme illiquidity. This has yet again shone the spotlight on valuations even more brightly than heretofore…
The industry has galvanized to address these concerns and there has been a myriad of reviews, standards, recommendations and sound practices issued by bodies such as AIMA, IOSCO, the President’s Working Group in the US, the Hedge Fund Working Group in the UK and we have seen regulators, governments, industry bodies and both US Congress and the EU parliament seek further information and clarification on the valuation processes in place and exploring the need for regulation.
Probably one of the greatest impacts of the credit and the ensuing liquidity crunch has been to expose a number of Market Myths.
The first myth is that AAA ratings mean an investment is risk free. Downgrades of triple A rated securities have been cruel and swift. By September 2007, a well-known rating agency had downgraded 78 top investment grade rated RMBS backed by second liens. Downgrades have caused some real hardship in the enhanced money market world, where funds have struggled not to “break the buck” and regulators have had to put provisions in place to facilitate or allow investment managers to make their funds whole. In the low rate environment, it appears that banks could not write mortgages quickly enough and often within a matter of days; these mortgages were packaged up, securitized and sold on. The production line was overheating in frenzy and euphoria….very few focused on the fine print. The agencies usually carry heavy disclaimers specifying that users of the information in the rating assessment should not rely on the credit rating or other opinion in making any investment decision. There is anecdotal evidence that structured finance is the biggest source of profits at the Big 3 rating agencies in the US with fees for ratings running at approximately 12bps versus only 4 bps for non-structured finance ratings.
The second myth is that market and broker prices are consistently reliable. The use of broker quotes was a fundamental block on which so much of the valuation processes historically have been built. A number of funds have suspended redemptions as prices being provided simply are not realistic or reliable. Many brokers have been quite clear that their quotes are indicative only and not to be relied upon as a tradeable price. Quotes from brokers can often be stale, due to no movement in the markets as all activity has dried up. Bid ask spreads for some investments are extremely wide, again raising questions about whether the provider would really trade on the prices quoted. In defence of the brokers, intrinsic value is relatively easy to produce but producing a meaningful bid/offer quote is much more challenging when there is simply no market activity at all. In addition, until the banks marked down their books, it was difficult for the brokers to take a different view from their banking counterparts who were valuing the collateral!
Finally, the belief that the broad and loose wording in an offering document or private placement memorandum on valuation, giving wide latitude and discretion, comprises an adequate documented pricing policy has to be challenged. All of the recently issued recommendations and principles’ starting premise is that there should be a documented pricing policy addressing governance, independence, models and methodologies, responsibilities, processes and escalation procedures, to name but a few.
Addressing the Myths
The obvious question is what to do or how to cope in this changed environment? Taking each of the myths in turn, there have been a number of downgrades in the past ten months; the fear and uncertainty arises from how many more are to come. A review of rating criteria and closer due diligence and assessment rather than simple reliance on ratings is needed. This applies as much to downgraded stocks as fixed income investments. Investment managers are closest to the details of the investments they make, so additional due diligence on their part can assist in assessing the validity of ratings or brokers recommendations for buy/sell/ hold.
If market and broker prices are not considered reliable, this does seriously challenge historical pricing processes which relied on those sources. The accounting guidance states that in an active market, the market price is the best evidence of fair value. So an assessment of how active the market is, is needed. A thinly traded market does not necessarily mean inactive and care needs to be taken in concluding that a market is inactive and therefore fair valuation principles apply. If there is a current exchange-traded price on the market, then it is difficult to justify a move away from that price, as it is an indication of the value at which willing parties transacted. If there are forced or distressed sale situations then it is likely the market is not as active. Broker valuations and market prices should be challenged if there is evidence of sales being transacted at variance to the quotes provided for valuation. Active monitoring of recent sales activity relative to daily indicative quotes from a broker is very important in assessing the reliability of the indicative quote provided. If there is no activity in the market it is important to assess whether a single quote is sufficient evidence of fair value. Consideration should be given to bias in the quote; historical reliability of valuation information provided; whether it is possible to model the value as a benchmark; whether it is possible to get a valuation expert to provide a view, etc.
Finally, broad and vague pricing policies in the legal documents, allowing extensive latitude and discretion in valuation, are no longer sufficient to meet the requirements of a “documented pricing policy”. Directors are constantly being reminded that they are ultimately responsible for valuation; valuation committees are now becoming much more common and expert valuation services are more active. Seeking out the experts in valuation going forward will be very important where there is a lot of subjectivity or judgement.
Looking to the future from an accounting perspective, there is a new US GAAP accounting standard called FAS 157 on fair valuation, which is effective for accounting periods beginning on or after Nov 15, 2007. The International Accounting Standards Board (IASB) has also issued a discussion paper on fair valuation which, to all intents and purposes, adopts what is proposed by FAS 157.
One significant change that FAS 157 introduces is the emphasis in the definition of fair valuation as an “exit price” or what you would get to sell an asset or transfer a liability. Historically, certain assets were fair valued using cost as a base for valuation. This would be considered an “entry price”, rather than an “exit price”. This change will put increasing pressure on those who use cost as an estimate of fair valuation. FAS 157 also introduces a hierarchy of values into “levels” and requires disclosure of same.
Hopefully we are going to see consistency across the board (US GAAP and IFRS) in valuation and greater transparency around the use of fair valuations and the processes involved.
We are all aware of the turmoil in the markets at present. This turmoil has introduced some significant challenges in funds’ valuations. Accurate valuation is extremely important in the funds world, where there is open-ended trading based on the NAV of that fund, generally on a monthly basis. Some of the foundations upon which traditional valuation methods have been based has been shaken to the core – inactive or illiquid markets, historical data not being indicative for the future, unreliable broker information due to extreme uncertainty - but at least if there is a documented and consistent process around the valuation, this helps. Challenging the “old ways” of doing things is key in the current environment. New accounting standards should bring consistency across the industry, with a focus on exit or sales prices. There is a rocky road ahead but at least armed with sound pricing policies and procedures, consistently applied standards can be upheld.