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Asset Valuation: Issues and solutions

The significance of asset valuation
Asset valuation has always been a thorny issue for hedge funds. Not uncommonly,
hedge funds hold a considerable amount of illiquid assets which are notoriously difficult
to valuate. Investors and regulatory bodies are also concerned with the fact that some
assets may be valued by the fund managers directly. Conflicts of interest arise and the
credibility of such valuation is called into question. As the hedge fund industry continues
its expansion, a number of overseas regulatory bodies and professional organizations
have looked into the valuation problem and highlighted its significance.
In the United Kingdom, the Financial Services Authority (FSA) in its Discussion Paper
entitled Hedge Funds: A Discussion of Risk and Regulatory Engagement (Discussion
Paper 05/4, June 2005, The Discussion Paper) identifies valuation weakness as a key
potential risk of hedge funds:
Valuation weaknesses; Weaknesses in asset valuation methodologies and
processes related to skill shortages and conflicts of interest are creating significant
potential for ill-informed investment decisions and detriment to market confidence.
(The Discussion Paper at P.6)
The FSA further elaborates its concern:
There are a considerable number of operational risks inherent in the valuation of
hedge fund assets which may affect investors ability to accurately assess hedge
fund manager performance (and therefore take informed investment decisions).
This might have implications for price formation in hedge fund shares and the
markets more generally, and therefore market quality. (The Discussion Paper at
P.48, paragraph 3.87)
In the United States, the Presidents Working Group on Financial Markets has formed
the Asset Managers Committee (AMC), a private sector committee comprising of
institutional alternative asset managers, with a view to prepare best practice guidelines
for hedge fund managers. The AMC, in its Best Practices for the Hedge Fund Industry
(15 Jan 2009, AMC Best Practice) also identifies valuation as one of the key areas
where the introduction of best practice can reduce risk and protect investors:
Valuation: Robust valuation procedures that call for a segregation of
responsibilities, thorough written policies, oversight and other measures for the
valuation of assets, including a specific focus on hard-to-value assets (AMC Best
Practice at P.III)
Apart from these regulatory bodies, the Alternative Investment Management Association
(AIMA) and the International Organization of Securities Commissions (IOSCO) are also
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aware of the valuation issues and have issued relevant guidelines after extensive
consultation. In Hong Kong, the Securities and Futures Commission (SFC) was also
involved in the preparation of the IOSCOs guideline. In the SFCs Press Release:
IOSCO Principles for the Valuation of Hedge Fund Portfolios (14 Mar 2007, at,
Wheatley expressed that the issue warrants the close attention of the market.
In light of the importance of this issue, this research article seeks to outline the problems
relating to asset valuation, and to outline the solutions adopted by various regulatory
bodies and professional organizations.
In summary, the asset valuation problem
can be further boiled down to (i) the governance of the hedge funds, (ii) the asset
valuation methodology and system, especially when the asset is hard-to-value and
illiquid, (iii) potential conflicts of interest, and (iv) transparency and investors protection.
As AIMA pointed out in its Asset Pricing and Fund Valuation Practices in the Hedge Fund
Industry (April 2005), the management organ of the hedge fund is accountable for
preparing accurate asset valuation information. Although the actual calculation can be
delegated to employees or other parties, the responsibility remains with the
management body, and therefore the management ought to maintain overall control. An
important question arises here: what kind of control should the management exercise?
Another problem relates to asset valuation error. In The Discussion Paper, the FSA
pointed out that in some jurisdictions the investors may not be compensated for
calculation error committed by the hedge funds.
A variety of solutions have been offered by the aforementioned regulatory and
professional bodies. The American AMC in its Best Practice recommends hedge funds
to establish:
A governance mechanism, such as a Valuation Committee or other responsible
body; this body should have ultimate responsibility for (i) establishing and reviewing
compliance with the Managers valuation policies and (ii) providing consistent and
objective oversight and implementation of the Managers valuation policies and
procedures (AMC Best Practice at 14)
AIMA also issued the AIMAs Guide to Sound Practices for Hedge Fund Valuation (Mar
2007, AIMAs Sound Practices), and recommends that a Valuation Policy Document
outlining the valuation practices, processes and controls would be approved and
reviewed by the governing organ after consulting relevant stakeholders. Important
decisions such as the use of a pricing model and deviation from adopted pricing policies
must be approved by the governing body.

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Valuation policies
As to the valuation policies, AMC suggests that the policies ought to be documented,
and guidelines to evaluate exceptions as well as compliance guidelines should be issued.
The IOSCOs Principles for the Valuation of Hedge Fund Portfolios (The Principles),
which is supported by the FSA, recommends that the policies have to state the valuation
methodology, which has to be consistently applied. The policies have to be reviewed
regularly. AIMA suggests in its Sound Practices that the policies must specify the role of
each party in the valuation process, the price sources for each asset type and provide
resolution procedure when it comes to exceptions. A hierarchy of price sources and the
tolerance levels for variances between the sources must be stated in the policies.
Hard-to-value assets
A recurring issue for hedge fund valuation is the valuation of illiquid and hard-to-value
assets. Hedge funds often invest in illiquid assets and ascertaining their market value
or fair value is inherently difficult. As the FSA pointed out in The Discussion Paper, not
uncommonly these assets are valued by the managers themselves, and even if
valuation is performed by third party administrators, the administrator places heavy
reliance on the managers valuation. This valuation difficulty is further complicated by
the potential conflicts of interest. Nevertheless, it is generally recognized that in such
instance the hedge fund managers are in a better position to value the assets, and thus
the various best practices issued focus on the valuation procedure rather than
prohibiting fund managers from performing asset valuation. For instance, the AIMAs
Sound Practices suggests that in some situations the hedge fund managers are the best
candidates to value a certain piece of asset, in which case the managers should provide
supporting information to the valuation service provider.
The AMCs Best Practice contains a full section devoted to this issue. In summary, the
hedge funds should inform the investors that such investment may be made in the PPM.
Valuation should usually be done or reviewed by a competent and independent party,
although for hard-to-value assets properly controlled internal calculation is also
acceptable. Nevertheless, the potential conflicts must be addressed by the valuation
policies and procedures. To this end, the Best Practice provides:
To mitigate these conflicts, valuation policies and procedures should address the
circumstances in which the Manager may rely upon models, the required support
and documentation when using a model and the manner and frequency of
reviewing models. In particular, any material exceptions or unusual situations
arising in the context of a pricing model (e.g., the creation of a unique pricing model
for a particular asset) should be documented and reviewed by the Valuation
Committee. (AMCs Best Practice at P.20)
As noted above, in some circumstances the valuation is provided by the hedge
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managers themselves. Since their remuneration is usually linked to the performance of

the fund, conflicts of interest arise. The best practices adopt two board approaches to
tackle the problems. The first approach is to encourage independent valuation or duty
segregation. For example, the AIMAs Sound Practices provides that the parties
involved in the investment affairs ought to be separated from the parties who perform the
Nevertheless, the first approach may be unrealistic since in some
circumstances the investment managers are more capable to value an asset. This is
recognized by the AMC. The second approach thus arises to minimize the potential
conflicts and control managers discretion when the managers are in the best position to
value the assts. For instance, the AMCs Best Practices provides:
In the event that portfolio management personnel do not believe that the valuation
of an investment is appropriate, a Manager should have in place policies that seek
to mitigate any conflict between portfolio management personnel and valuation
personnel. For example, the Manager may develop a process for portfolio
management personnel to challenge the determinations of valuation personnel in
which the ultimate decision as to the appropriate price for a challenged asset
would be made by participants in the Valuation Committee after consideration of
pricing support provided by valuation personnel and input from the applicable
portfolio management personnel. (AMCs Best Practices at P.17)
The IOSCOs Principles is also apposite here. The Principles provide that the valuation
policies should be independently applied and reviewed to an appropriate extent.
Individual valuation, particularly valuation influenced by the fund managers should be
reviewed with a certain level of independence. The funds ought to conduct initial and
periodic due diligence on the independent parties that provide valuation services.
Ultimately, the valuation calculated has to be communicated to the end users, i.e. the
investors. To this end, the AIMAs Sound Practices sets out the relevant principles. The
PPM should name the party responsible for the valuation, and material involvement of
the fund managers in portfolio position pricing ought to be disclosed. NAV reports
should be given to investors directly by the administrator (if any), and NAV reports
prepared by hedge fund managers have to be qualified as such.
One must of course note that the above best practices are not the silver bullet that
solves all the problems. They are not one-size-fit-all solutions, as AIMA warned in its
Sound Practices. Nevertheless, these general principles are still useful to Hong Kong
hedge funds.
Moreover, to achieve better asset valuation, hedge funds are not the only actor. Other
market actors, such as investment banks and administrators, also play significant roles.
Ultimately, the SFC and the government should look into the matter. As Mr. Wheatley
said, the issue no doubt deserves closer examination.

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