Independence at centre of valuation

What are the main challenges fund administrators face in verifying valuations to calculate NAV? How are administrators valuing illiquid or hard-to-value instruments and what are the problems they face?

Independent valuation tops the list of concerns for administrators when they calculate net asset value (NAV). This activity brings with it a number of challenges, particularly if the valuations concern over-the-counter (OTC), hard-to-value or illiquid securities.

According to Liam McNiffe at Bank of Ireland Securities Services, independent verification of a fund’s NAV is the administrator’s primary function. “Challenges can arise where the administrator cannot use its usual sources to value some OTC or illiquid securities. The administrator’s role is to ensure independence and fair value is applied at all times,” he says.

The use of pricing models provided by a third party such as Bloomberg and the use of third-party pricing vendors who value such securities can help the administrator in this task, believes McNiffe.

“It is imperative that the administrator ensures that a well-documented, clear and concise pricing policy exists,” he notes. He also believes a pricing committee for the fund is needed to review and authorise prices for securities where no regular market exists.

At Citco Fund Services, Oliver Scully says independence, expertise and automation are the key challenges. “There is no simple solution to the issues surrounding illiquid or hard-to-value instruments. The key is to ensure transparency so that investors know what positions and percentage of the NAV have been independently verified,” Scully notes.

The main challenge for Akshaya Bhargava at Butterfield Fulcrum is in the variety of illiquid, hard-to-value instruments. “We value such instruments by using third-party pricing sources that are experts in particular asset classes,” he explains.

“It can sometimes be difficult for us to independently obtain broker quotes. The brokers do not recognise the administrator as their client, so they will often send the quotes to the fund manager, who then has to forward them to us. From a risk management standpoint, we would prefer to receive all quotes directly from the source rather than via our client,” Bhargava says.

Dermot Butler at Custom House Global Fund Services says the valuation challenges are no more difficult than they were in the past, except for the fact that the old model has been discredited.

“If we agree that the administrator’s job is to independently verify prices, rather than create the prices in the first place, then the main challenge will be that the administrator understands the asset and how it is structured. The administrator then needs to ascertain whether it is possible to value the assets in accordance with a pricing policy that has been specified for the fund; if so, that should mitigate many of the problems and challenges that exist,” believes Butler.

He says the administrator needs to get “back-up” for the prices received and ensure the methodology used is applied consistently.

“The problems occur when the manager and the administrator and/or the vendor fundamentally disagree with the price supplied to the administrator, either by the manager or the third-party vendor. Then there needs to be a procedure in place, which could be referral to a valuation committee, to resolve the situation,” concludes Butler.

The majority of administrators now use one or more independent price sources for vanilla securities, says Stephen Castree at Equinoxe Alternative Investment Services. He agrees with Butler that applying “strong procedures consistently is key” and believes additional detail around valuation in the offering documents to the fund will remove risk in this area over time.

At GlobeOp, Hans Hufschmid points out that large institutional clients and their auditors “recognise the value of working with a comprehensive, centralised valuation services provider.” He believes administrators must provide “integrated solutions to requirements for comprehensive product coverage, accuracy and timeliness in providing an independent valuation analysis across large and varied portfolios. Other fund manager and investor criteria include a SAS 70 Type II-certified technology platform, pricing analytic reports that enable valuation committees to focus on exceptions and that also help support year-end audit preparations.”

Peter Hughes at Apex Fund Services points to the remaining issues resulting from the use during the financial crisis of side pockets for investments. These he thinks could take another year before they can be unwound, particularly in some emerging market strategies. “When they are structured into open-end vehicles, administrators need to drive the valuation process to ensure independent timely valuations are received so that they can report efficiently to investors,” advises Hughes.

“Many more alternative strategies are appearing such as art, wine and bloodstock funds and administrators will struggle to provide a good level of service to these unusual strategies if they try and commoditise their service to these funds,” he concludes.

 “Administrators must understand the valuation process, side pockets, claw-backs and even tax issues,” declares John McCann at Trinity Fund Administration. “Administrators will have to continue to develop pricing expertise to contribute to the market’s move towards understanding the risks and gaining greater transparency,” he says. “There will also be greater demands for independent price calculations, and real-time systems that offer comprehensive investment accounting and sufficient portfolio information, to perform the analytics necessary for global investment portfolios.”

Jonathan White at Viteos Fund Services believes administrators need to ensure they have sufficient sources for pricing using an impartial and independent valuation policy acceptable to an auditor. “What has always been an issue is the cost of data, even for liquid securities, a sensitive matter for some fund managers,” he says.

“With regard to illiquid securities, many administrators in the past have fallen foul to falsified or inaccurate manager’s marks provided to value the portfolio for NAV calculations,” he cautions. This was because of the illiquid nature of some of the securities, especially OTC derivatives where there is no market price available.

Although some fund administrators have offered valuation services, experience has shown they have sometimes failed, resulting in litigation between investors and administrators. White sees the solution in third-party valuation.

All clients must define a valuation policy by asset class with a consistent application of that policy. The valuation policy must include a dispute mechanism on how to escalate pricing issues to, for example, a valuation committee.

The pricing policy is a key control and a process that should govern the administrator’s actions in sourcing portfolio valuations, says John Buckley at Omnium. “Illiquid instruments clearly present a challenge given the lack of readily available valuation data,” he admits. Using external resources that increase the transparency of pricing for all instruments is one way to solve this problem, believes Buckley.

Ian Headon at Northern Trust believes a lack of both industry best practice and understanding among investors and managers about pricing has led to problems. The Alternative Investment Management Association (Aima) and International Organisation of Securities Commissions (Iosco) reports of 2007, together with subsequent work by the Irish Funds Industry Association, the Hedge Fund Standards Board and others, may offer some guidance, he believes.

“There is now broad consensus on how a best practice valuation policy should be structured which, upon securing fund manager and investor input, can be relied upon by all parties as a roadmap for delivering valuations. The challenge is to continue to demonstrate this control and governance, particularly with hard-to-value instruments,” he concludes.

Hedge funds that start out vanilla and liquid and subsequently become more complex or illiquid due to growth or market conditions could outgrow their administrator’s valuation capabilities, notes Stuart Feffer at LaCrosse Global Fund Services. “Controls and procedures for valuing illiquid or hard-to-value securities need to be established upfront in the fund’s valuation policy and disclosed to investors. The valuation team needs to have sufficient experience and the right tools to handle broker quotes, models and manager marks, without compromising the integrity of the process,” he says.