Auditable valuations challenge administrators

How are administrators valuing instruments and what are the problems they face? Will the increase in illiquid instruments be a major factor only in the short- to medium-term or will it have a longer-term impact for future valuation?

Valuation of instruments is a major issue for fund administrators. In the wake of the problems posed by subprime, complex and often illiquid financial instruments will continue to be a challenge for administrators.

Don McClean at UBS Ireland believes the independence of valuations "is critical including for difficult-to-price instruments." He says the increase in illiquid investment is "creating a demand for specialist pricing vendors. Vendors are developing solutions so these illiquid instruments are causing the industry to come up with a solution."

At Trinity Fund Administration John McCann says this is "the key issue facing administrators, especially in relation to illiquid and hard-to-value instruments."

He points out that "for reasons of reputation as well as legal liability, the vast majority of administrators will steer clear of calculating values themselves and opt instead for validating prices recommended by external specialists such as prime brokers, exchanges or other external specialist firms. There is the risk of potential lawsuits, as derivative pricing is more art than science."

For all investments, but illiquid ones in particular, Trinity believes administrators "certainly must understand the valuation process, 'side pockets', claw-backs and perhaps even tax issues. Administrators will have to continue to develop pricing expertise to contribute to the market's move towards understanding the risks, and gaining greater transparency. 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," concludes McCann.

"Independent record keeping and pricing complex and illiquid securities are challenges that are not going to go away. It adds to the importance of independent providers. However, the question is whether it is a core competency of administrators or of other third parties better suited to provide valuation of these types of securities," says John Alshefski at SEI.

At Portal Fund Administration Stephen Edmonds sees an "increased adoption by boards of pricing policies and disclosure of methodologies particularly for illiquids is the way forward. The independent pricing of the investment portfolio, covering all instruments is well established for alternative investment funds. The use of specialist pricing vendors is also increasing to support pricing independence as a cornerstone of good administration."

Jeff Potter at Northern Trust thinks administrators will "continue to look for independent valuations sources, or at least a process to validate valuations provided." He says the availability and cost of these sources is a factor for administrators. "Assets that are hard to value now will become easier over time, but new instruments will replace those. Therefore, it is anticipated that the need for accommodating illiquid instruments will continue."

"Administrators are bound by the pricing policies of the specific fund," comments Hans Hufschmid at GlobeOp. "Ideally those policies should define the range of pricing sources that should be used, their hierarchy, the snapshot time and any override authority."

Hufschmid says for illiquid instruments, "counterparty marks will remain the basis of valuation. For example, what is someone willing to pay for what you have? Because of their complexity, valuing illiquid instruments is not as easy as a long/short equity fund. It will continue to be a time- consuming process. But in the conflict between speed versus accuracy, accuracy should always prevail."

Oliver Scully at Citco Fund Services in London says this is the topic of the moment and "one that attracts polarised opinions in many cases". He says some commentators believe "the investment manager, as the expert in the field, should take responsibility and ownership of the valuation process. Others now see the complete independent valuation of the entire portfolio as a basic requirement of the administrator."

David Warnon at Capita Financial Group points out that hedge fund managers are launching increasingly complex investment strategies. Funds are continuing to invest in more illiquid and structured asset classes.

"The increasing complexity of investment classes and the lack of liquidity could lead administrators to refuse to administer certain types of structures. Apart from bank and broker pricing, it can be difficult to get independent pricing," says Warnon.

Illiquidity is core

Bank of New York Mellon's David Aldrich says: "Clarity and simplicity of process can help ensure that assets are both correctly valued and consistently treated in the case of hard-to-value assets. The AIMA and Hedge Fund Working Group papers on valuation are essential reading on this topic."

Mara Alido at ATU Fund Administrators expects administrators to continue to face valuation challenges. "With the market turmoil, promoters and investment managers are searching for alternatives to outperform the market, including investments in other asset classes which may include hard-to-value portfolios and non-listed and illiquid investment."

Peter Hughes at Apex thinks the valuation of instruments is a major issue. "The growth of private equity will mean valuation of illiquid securities will become mainstream and administrators will have to adapt and find ways to independently value these instruments or decide not to take on these clients," he says.

Paul Chain at AIS Fund Administration says the key is a strong valuation policy. "With valuations, administrators have to decide on the methodology, which should be signed off by an audit firm so audit firms agree with policy of firms. The administrator must act as a policeman. Today we spend a lot of time talking about valuations. We strongly suggest a good auditor is involved to sign off on it."

He concludes, illiquid instruments "are driving structure of funds so no, I don't think it will be a major impact."

ADMINISTRATORS DEBATE THE NEED FOR MORE REGULATION

What are the positive and negative impacts from regulations expected on administration business?

John Alshefski at SEI believes that no matter what level of regulation the industry evolves towards "we've always focused on instilling a culture of compliance in our own firm and also helping our clients do the same. A strong compliance culture can give firms a competitive advantage."

"The positive impact of regulation on the administration business is the increased transparency it provides to investors," says Oliver Scully at Citco Fund Services.

"It is important that any regulation or guidance is only introduced after consultation with industry participants so that it does not stifle innovation and competition," says Scully.

Clay Burton at Fortis Prime Fund Solutions takes a slightly different view. "More stringent regulation of administrators can have the positive impact of standardisation of services, transparency and maintaining high quality of service. The major drawback to increased regulation is the cost," he comments.

"Extra reports, need for more highly qualified staff, training, potential liability for errors, false assurance to investors, will all raise the cost of delivery of the services - reducing the return to the investors. It also usually slows down development of new products, creates more bureaucracy within the administrator to make sure they are compliant," says Burton.

"Regulation continues to grow and we have to be in a position to cater for this," explains Don McClean at UBS Ireland. He points to the third EU anti-money laundering directive as an example. This measure will "take a principle-based approach rather than a prescriptive approach and that's to be welcomed by the industry and so increased regulation may require us to increase resources in this area. I think increased regulation will make our industry more attractive to institutional investors."

Jeff Potter at Northern Trust says the positives are "for the fund administrators with robust reporting capabilities." He believes regulations and institutional investors are driving the need for more transparency in reporting "along with more independence in the pricing process." He concludes that fund administrators that have the infrastructure and processes in place to support the expanding needs will see the changes in a positive light.