Facing valuation challenges

What are the main challenges fund administrators face in verifying valuations to calculate NAV/AUM? How are administrators valuing illiquid 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?

The main challenges relate to valuations of private securities, over-the-counter (OTC) securities and thinly traded securities, according to Sharon Grosman and Brendan Conlon at SGGG Fexco. Generally, they say administrators value these instruments based on the policies set out in the legal offering documents.

Problems arise when the values provided are reviewed and are found to be inconsistent with available information or with values provided by other investment managers of other funds. This can lead to tension between the client and the administrator, they say. 

All clients must define a valuation policy by asset class with a consistent application of that valuation policy, says Matthew Wilson at Citadel. This 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 process document that should govern the actions of an administrator.

Illiquid instruments present a challenge, given the lack of available data to verify valuation independently. Citadel has developed relationships with external pricing resources that increase the transparency of pricing for all instruments.

According to Andrew Rogers at Gemini, the main challenge facing verifying valuations to calculate net asset value (NAV) and assets under administration (AUA) is the ability to obtain market quotes. “We have found that due to market volatility there are fewer parties willing to provide quotes. This is especially true for illiquid instruments, making it difficult to calculate NAV/AUM on a timely basis. Additionally, reconciling illiquid instruments with a custodian is often an issue as they are not often held with a prime broker but rather with a counterparty,” he says.

Lacking consistency
State Street’s Deborah Yamin sees the lack of a standard policy for valuing securities, especially with illiquid and other hard-to-price instruments such as OTC derivatives, as the main problem. “While industry working groups continue to collaborate on consistent pricing standards, the recent crisis in the financial markets has raised the urgency of resolving this issue and may accelerate the adoption of one of the new valuation standards, such as the one proposed by the President’s Working Group,” she concludes.

“Effectively servicing more complex instruments requires investments in niche technology solutions that can accommodate the life cycle and valuation of these instruments,” says José Santamaria at RBC Dexia. “The key to effective pricing and valuation of all instruments is consistency,” says Santamaria.

Don McClean at UBS believes one response to the valuation challenges posed by illiquid instruments has been the provision of services by specialist pricing vendors. “What is viewed as a difficult-to-value product changes over time. What might have been considered hard to value two years ago, would not necessarily pose as many challenges today. However, there are always new products posing different valuation challenges replacing those products for which new solutions have simplified the valuation challenge,” says McClean.

Following clearly laid out policies and procedures in a transparent manner is key, advises David Aldrich at Bank of New York Mellon. “Illiquid securities are primarily a problem for investors and as the proportion of these has risen within portfolios they have found that the funds themselves have proven to be much less liquid than they had been led to believe,” he says.

Conifer Securities independently prices its clients’ portfolios daily on the primary exchange, explains Jack McDonald. “Illiquid instruments are priced in accordance with the portfolio manager’s valuation policy, supported by the fund’s auditor. Obtaining last exit price is a concern with instruments that are thinly traded for all parties involved. Of utmost importance to us is having a transparent valuation policy that is consistently adhered to,” he confirms.

Adapting to changes
The growth of private equity funds and the blending of hedge and private equity will become more prevalent, forecasts Peter Hughes at Apex. “This will become part of the mainstream fund industry and administrators will need to evolve their business models to cater for this,” says Hughes.

The valuation of complex instruments, such as OTC products, has been under the spotlight in 2008, notes Karen Tyrell at Citi. “There is increasing wariness of pricing that relies on counterparties, while some modelling fails to take account of the quality of the underlying instruments. For hedge funds keen to retain the confidence of investors, it has never been more important to be able to demonstrate transparency of investment pricing,” she advises.

Hans Hufschmid at GlobeOp says its fair market value committee often assists managers in establishing best practice structures and procedures, in addition to helping funds resolve pricing disputes. “While illiquid instruments can be complicated, we use best practice, counterparty marks, to mark the portfolio. This has validity over theoretical pricing of securities – for example mortgages, convertible bonds – as it is an indicator of what someone is actually willing to pay for an asset,” explains Hufschmid.

“As we saw in 2008 with collateralised debt obligations (CDOs) and other instruments, when the market seizes up, both funds and their administrators might struggle with valuing those instruments,” notes Akshaya Bhargava at Butterfield Fulcrum. “Fund administrators have a role to play in valuing illiquid instruments by helping managers develop and follow clear valuation policies according to industry best practices. In the long run this service provided by the fund administrators will be a positive long-term benefit for alternative asset managers,” he concludes.

Outsourcing benefits
At Fortis PFS, explains Charlie Woolnough, no individual vendor has complete market coverage. “We use a basket of specialist third-party pricing vendors to independently price illiquid assets. We believe this approach is ultimately more scalable and more encompassing than any capability we could build in-house. Indeed, the specialist vendors have far greater access to the underlying data that is required to price and test stress models,” Woolnough says.

For all investments, but for illiquid ones in particular, “we believe administrators must understand the valuation process, side pockets, claw-backs and even tax issues,” says 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. 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.

The valuation policy is set by the manager and should be specified in the operating memorandum and possibly further delineated in a written policy. This policy should be reviewed by the fund’s auditor and signed off by them. It is the administrator’s role to follow the policies set by the fund and provide independent verification if that is what the documents call for, says Paul Chain at AIS Fund Administration. “This is one of the most misunderstood aspects of an administrator’s role and requires more discussion than possible in this format.”

International Financial Administration Group’s Derek Adler accepts “very few funds of funds unless we are the administrator throughout. We will not accept funds that we feel are too difficult to value.”