Valuation process

Calculating an accurate NAV for certain hedge fund strategies is not as straightforward a process as some may believe

In the view of most investors, the primary function of the administrator of a hedge fund is to produce an accurate net asset value (NAV) promptly, which means as soon as possible after the valuation date.

For many funds that deal in liquid exchange traded securities, this presents no problem, although for funds that invest in complex derivative instruments, or illiquid investments, it is not so easy to get independent, accurate prices.

Having said that, problems can occur when, for example, the shares of a company are suspended. In such circumstances, the administrator will consult with the board and the auditor about how to value those shares. Usually common sense prevails, but nevertheless a decision has to be made whether the last quoted price should be used, or whether to defer the NAV calculation, which may not be practical if there are subscriptions or redemptions outstanding.

In such a case, it may be decided to 'side pocket' the problem investment. This means it will be held in a separate 'account' for the benefit of all existing shareholders, who will be the only shareholders to participate in that investment.

The side-pocket structure can also be used in other circumstances, such as the bankruptcy of a company into which the fund has invested, which may lead to extended legal action.

These are, thankfully, relatively rare occurrences. The problems administrators have with regard to valuations more often relate to illiquid, or complex investments, where there may be several different methods of valuation.

To ensure the integrity of a fund's NAV, it is essential the administrator values the portfolio using prices that are both accurate and independently sourced. Although sometimes it is unavoidable, it is never satisfactory for the administrator to rely on prices supplied by the manager, because of the obvious conflict of interest.

Several strategies in particular can be problematic for the fund administrator.

Emerging Markets

The valuation of an emerging market equity portfolio should be fairly straightforward, providing the securities are quoted on the relevant stock exchange. However, as witnessed in 1998, many such stock exchanges can prove to be incredibly inefficient and absolutely illiquid in bear markets.

The most common method of valuing liquid securities is to use the mid-price between the bid and offer on the relevant exchange. However, as an example, consider the performance of the shares of a Russian company during the 1998 Russian stock market debacle. At that time the shares, in what had previously been a reasonably liquid market, were suddenly quoted at $11 bid and $23 offered ' that is, an NAV based on the mid-price of $17. This is blatantly unfair to existing shareholders, because new investors could buy into the fund too cheaply and anyone redeeming would be paid too much.

There are some who argue that all equity portfolios should be valued on a bid-offer price, rather than the NAV, precisely due to this problem.

How can this problem be resolved? There are several ways, none of which are satisfactory unless the risk of such an occurrence had been anticipated and stated within the risk factors shown in the Offering Memorandum, with a procedure agreed in advance. Such procedures could be:

• To instigate bid-offer prices for the shares of the fund, rather than using the NAV based on the mid price.

• Suspend the fund until stability returns to the market.

• Distribute the assets of the fund to shareholders, in specie.

• 'Side pocket' those holdings with unacceptably large spreads, and calculate the NAV of the rest of the portfolio in the normal way.

Venture Capital and Private Equity

The valuation of private equity or venture capital funds should be based on a disclosed price formula, because independent market prices will not be available.

Ultimately, it is the manager's choice as to which method of valuation should be used. I believe the most practical procedure for valuing private equity and venture capital funds is to follow the European Private Equity and Venture Capital Association guidelines, which offer a number of variables.

The two recommended EVCA valuation methodologies are the Conservative Value and the Fair Market Value.

The conservative valuation would value all unquoted investments at cost, unless there has been some event which would naturally change the value upwards or downwards. The fair market valuation is 'the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arms length transaction.'

The guidelines add: 'The most appropriate indication of fair market value is likely to be an independent third party transaction within the valuation period.' However, in the absence of such a transaction, the EVCA guidelines provide for other methods of valuation.

The full guidelines are too long to go into in this article, but you can view them on the EVCA website at www.evca.com.

Distressed Securities

Often the valuation methodology used for a distressed securities does not necessarily produce a conflict of interest, providing the methodology is clearly stated and independently verifiable.

Some investment managers have their own proprietary methods of valuation, effectively creating their own 'fair value' methodology. This may vary slightly from other methodologies used, but is nonetheless valid.

In essence, any fair value methodology will be similar to the EVCA methodologies described above, taking into account adjustments that will be reflected in accordance with the amount of time the investment has been held compared with the expected holding period.

Of course, during the life of the investment, the manager may find it necessary to adjust that expectation, either to a longer or shorter period. As a result, the fair value calculation will be adjusted accordingly.

Some distressed (and other) investments realise cashflow, which may be dividend or interest distributions, or capital disbursements, received before final liquidation. It is important the character of the cashflow be identified and shown in the fund's assets, either as current income or capital gain. Capital gains will effectively reduce the basis cost of the investment and, thus, increase the fair value for that particular investment. As I indicated above, sometimes this is not necessarily practical, indeed occasionally even impossible.

Fund of Funds

Finally, on strategies, one should talk about fund of funds. On the face of it, a fund of funds administrator has a relatively simple job ' merely waiting for the administrators of the funds to provide the NAV per share of those funds, and then calculating the NAV of the fund of funds ' not a difficult job.

Problems occur, however, with the delays in obtaining the NAVs of the underlying funds. This is sometimes because the administrators of those funds may be inefficient, but often it will be because those administrators have had to resolve some of the problems that I have discussed above.

Usually, there will only be one or two delinquent funds within a portfolio that will delay the valuation.

This can cause friction between the manager and investors, and the administrator, because the investment manager of the delinquent funds may have calculated and published an estimated NAV utilising their own in-house accounting system.

So why is the NAV of the fund of funds delayed? As mentioned above, the administrator's function is to provide an accurate NAV, and in the context of a fund of funds, that must be based on the final numbers provided by the administrators of the underlying funds, as the independent source, and not on figures provided by the manager.

Having said that, sometimes it may be practical to issue an estimated NAV, based on the estimated numbers provided by the managers of the underlying funds, provided:

• The fund(s) in question do not represent more than, for example, 10% of the total assets of the fund of funds.

• Historically, the estimated prices provided by the managers of the delinquent funds has never been more than, for example, 10 basis points out, over the previous 12 months or so.

• The final NAVs of all the other funds have been received from the administrators of those funds, because 10 basis points error on 10% of the portfolio equates to only one basis point error on the whole portfolio.

Therefore, the estimated NAV can be published for client valuation purposes, but the price for redemptions, or subscriptions, will be deferred until final NAV of the fund of funds can be published.

Due Diligence

All the above is fine in theory, but what can investors do to ensure the above policies are being followed, resulting in accurate valuations. First and foremost it is incumbent upon investors themselves to carry out their own due diligence, and find out where the administrator is obtaining the price and portfolio data from.

In this regard I would suggest investors use the Alternative Investment Management Association (AIMA) due diligence questionnaires as a first step in carrying out its due diligence on administrators and managers, prime brokers and custodians for that matter. For more information, visit www.aima.org.

Key Points

Calculating the net asset value of a fund that invests in complicated derivative instruments or illiquid investments can be problematic.

Investors themselves should find out where the administrator is obtaining information.