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The Board’s Role in Hedge Fund Valuations
Olwyn Alexander, PwC February 2005

 

Many European hedge funds have Boards of Directors ("the Board"). As pressures build to achieve more consistency and ultimately global standards in hedge fund valuation processes and structures, here are four areas which the Board needs to be addressing today:

Documented pricing policy: There is no excuse for not having a documented pricing policy, no matter how simple the portfolio may appear. It needs to be clear and readily understood by administrators, as well as the investment managers who implement it and the Board who must approve it. It should be as comprehensive as possible to eliminate or minimise areas of subjectivity and inconsistency. Finally the documented pricing policy should be current – kept up to date for advances in best practices and valuation methodologies. It should be recognised as a working document and regularly reviewed and updated.

Independence: A party independent of the investment manager should value the portfolio regularly. In Europe this tends to be a third party administrator whereas in the US, where valuation is often performed in-house, it should be a separate operations department, with a good price challenge mechanism in place. The most effective way for this to work in practice is through valuation committees. In an ideal world the independent party’s pricing source will also be independent of the investment manager, for example using Bloomberg if the manager uses Reuters, so that if a reconciliation is performed and overrides are permitted, differences can be challenged.

Segregation of duties: It is critical that traders and investment managers do not have ultimate power in dictating valuation. There needs to be segregation of duties. A proactive independent party should be engaged who can produce a Net Asset Valuation regularly, reliably and consistently. In practice the best hedge funds permit overrides by the investment manager only within documented guidelines and limits which are then communicated to the Board on a regular basis to allow for adequate monitoring. Standardisation of these practices would be a very positive step forward.

Supervision and oversight: Ideally the Board should have at least one member, independent of the investment manager, who is familiar with the fund’s strategy, the instrument types and their relevant valuation issues. This director then has the ability to adequately supervise price overrides, the regularity and quantum of such overrides and question valuation issues in detail as dictated by the risk level involved. The communication to the Board should be in line with recommended standards – such as a summary of stale prices, price overrides, liquidity issues and non-exchange traded investment valuations being reported and approved. There should be an opportunity for Boards to query problems or probe issues. All this should be regularly presented, with the overrides and pricing procedures approved as needed.

The hedge fund industry must be seen to react to instances of fraud and poor valuation practices by being proactive, and the tone should come from the top, with the Board ensuring that they have implemented documented pricing procedures, good supervisory and oversight processes, independence in the valuation process and a strong code of ethics.

 
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