Hedge Fund Asset Pricing Revisited: First; Communicate the Process. Then; Follow the Process. It's That Easy.

People who know me know that I am way into process and control. Define the process. Test the process. Refine the process. Document the process. Communicate the process. Follow the process with rigor and collect data along the way to ensure that the process continues to be both accurate and stable. This is the way it's done. Sounds easy, right? Easier said than done in practice (though why, I'm not too sure). Today's Financial Times carried an article on one of my favorite subjects - valuation of complex hedge fund assets - which is really all about creating an effective, clearly communicated process and adhering to it with religious fervor. While reading the article I had this familiar feeling of deja vu. Where have I read about this illiquid asset valuation stuff before? Hmmm. Oh, that's right. My blog, that's where!

This is not a new issue by any stretch, but FT piece does provide a helpful reminder of how important this topic has become given the proliferation of complicated, over-the-counter derivatives such as CDOs, CDSs, TRSs, and other three-letter acronyms. It is only with clear and effective processes and policies that the continued, healthy institutionalization of the hedge fund business can continue apace. Otherwise, issues of trust and transparency will rear their ugly heads and the inevitable blow-ups will occur, ruining what represents a historic opportunity for the hedge fund industry to grow in a prudent, risk-controlled manner and to take its rightful place in the architecture of institutional portfolios as a core asset class. From the FT:

The valuation of hedge fund assets has risen from nowhere to become a hot-button issue. How to value illiquid instruments is occupying minds inside and outside the industry. On the inside, the Alternative Investment Management Association in March published its Guide to Sound Practices for Hedge Fund Valuation. This followed the International Organisation of Securities Commissions releasing its Principles for the Valuation of Hedge Fund Portfolios. The issue was even on the agenda of a meeting in April of the G7 advanced industrial nations where representatives of leading hedge funds met deputy finance ministers.

This sudden focus is recognition that valuation of the increasingly complex assets used by hedge funds is a big issue for investors. Incorrect valuations can mean investors pay too much for units in a fund, lose out when they sell, or pay too much to managers in performance fees.

Pricing and valuation is only a minor issue in equity long-short funds, where standard mark-to-market techniques are sufficient. But there has been a proliferation of sophisticated strategies in recent years that have required advanced valuation techniques. These techniques are required primarily for over-the-counter derivatives, which are illiquid and therefore not easily priced. Instruments include collateralised debt obligations, credit default swaps, total return swaps and mortgage derivatives, all of which have grown enormously in popularity.

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Complex and illiquid issues are typically hand-priced, involving an evaluator calling the desk of a broker-dealer that makes a market in the security (ideally the primary dealer). Mortgage-related products are often priced using models with analytical data and dealer quotes as inputs. Vendors will often incorporate actual trade data into the models and adjust the model prices in line with any visible trades in the market. This process is clearly far from straightforward.

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Meanwhile, an Iosco committee including US, UK, French, German, Hong Kong and Spanish regulators, as well as hedge funds and investors, proposed nine principles of valuation. The main suggestions were that hedge funds should draw up policies for valuing investments, ensure they are used properly and applied as independently as possible. Valuation methods should also be made clear to investors.

While there are no precise answers to the questions of complex derivative pricing, there can be a precise, clearly communicated process that is followed for valuing such instruments. And this is what will set hedge fund managers free. It is hard to get angry - much less get litigious - if someone tells you the process they are going to follow for handling a complicated problem that is carefully adhered to and logical on its face. No funny business. No single-data point valuation on which NAV and, therefore, compensation is based. Engage several dealers, maybe even rotate among a larger number to ensure fairness and independence, toss out the high and low, document all responses, repeat. To get a sense of how important I believe this issue to be, here are some thoughts I had written last July when discussing how poor illiquid asset valuation can skew NAV and cause a big, big problem for the industry:

But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

And if the industry doesn't take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they'd rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.

For those who care, here are some posts I had written previously that also discuss the illiquid asset valuation issue:

• 07/21/2006: Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Firms begin?
• 08/04/2006: Side Pockets - Use or Abuse
• 12/26/2006: Hedge Fund Convergence: Strategy Versus Structure
• 04/30/2007: DE Shaw and Convergence: Putting the Issues on the Table

Sometimes getting the right answer is easy. And notwithstanding the complexity of the instruments at hand, the right answer to the valuation question is simple: clearly communicate and follow the process. End of story.