The recent recommendations put forward in April 2008 by the President’s Working Group on Financial Markets call for much-needed changes to valuation policies, disclosure, and accounting practices within the hedge fund industry. Industry experts agree that change is both necessary and imminent, but recognize the significant challenges to implementing a consistent, transparent and fair pricing methodology throughout the alternative investment management sector.

Hedge fund pricing has always been, at best, a highly inconsistent and unreliable process. The hedge fund industry has never been required to adopt a standard policy for valuing securities, especially the private, illiquid, and over-the-counter asset classes. However, recent market volatility and mounting pressure from institutional investors has forced hedge fund managers to focus on the adoption of a standardized pricing and valuation methodology.

Regardless, the recommendations fall well short in addressing the deeper industry conflicts in the handling of asset pricing and valuation. The current methodology is clearly flawed: Today, any two hedge funds can price the same portfolio differently, and in both cases, the approach can be considered fair and accurate. This pricing inconsistency is a huge dilemma that must be addressed in order to demonstrate a good faith effort to provide transparency and pricing standardization to investors and regulators. This challenge is further complicated by the need for robust technology and operational processes to accurately and consistently value these securities across the industry.

There is a need for a collaborative effort amongst hedge funds, fund administrators, prime brokers, data vendors, and technology providers to define, implement, support and police an industrywide pricing solution.

Fund Administrators
Fund administrators play an important but often misunderstood role with respect to pricing. The administrator’s responsibility to value a portfolio is determined by the individual administrator’s agreement with its hedge fund client, and not by any industry standard. Any time there’s a discrepancy with the administrator, the hedge fund manager has the final say on prices. Based on interviews with fund administrators, it appears as though hedge fund and administrator documents are becoming increasingly vague. As a result, the fund administrator often has difficulty getting the “last word” on pricing.

To gain transparency for investors, this trend must be reversed. On the manager side, a hedge fund should, in its private placement memorandum, provide detailed specifics about pricing, taking into account the procedures or valuation hierarchy it will use to ensure an accurate valuation of the fund. This will form the basis for its relationship with its fund administrator. At the same time, fund administrators must move toward establishing their own pricing procedures, valuation methodologies and hierarchies in order to be a true partner for their hedge fund clients.

Prime Brokers
Prime brokers and counterparties are responsible for valuing instruments they trade, hold on their books, or have exposures to. Their buy-side clients typically rely on this information for internal valuation. Despite the existence of independent pricing sources, the use of counterparty valuations is still a common practice for hedge funds and asset managers, especially when working with OTC, exotic, and illiquid securities. There are a number of inherent problems with using a single counterparty price. Although counterparties may use the most complex and sophisticated methodology to price OTC securities, the valuation is perceived to be somewhat biased because the organization’s exposures and performance are tied into the price. Further, the primary reason prime brokers value a hedge fund’s holdings is to calculate collateral financing, which could be a conflict of interest. To make matters worse, the prime broker often relies on their internal trading desk for a price, which again has inherent conflict. There even exists the perception that smaller prime brokers / counterparties are not forcefully controlling “Chinese walls,” which could result in information leakage between conflicting areas of the firm. In addition, as the reliance on counterparty and dealer quotes becomes more prevalent, counterparties are having a difficult time keeping pace with valuing these complex instruments in a timely manner.

Given the fact that the use of broker-supplied prices by the buy-side is inevitable, there are a few practices that hedge funds can use to mitigate pricing risk. In some cases, hedge funds use multiple prime brokers for pricing as well as independent valuation services and will compare sources to determine an asset’s value. The goal of the chief financial officer or chief risk officer should be to collect as many prices as possible from various sources including broker quotes, data vendors, traders, internal models, and independent valuation services and then to apply a consistent arbitration model or averaging formula to produce a conservative and transparent valuation.

This practice does require experienced staff and specialized technology to collect, analyze, store, and report historical pricing information. But once the pricing infrastructure has been established, the addition of new sources, valuation rules, security types, etc. is a small marginal effort. By using multiple sources and arbitrating between them, buy-side organizations can demonstrate a consistent and proper approach which should be well received by investors.

Prime brokers can do their part to help the industry solve this problem by providing more transparency around their pricing methodologies. In some cases, prime brokers have established independent valuation services for their customers, which would greatly benefit the industry if the practice could become more widespread.

Next Steps
The first step to solving the pricing dilemma is defining a pricing standard that is supported by the various industry groups across all asset classes, with fund managers’ agreement on the methodology, whether or not they hold that asset class in their portfolio of securities. These standards, combined with written pricing policies at hedge funds and backed by documented procedures and valuation hierarchies by third-party independent fund administrators, will lay the proper pricing foundation for the industry.

Well-documented and communicated operational and pricing methodology, supported by sufficient infrastructure and operational process, will benefit hedge funds and the industry at large and take the mystery out of pricing. Ultimately investors will allocate more capital to hedge funds and the industry will benefit as a whole.

This article is based on a white paper published May 20, 2008 by Paladyne System., Access the white paper by visiting www.paladynesys.com/NewsArticles/ValuationsPricing-PaladyneFinal.pdf

The views expressed in this guest article do not necesarilly reflect the views of HedgeFund.net