Hedge Fund Portfolio Valuation

Valuation of hedge fund portfolios has become a hot topic in the international regulatory platform. Last week IOSCO published a consultation paper which proposes nine principles to ensure that hedge funds' financial instruments are appropriately valued and these values are not distorted to the disadvantage of fund investors.

The drivers of IOSCO's focus on hedge fund portfolio valuation:

• Increasing importance of hedge funds to global capital markets
• Complexity of certain hedge fund portfolio strategies and their underlying complex & illiquid instruments
• Central role of financial instrument valuations to hedge funds' NAV pricing & performance presentation
• Conflicts of interest arising from fund managers' active role in the valuation process
• Different structures & governance systems of hedge funds organized in different jurisdictions

The nine principles mentioned in IOSCO's paper are quite high level and stereotypical:

1. Documented valuation policies & procedures
2. Identificatio of valuation methodologies
3. Consistency of valuation
4. Periodic review of policies & procedures
5. Independent application and review of policies & procedures
6. Independent review of individual values (in particular those influnced by the fund managers)
7. Independent review of price overrides
8. Initial & periodic due diligence on third parties providing valuation services
9. Transparency of valuation to investors

Since valuation of complex & illiquid instruments is readily and objectively ascertainable, the regulators are concerned with abuse of the valuation process by the fund managers. I think the most difficult issue not addressed in IOSCO's paper is whether qualified and independent "valuation experts" are adequately available. Academics and industry practitioners should work together to develop more well recognized valuation models.