By Ian Blance, Ian Blance Consulting

One of the most controversial and problematic issues associated with the impending regulatory overhaul of alternative investment management has been in the area of valuation - both at the individual asset and portfolio level. This is particularly important in the area of illiquid and/or hard to value instruments.

The proposed EU directive on alternative investment fund managers, for instance, suggests a third party valuation agent independent of the fund manager should be appointed for each fund managed.

US Treasury proposals are still under debate. What is clear so far is that the hedge funds and private equity companies are going to look a lot more like 'regulated' investment companies than they do now, with concomitant independent valuation requirements and oversight.

Guidelines do exist
There have been guidelines on sound valuation practices for hedge funds around for some time. Both the main industry associations - global organisation Alternative Investment Management Association (AIMA) and the Managed Futures Association (MFA) in the US - have comprehensive proposals for members. IOSCO has published international recommendations.

While these differ in the detail there are consistent themes running through the advice from all parties. The IOSCO principles for the valuation of hedge fund portfolios, proposed in 2007 and confirmed in its June 2009 report on hedge fund oversight, is non-binding.

Given IOSCO is a committee of the main national securities regulators, this will be taken into account when framing any formal regulation. IOSCO has nine principles for hedge fund valuations. These are

Document valuation policies and procedures; identify methodologies used for valuing each instrument type; consistently value each instrument in accordance with this policy; review this periodically for appropriateness; ensure independence of policies and procedure and their review; ensure independent oversight of actual valuations, especially those influenced by manager; describe and document price override process; perform periodic due diligence on third party valuation sources; and make these processes transparent to investors.

AIMA's 2007 Guide to Sound Practices for Hedge Fund Valuation was issued before the IOSCO paper and covered much of the same ground. It gave 15 recommendations. It recommends the production of a valuation policy document which should enshrine practical valuation policies and procedures, clarify roles and responsibilities and identify price sources and methods for each instrument type.

This should be regularly reviewed by the Governing Body and should be designed to segregate the fund valuation process from its investment process wherever possible.

AIMA suggest this segregation can best be achieved by the appointment of a third party valuation service provider to undertake the valuations and net asset valuation (NAV) calculations.

Wherever the manager has input into this process, there should be robust controls and oversight.

The 2009 edition of MFA's Sound Practices for Hedge Fund Managers gives extensive guidance on valuation in a similar vein. Its key recommendations are the establishment of a governance mechanism (such as a valuation committee) with sufficient authority, the development of documented policies and procedures and the segregation of the investment process from valuation.

The whole framework is subject to review on a periodic basis - at least once a year. There is much focus on the personnel involved (internal or external) being sufficiently knowledgeable to understand the instruments in question and the methods and sources deployed.

Implementation
All this may sound like hedge funds have valuation pretty much covered. However, there is a world of difference between sound guidelines in theory and in practice. Recent surveys have suggested that while a few of the more obvious recommendations have been widely adopted (notably the valuation policy document) there is still a way to go before a robust and consistent valuation framework is more generally implemented.

Both AIMA and the MFA look in detail at the sources and methodologies of valuations, correctly identifying some of the issues surrounding the use of broker quotations and internal models.

However, it is apparent there a general lack of awareness of the pros and cons of different methods and that these methodologies are frequently 'mixed and matched' in portfolio valuations where specific issues can get obscured in the aggregate.

Many valuation users were using 'independent' sources without any deep knowledge of what these represented or what (potentially superior) alternatives were available.

There was also inertia, especially among administrators, to review periodically these sources.

Time to get compliant
The tendency identified would tend to militate against some of the core valuation principles proposed by IOSCO, AIMA and MFA. While these remain voluntary guidelines, this is not necessarily a disaster. However, the fund and its investors are still exposed to fraud and/or mis-valuation risk.

Probably the one thing IOSCO, AIMA, MFA and all the regulators do agree on is that the ultimate responsibility for valuations policy, procedure, process, oversight and outcome lies with the governing body of the fund.

If the guidelines become regulations then funds and their service providers are going to have to become compliant quickly with this framework and these issues.