Waters Comments On Hedge Fund Portfolio Valuations

by Philip Morton, Investors Offshore.com

16 April 2007

Speaking last week at the AGM of the International Organization of Securities Commissions (IOSCO), Dan Waters, FSA Asset Management Sector Leader and Chair of the IOSCO working group, commented on the Organization's 'Principles for the Valuation of Hedge Fund Portfolios' report, published last month.

Chairman of the IOSCO Technical Committee, Michel Prada, speaking at the time of the report's publication, explained that:

"The chief aim of these Principles is to seek to ensure that hedge funds' financial instruments are appropriately valued, in particular, that these values are not distorted to the disadvantage of fund investors. Therefore, it is extremely important that hedge funds adopt and operate robust portfolio valuation policies."

He continued:

"The Principles describe techniques which should strengthen the valuation process thereby making it more likely that the resulting valuation is appropriate. They emphasize the importance of clear written procedures which are consistently operated and regularly reviewed, and which provide for an appropriate degree of independence to deliver effective checks and controls."

"In developing the principles, IOSCO drew upon the assistance of industry experts. IOSCO acknowledges the generous time and commitment given by these specialists. Their insight into effective valuation processes and their open dialogue with regulators was invaluable in bringing this work to a timely and successful conclusion."

Speaking last week with regard to the Principles, Mr Waters announced that:

"The first thing to say is that IOSCO considers that the Principles comprise a flexible but robust framework, which should promote good governance over the valuation process. When formulating the Principles, IOSCO recognized that hedge funds and their managers operated a variety of business structures. In each of these structures, however, there is the potential for conflicts of interest between the interests of the hedge fund manager and the interests of the fund and its investors."

"The characteristics of the various jurisdictions in which hedge funds operate required careful consideration when formulating Principles for an industry that often cries, "One size does not fit all!" The aim has been to formulate Principles that should benefit investors across the full range of different structures."

"Briefly summarised, the Nine Principles call for:

• Comprehensive, documented valuation policies and pricing procedures;
• Identification of the valuation methodologies used for all financial instruments;
• Consistent application of the valuation policies;
• Periodic review of the valuation policies and pricing procedures;
• Independent application of the valuation policies;
• Independent review of the resulting valuations, in particular of any valuation influenced by the Manager;
• A process for handling price overrides;
• Initial and periodic due diligence on third party valuation service providers; and
• The valuation arrangements to be transparent to investors.

You might say that these are a statement of the blindingly obvious. If that is your response, I encourage you to read the report closely. Each principle is elaborated through a number of additional pieces of guidance and illustrative examples. These reflect the complexity of the issues involved. In addition, in addressing practical problems, more than one Principle may come into play, which adds to the impact that they have in real-world scenarios."

Addressing the question of whether the Principles will make a difference, Mr Waters observed that:

"Announcing a set of Hedge Fund Valuation Principles is all very well, but one might wonder whether they will actually make a difference in the real world. Whether they will or not is of course dependent upon whether or not they are taken up."

" IOSCO considers that this statement of principles represents good practice in the industry and that many hedge funds and their managers all already adhering to practices that are consistent with them. We consider that wider application of them should make a difference in helping to prevent future problems in the valuation of hedge funds."

He ended his speech by stating:

"In conclusion, it would be naïve to expect that the application of the Principles will come about solely through the insistence of IOSCO. As I have mentioned, the hedge funds themselves and their managers, and, importantly, their investors all have a role to play. So we encourage active engagement with the Principles through this period of consultation."

"It is very important that they attract a high degree of international acceptance and active support, so it is essential that we get them right. We will be very pleased to receive and consider comments and critiques from those who have an interest in strengthening and improving valuation standards in the global hedge fund industry."

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