We looked long and hard for a valuation provider with the experience, expertise, and empirical data to value illiquid securities portfolios accurately.

The Valuation Equation


By: Jacob Bunge | November 07, 2007

Even after a tumultuous summer, valuation remains a work in progress for many managers, but with new regulations and rising pressure from investors, experts say the outlook is improving.

If the first step toward recovery is admitting that you have a problem, hedge funds may be on the path toward a valuation system for hard-to-value instruments that's healthier for managers, investors and regulators alike.

"Everyone we talk to nowadays pretty much realizes they have a problem," says Espen Robak, president of Pluris Valuation Advisors LLC, a New York-based firm that specializes in valuing restricted securities and other illiquid assets for hedge fund clients.

And while many hedge funds may have had a feeling in recent years that their valuation practices were not up to snuff, this past summer brought a moment of clarity, when some hedge funds invested in subprime mortgages and other credit instruments floundered as they found themselves unable to correctly value the contents of their portfolios.

"One of the things that came out of the [collateralized debt obligation] debacle, the reason why funds were overvaluing their portfolios to such a gross extent was that they were relying on mark-to-model analogies," says Mr. Robak. "[The portfolios] had all kinds of theoretical value, but they were wrong—it was not reflective of the illiquidity and a lot of funds got caught, which is a terrible position to be in when you have to make a significant markdown."

"The emphasis on valuation is definitely out there," agrees John Borse, co-founder, president and chief executive of Sky Road LLC, which provides front-to-back office services for hedge funds trading cross-asset strategies. Beginning last summer, he says he's seen funds putting more emphasis on new investor reports, while managers are digging deeper for information than they have in the past. "We've seen a lot of activity where we're spending a lot of time explaining every little detail involved in calculating these valuations."

Mark-to-Model Murkiness

Up until now, the vast majority of hedge funds valued their portfolios with a mark-to-model approach—developing internal rules of thumb to calculate the general value of hard-to-value securities and instruments held by the fund, forming a model around these rules, assigning it to the fund's administrator, and getting someone on staff to plug in the numbers each month to come up with the price of all such hard-to-value assets in the portfolio.

The mark-to-model approach has a lot going for it, namely that it's simple, cheap and easy to apply. The problem is that it's difficult to tell if these models accurately reflect the market conditions and liquidity of the real world. Managers may find themselves in for a rude awakening when they try to unload assets that turn out to be worth far less than they anticipated, or worse, discover they can't find a buyer.

Pluris, which launched in September 2006, focuses its valuation services on restricted securities, mostly Rule 144-restricted stock, warrants, and convertible equity-linked securities. When valuing these assets, the firm draws on empirical trading data from its sister company, Restricted Stock Partners, which operates the Restricted Securities Trading Network, made up of around 300 institutional and accredited investors. The RSTN has become an exit market for funds holding restricted securities, and when Pluris is called upon to value similar assets, the RSTN serves as a database for transactions involving restricted stocks, warrants or convertibles.

Mr. Robak says that in recent years, a consensus has grown among managers, auditors, consultants and lawyers in the hedge fund industry that there exists a "tremendous inconsistency" in how funds value restricted securities. "This opened up a great opportunity for us in terms of providing empirical data to hedge funds," he says. "We look at any type of illiquid security, but restricted securities are a major part of what we do." The firm serves equities-focused hedge funds with a small percentage of their portfolios in illiquid securities, as well as funds focused on private investments in public equity, or PIPE vehicles.

Empirical market data is imperative when it comes to valuing credit derivatives as well. Sky Road's Mr. Borse has been fielding more inquiries from credit funds in recent years, leading his firm in December 2006 to integrate into its platform a data feed from Markit Group Ltd. for valuations on over-the-counter derivatives. This includes pricing for credit default swaps, iTraxx and Dow Jones CDX indexes, along with the Markit Reference Entity Database for reference entity and reference obligation identifiers used in the CDS markets. Funds using the Sky Road platform can configure it to accommodate capital structure arbitrage, fundamental and other credit-based trading strategies, according to the company.

"As you're valuing complex derivatives, it's really critical to have a handle on the market data that is the building blocks of those structures," Mr. Borse says. "If you just blindly value these structures without thinking about the inputs going into the models, the investors and clients are both going to suffer from that lack of information." He adds in the last few months, Sky Road's clients have been asking for enhanced risk reports that demonstrate the effects of various "scenario shocks" to their portfolios.

The topic of valuation was always an issue for Stuart Farr, CEO of Linedata Beauchamp Hedge Fund Solutions, which is based in New York and markets a hedge fund data solution that assists in the valuation process, mainly for credit products. Now, however, he says it's become a part of real conversations, and funds are actively implementing solutions to address the issue.

"Over the summer, with the problems in the subprime market, the whole issue burst through very visibly, like a volcano, but it didn't come out of nowhere," says Mr. Farr. "The reason it's been bubbling away for a while is essentially the following: While there are various specialist firms who can indeed value these things correctly—some companies make it their business—certainly some fund administrators have struggled with storing and maintaining the correct terms and conditions for these products, which are required for the valuation process."

The Beauchamp solution doesn't value the products itself—that, Mr. Farr says, is left to professional valuation firms. What Beauchamp does is solve for the mechanical problem, storing and maintaining the full terms and conditions of the products so valuation professionals have the complete picture of each product that needs to be valued. Legacy software or software designed for handling equities often is unable to properly store and communicate this information, according to Mr. Farr.

Mr. Farr adds that the Beauchamp solution allows users to submit each instrument to more than one valuation firm, as a way for funds to get second and third opinions on market value. "It gives [funds] a level of confidence and demonstrates that the valuation is sound," he says.

The Watchdogs

Administrators and auditors are, in theory, the ones that hold managers to a higher standard when it comes to valuation, and while some set the bar high, others may be letting funds' practices slide, especially in the case of mark-to-model valuation, according to Mr. Robak. "Auditors have been signing off, in their annual financial statements, on these values being fair value," he says. "They're supposed to have a higher standard, but it's hard to say for sure."

Meanwhile, regulators have a higher standard all set to go—the Financial Accounting Standards Board, which holds the highest authority over U.S. Generally Accepted Accounting Principles, has a new set of valuation standards ready to take effect beginning Nov. 15. Financial Accounting Standard No. 157, or FAS 157 as it's become known, deals with fair value measurement. In particular it lays out a set of standards for valuing illiquid and hard-to-value assets, defining an asset's "fair value" as the price a fund or manager would have to receive in order to sell that asset. This "exit price" approach to valuation differs from the "entry price" approach, which is based on what the fund or manager would pay to buy such an asset. FAS 157 takes a similar approach with liabilities. The principal or most advantageous market must be used to calculate the exit price.

FAS 157 also establishes three separate levels of valuation inputs—the information used in valuing the asset in question. Each comes with differing disclosure requirements. Level 1 inputs are defined as actual trades in the security that is being valued, i.e., quoted prices in active markets. Level 2 inputs are trades in similar securities, derived from outside sources. Level 3 inputs are the assumptions of the reporting entity itself, such as a mark-to-model approach. As the level number goes up, so do the disclosure requirements for the reporting entity.

Managers and funds aren't the only ones held to a higher standard by FAS 157. When it comes to hedge funds' financial statements, administrators are assigned responsibility for tracking transactions and segregating securities.

Pressure from Investors

Hedge funds, however, must eventually answer to a power even greater than government regulators: investors. Pluris' Mr. Robak says that the primary concern he hears from new fund clients looking to raise money is implementing asset valuation practices that will satisfy potential investors. "If you want to go out now and raise money, you need realistic, market-based values," he says, "because that's the only way that institutional investors, in particular, are going to be comfortable that they'll get proper reporting down the line."

Big institutional investors, such as funds of funds and pension funds, have long aired concerns about the lack of transparency with regard to valuations. Mr. Robak also notes that several pieces of recent research suggest hedge funds using a mark-to-model valuation method could be smoothing returns, which lowers their reported volatility. "It's just a big potential reporting problem," he says.

A fund overvaluing its portfolio is the most oft-raised concern, but undervaluing presents problems as well. While the conservative approach to valuing illiquid assets is to aim low, redeeming investors may end up with less than their fair share when they pull their investment, possibly leading to litigation.

"What I would predict is by early next year, virtually all the larger funds that are in this space with any kind of concentration in restricted securities will have switched to market-based pricing," Mr. Robak says. "There's just way too much at stake."