Read our article in the Cayman Financial Review Magazine, eversion
Politicians make much of sharing values with their constituents, though they struggle at times to elucidate precisely what those values are and what it is that is of value to both sides of the equation.
This difficulty was paralleled in the hedge funds world in late 2007 and 2008 when the financial markets seized up: investment funds held assets which to managers’ minds had an intrinsic value but few other participants in the market agreed as to their valuation.
Hedge funds are built on a premise that the assets which they hold and trade not only have a value but that it can readily be identified and recorded, for so much of the economics of the industry relies upon the determination of the value of a fund’s assets; investment managers are remunerated on the basis of the value of the assets which they manage, administrators on the basis of the value of the assets which they administer, brokers and custodians on the basis of the assets which are traded or custodied with them and investors take the upside or the downside of any changes in the underlying value of the fund in which they are invested.
Thus when the financial crisis deprived the industry of relative ease of identification of asset values it triggered many responses, including bringing to the fore the legal, regulatory and fiduciary terms which tie together the industry.
Valuations in the spotlight
Fund valuations have become a focal point within the industry, including of regulatory enforcement bodies (the asset-management unit of the US Securities and Exchange Commission (SEC) has declared that it will “…focus on whether there’s a systematic and consistent way [in which] valuations are applied”) and of investors (whose attention to operational due diligence and propriety of process continues to grow).
But the industry has a broad ranging resource to safeguard due rigour in the valuation process, whether assets are liquid and able to be priced readily or whether they are less liquid and thus harder to price.
The US Financial Accounting Standard Board’s statement 157 (FAS 157) seeks to establish a framework for measuring fair value in generally accepted accounting principles (GAAP), with expanded disclosures about fair value measurements, which is also able to be used under other accounting standards.
FAS 157 seeks to facilitate consistency and comparability in fair value measurements and related disclosures, by reference to a fair value hierarchy which grades or categorises pricing inputs into three broad levels, giving the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3).
Other industry bodies have taken steps to produce principles for valuing hedge fund portfolios, including – as long ago as 2007 – the International Organisation of Securities Commissions (IOSCO) and the Alternative Investment Management Association (AIMA), but despite this attention to due process and rigour in the valuation process the question of valuation still grates with many in the industry.
Determining value with certainty
That investment funds are able to draw upon well-established principles regarding portfolio valuation and can account and have their financial statements audited to standards of accounting such as US GAAP (including FAS 157) is helpful for investors, though regulatory bodies appear to struggle to find evidence of a broad and rigorous application of these principles throughout the industry, with the SEC paying special attention during investigations to “controls and procedures for valuation of illiquid and difficult-to-price securities”.
The ability to determine the net asset value of a hedge fund is critically important to the efficient operations of the fund, for without a determined value it becomes very difficult for the fund to operate normally: net asset value often informs the price at which investors are admitted to the fund (in the case of funds which operate equalisation accounting rather than series accounting) and the price at which they may withdraw their investment from the fund, as well as the remuneration payable to certain of the fund’s service providers.
It stands to reason that determining a fund’s net asset value accurately and with certainty is paramount, as investors need to be able to place reliance on the finality of the pricing at which they subscribe and redeem.
To fall short of operating a regime which mandates finality to net asset value determinations would render funds subject to complex adjustments of investors’ interests following a restatement of net asset value, as well as the difficulty of seeking (and enforcing) a claw-back of any overpayment of redemption proceeds based on inflated net asset value calculations.
Thus it is usual for fund terms to state that any determination of net asset value shall, in the absence of manifest error, be binding on all persons.
Where a fund’s constitutive documents provide for valuations to be revisited in the case of manifest error, a link is drawn to the law of mistake which may facilitate a claim for restitution, though short of this it will be difficult to overturn the determination of net asset value which has been settled.
However, other claims by aggrieved parties may exist, including claims in contract and tort, where valuations may be inaccurate leading to damage being suffered.
Invariably the task of calculating or determining net asset value is delegated by a hedge fund’s directors to a third party, and usually to the administrator. In delegating this responsibility, directors are duty-bound to retain a fiduciary oversight of the valuation process and the exercise of the delegated function by the relevant service provider(s), and this was reinforced in Weavering Macro Fixed Income Fund Limited v Stefan Peterson and Hans Ekstrom.
Thus for fear of personal liability for breach of duty, the directors should take care to delegate the valuation function only to persons who are reasonably competent to exercise the function and to monitor their performance of the function notwithstanding its delegation.
It is normal practice for the terms of any delegation of the valuation function to prescribe parameters within which the valuation agent is to discharge its duties, though by the same token latitude for the exercise of independent judgement is imperative to facilitate thoughtful valuations in terms of FAS 157 and other valuation standards and the fund’s own valuation policy.
But where the agent deviates from its terms of reference, either in breach of the terms of its engagement or acting recklessly or negligently, liability may accrue to the agent (and to the directors if their oversight is found wanting) in contract or tort; noting that investors are unlikely to have a contractual nexus with the valuation agent, directors are well advised to give due consideration to the interests of the underlying fund in assessing whether or not to seek compensation for any loss which arises.
Hedge funds are increasingly considering the inclusion within their terms the facility for clawing-back redemption proceeds which are paid to investors in excess of what is really due tot hem, based on valuation errors which later come to light.
Mechanically it may be straightforward to structure a claw-back provision, though implementing and enforcing such a provision is famously difficult, not least where the relevant investor no longer maintains an exposure to the fund.
One manner of addressing this is less through a claw-back and more by retention of a percentage of redemption proceeds pending confirmation by the auditors of the fund’s valuations during the preceding financial year; this has some currency in certain markets but is resisted in others.
Indeed a corollary of this is to build into fund terms the potential for clawing-back from investment managers overpaid management or performance fees which are paid on the basis of an inflated net asset value calculation, and it stands to reason that similar provisions should track through to other service provider agreements where the model of remuneration is linked to underlying asset values.
With hedge fund valuations coming increasingly into focus for all participants in the valuation process, the integrity of governance and process relating to valuations is paramount.
The various industry association guidance and regulatory and quasi-regulatory statements on valuation processes and policies do not and should not homogenise the valuation process, but rather all funds should adopt valuation policies and mandate their service providers with sensitivity to the funds’ underlying asset class.
In doing so regulators, investors and fund directors will all take comfort from the appropriateness of the valuation process, with reduced scope for regulatory intervention or legal redress.