Sunday, April 29, 2007

FSA Official Examines IOSCO Hedge Fund Valuation Principles

By James Hamilton, J.D., LL.M.

Investors in hedge funds that are not compliant with the recently-announced IOSCO principles for hedge fund valuation are accepting greater risk than they probably realize, warned Financial Services Authority Director Dan Waters. While no system is foolproof and the principles are not a failsafe, emphasized the FSA director, failure to raise industry standards around the valuation process risks repeating costly mistakes of the past. He went on to state that independence, consistency, and transparency are principles underlying the guidance, but that the key principle is independence. The director is chair of IOSCO’s Hedge Fund Valuation Subcommittee.

In remarks delivered at IOSCO’s annual meeting, the director explained that the IOSCO principles cover the valuation process up until the point at which all the financial instruments in the hedge fund portfolio are valued. But they do not address events taking place later in the process, such as the timeliness and method by which the net asset vale is communicated to investors. Moreover, IOSCO did not venture into the difficult territory of debating appropriate audit or accounting standards that should be applied to hedge funds and their assets, or to resolving differences in international approaches.

Although independence is central to the valuation process, noted the official, the principles do not demand that hedge funds hire an independent evaluation administrator. Principle 5 mandates a high level of independence in the application and review of the valuation policies and procedures. IOSCO provides three specific ways in which to introduce appropriate independence: (i) third party pricing services; (ii) independent reporting lines within the manager; and/or (iii) a valuation committee.

Even if a fund does hire an independent administrator of valuation, he cautioned, that is not the end of the matter. IOSCO expects the fund’s governing body to formally review the capability of the external valuation provider. Under Principle 8, the governing body should conduct initial and periodic due diligence on third-party valuation services.

One reason that IOSCO did not mandate independent valuation administrators is that hedge fund investors, the vast majority of whom are institutions and high-net worth individuals, have not universally demanded it. It seemed disproportionate to suggest that a particular business model should be mandated, when the principal investors in hedge funds, who are well placed to make such demands, have not generally done so.