Rethinking Fund Administration 1.5

In one of our last posts, we began a series of comments discussing the current state of the hedge fund administration industry, with a particular focus on valuation.  We promised that our next post would address some solutions to the "valuation dilemma", and we will return to this topic shortly.

However, we were interested to read the new version of the AIMA Guide to Sound Practices for Hedge Fund Administrators, published in September (available here).  This includes, as would be expected, commentary as to the role and responsibilities of the administrator regarding valuation.  

Before we go to our second post on solutions, we thought that it would be useful to make some comments on the AIMA paper - which holds itself out as the central benchmark of administrator "sound practice" - as an addendum to our prior post.  We hence have some comments on rethinking hedge fund administration 1.5.

The point we would like to make is to compare what AIMA now say in 2009, with what they used to say in the first version of the administrator sound practices guide, which was published back in September 2004. 

In Section 3.2, Security Pricing, the "Old Guide" stated:

Security pricing is a high-risk area for administrators, managers and prime brokers. It requires high quality data feeds, automated price validation systems and highly experienced staff. The risk of applying the wrong prices to a fund is ever present and extreme care is required to avoid this and any consequent reputational damage to the manager, administrator and prime broker.

It is also vitally important to consider the independence of the pricing process. Wherever possible, the administrator must independently price the assets of the fund. This is essential to preserve the actual and perceived independence of the NAV process and to protect the manager from accusations of bias. If the pricing environment of the fund is not rigorous, then the investors could be exposed to the risk of incorrect pricing.

However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is agreed with the administrator and the auditor before the fund is launched and that there is some way for both of them to check the pricing of the instruments during the life of the fund. The administrator should be able to assess the “reasonableness” of the manager’s and/or product issuer’s price.

We would completely agree that it is "vitally important to consider the independence of the pricing process".  Moreover, even for the hardest to value securities, AIMA's 2004 guidance states that the administrator (and auditor) must find "some way for them both to check the pricing of instruments during the life of the fund."

When getting to the very hardest to price securities, the Old Guide states:

In some cases, the administrator may be required to rely on prices determined by the manager, using its own pricing model for some specific complex derivatives instrument, for example. Although this is not desirable, there may be no alternative. In such cases, the administrator should:

1. ensure that the valuation procedure whereby the administrator is obliged to value the fund’s portfolio on prices based on the manager’s pricing model or formula is fully disclosed in the offering documents and the administration agreement;

2. ensure that the manager discloses both to the administrator and the fund’s auditor how the pricing model works and permits the auditor to carry out spot checks from time to time, to verify correct application of the pricing model; and

3. if possible, install the pricing model on its own system so that it can check the prices provided by the manager.

Armed with their own sources and the counterparty’s valuation, the administrator should be in a position to value the OTC position competently.

These provisions, therefore, provide specific guidance to the administrator when looking at OTC trades and, overall, create a "do as much as you possibly can" mindset.  The guide continues:

Security pricing is a highly skilled area, requiring highly trained and knowledgeable staff. It should not be done by “part-timers” nor should there be duplication of effort. Ideally, each security should be priced once for all funds holding that security at that time. Control of this function is one of the central obligations of the administrator, who should be employing common pricing procedures across all of the funds it administers.

This again suggests that there is a clear responsibility for the administrator to both disclose any manager pricing and, moreover, do all that is possible to derive independent valuations.  We particularly like the comment that "control of the [pricing] function is one of the central obligations of the administrator."  Moreover, the Old Guide makes it clear that this work should be supported by suitably skilled resources within the admin's organization.

Well, what a difference five years makes.  These are the key comments on valuation from the New Guide:

In all cases, it is important to consider the independence of the pricing process. Wherever possible, but subject in all cases to the fund’s pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund. However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is documented, checked where a secondary source is available and reported to the pricing committee or board, periodically.

OK.  So now it is "important", not "vitally important" to consider the independence of the pricing process.  There is also a big difference between "wherever possible, the Administrator must independently price the assets of the fund" (which means that the administrator's prices would be used in the NAV) and "wherever possible, but subject in all cases to the fund's pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund."  Note also that we are now in a world where there "will", rather than "may" be occasions where valuations can only be made by the manager.  We continue:

The pricing policy document should be approved by the board or governing body of the fund on a regular basis (annually or when altered).

It should be noted that while some HFAs have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility.

Particular attention should be given to the governance aspects of the AIMA Guide to Sound Practices for Hedge Fund Valuation, as the observance of their principles should avoid any misunderstanding or lack of clarity around pricing and responsibility.

The Guide notes that the area of valuation has been topical and, in some cases, controversial. The role of the HFA has regularly been questioned and many investors and other industry participants have asked: “Is the HFA responsible for valuations?”

The Guide notes (and agrees) that both the AIMA and IOSCO documents suggest that it is the governing body that is ultimately responsible for the valuation of assets. In most cases, this is a board of directors or a general partner. Typically, the board will set a pricing policy.

The main thrust of the new document, therefore, is to revert attention to the pricing policy (and how many funds actually have one which really is detailed and comprehensive?) and place the administrator in a secondary, reactive role.  The guidance is much more vague, and there is certainly not the same emphasis on the "essential" need for administrators to "independently" value assets.   Moreover, there is now room for "many" administrators not to be "capable" and "expert" in the calculation of recommended prices for individual securities.  

Our biggest comment though, is one we have made before.  It remains utterly, utterly and utterly ridiculous to suggest that a Board of Directors comprised of two gentleman in the Cayman Islands with corporate secretarial backgrounds, who serve on the boards of hundreds of other hedge funds, can be "ultimately responsible for the valuation of assets" and "set a pricing policy".  For investors who allocate tens of millions - or hundreds of millions - of dollars to individual hedge funds, this comment can best be described as disingenious fallacy.  In fact, it is an insult to the intelligence of everyone concerned.

We would also point out that investors can pay the administrator millions of dollars per year for their services on some larger funds, while the average Cayman director gets $5-10,000 per fund.  That would seem to place some framework around who has the better knowledge and who is better placed to get involved. 

Perhaps the best comment, however, is the final "sound practice" guideline.

The governing body and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.

AIMA, therefore, leaves us in exactly the same place as our own experience of current administration servicing.  While some administrators do complete thorough and robust servicing, including detailed pricing, many do not.  The message from the industry to investors, though, appears to be fairly casual - don't take anything for granted, or "automatically assume" a standard model.  In other words, caveat emptor.

The real issue here - and one that must be addressed, sooner rather than later - is that post Madoff, post financial crisis, and post the greatest stress period the hedge fund industry has ever seen, hedge fund investors have increasing, not decreasing, exposure to managers pricing their own securities.  We would have thought that all this pain would leave us with more protections - but no, we continue with all the evident risks that go along with managers marking their own books.  Moreover, everyone concerned - managers, administrators, auditors - seem to assume that this is an entirely satisfactory state of play and, indeed, is "sound practice".  

As the boy said to the naked emperor, it is not.

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