The decision by Union Bancaire Privée in December to pull all of its money from hedge funds that did not have an independent administrator may not have made many headlines. But the move by the Swiss private bank, which admitted to client losses of $700 million in the Bernard Madoff Ponzi scheme, offers the first public evidence of a change that has been quietly transforming the industry for more than a year. Many investors are now insisting that fund net asset values be provided not by the manager, but by a third party that will guarantee independence and transparency.
The bull market long allowed managers to set their own terms — by closing funds to all but the most compliant investors, for instance — and the tradition of self-administration continued unchallenged. Internal pricing allowed managers to smooth returns, and in extreme cases perpetuate fraud of the sort alleged in the cases of Houston-based Stanford Financial Group and New York–based Bernard L. Madoff Investment Securities (though neither was a hedge fund, strictly speaking). But the tables have turned: Now it’s investors who are calling the shots, using their newfound muscle to challenge the reporting status quo, forcing managers to either return capital or adopt independent-valuation standards.
Some sizable managers are going along with it. Millennium Partners, which runs $13 billion, wasted no time in acquiescing. Just weeks after the UBP announcement, the New York–based multistrategy firm appointed specialist hedge fund administrator GlobeOp Financial Services to provide independent administration. “Despite the controls we have in place — which have been reviewed by a number of other independent parties — we accept that the marketplace is now demanding an additional layer of comfort provided by an independent administrator,” explains Millennium chief operating officer Terry Feeney.
Some managers have not been so willing. D.E. Shaw & Co., a $30 billion New York–based hedge fund firm, appointed HSBC in January to provide an independent pricing service to supplement D.E. Shaw’s own back-office pricing. Shaw asserts that a combination of internal and external expertise in fund administration produces more accurate pricing.
But resisting a swell of investor opinion seems a potentially dangerous game at a time of large-scale redemptions. UBP, which has $33 billion in funds of funds, making it one of the biggest hedge fund investors in the world, is withdrawing from funds that will not comply with independent-valuation standards. Although UBP declines to confirm which funds are on its hit list, funds it invested in that, as of December 2008, were self-administering included some of the biggest names in the industry: Caxton Associates, Citadel Investment Group, Millennium, Renaissance Technologies Corp. and SAC Capital Advisors.
The drive toward independent administration has been building for some time and gained steam last year with the widespread problems in the valuation of mortgage-backed securities. But as long as funds were making money, investors were in no position to insist on changes — and those who did were quietly shown the door. When Hans Hufschmid, CEO of GlobeOp, was a partner at Long-Term Capital Management in the 1990s, the firm brought in outsiders for occasional spot checks but did day-to-day NAV calculations in-house. LTCM’s 1998 collapse is still the most famous hedge fund blowup in history, but keeping valuations in-house remained the norm among U.S. funds. Now that habit has begun to fade.
“Redemptions and negative performance have shrunk assets under management; even well-established funds are more open to investor requirements,” notes Hufschmid, whose company has its main offices in London and New York and administers some $88 billion in assets. “Independent administration — including verification of pricing, positions and cash balances — is something that new investors are in a position to insist on.”
And insisting they are. Managers at Nedgroup Investments, a Cape Town, South Africa–based fund-of-funds firm with about $350 million in assets under management, have always required independent valuation but say they now look over everything even more closely than before. “Even if a due diligence review approves the asset management process, the operational review has a right of veto,” notes Tracey Wiltcher, Nedgroup’s head of product investment management.
At Credit Suisse’s fund-of-funds group, the mere presence of an outside administrator is not enough. “We are asking considerably more questions around the process that underlies fund valuation,” says Christopher Vaz, the group’s New York–based head of operational due diligence. Vaz reports seeing an increasing number of detailed valuation policies being adopted between funds and administrators. This heightened scrutiny is applied especially in instances involving illiquid assets. “In the case of the harder-to-value assets, we would expect to spend time with the administrator talking through how they are valuing assets so that we are fully satisfied with the approach,” Vaz explains.
Although everybody seems to believe that external administrators have a role to play, there remains substantial disagreement over what that role should be. The London-based Alternative Investment Management Association has produced guidelines that explicitly recommend externally written valuations. The Washington-based Managed Funds Association, on the other hand, argues that “in certain instances the investment manager has the best insight with respect to the valuation of particular instruments.” However, two quasigovernmental groups, the Madrid-based International Organization of Securities Commissions and the U.S.-based President’s Working Group on Financial Markets, favor independent valuations. IOSCO recommends “an appropriate level of independent review,” and the U.S. group stipulates that “a fund should generally seek competent and independent review or generation of its final valuations.”
Champions of third-party assessments argue that placing counterparty pricing at the core of a valuation model gives true mark-to-market values. This approach quotes prices at which — or close to which — a fund would be able to sell its assets if required. One drawback: When liquidity dries up, there may be no counterparties that can provide a market value.
The manager-hosted model, which is likely to have more theoretical pricing, has at times been found severely wanting. Manager reliance on historical data pushed valuations rapidly out of line with reality when demand for asset-backed securities dried up during the financial crisis, sending valuations crashing at such hedge funds as the two Bear Stearns & Co. credit vehicles that collapsed in 2007.
Most guidelines imply that the ideal valuation model will vary from fund to fund. Contrast, for example, a long-short equity fund investing almost entirely in exchange-traded stocks against an arbitrage strategy specializing in highly illiquid asset-backed securities. The former’s valuation is best rooted in mark-to-market standards; the latter is not as suited to such an approach, which is why it may be more important to require transparency rather than insist on independent valuation. Fund incorporation documents, in such cases, must clearly define the methodology by which assets are valued. The fine print in cases in which third-party valuations are suitable should also guarantee an outside administrator’s access when market conditions do not favor the manager.
“The key point is that the agreement endows the administrator with sufficient independence not to be pressured by the investment adviser when things get difficult,” explains Whitney Bower, a partner and administrator specialist at London-based private equity firm 3i Group, which has $14 billion in assets under management. “Unfortunately, that is not what happened in the Bear Stearns funds, which created huge valuation ranges between internal valuation and fair market value.”
The potential price of shoddily drawn agreements has only lately become apparent. Many of the lawsuits pending against hedge funds and funds of hedge funds for their investments with Madoff may fall apart if it is shown that they had been informed that valuations were dependent on Madoff’s in-house brokerage.
The clamor for independent valuation may not sound a gloomy note for managers. “The growing importance of accurate valuations is increasingly clear to managers themselves,” argues Ian Headon, a vice president of hedge fund administration for Chicago-based investment management company Northern Trust Corp. “It can only be healthy because it encourages them to focus on the growing importance of accurate valuation for managing counterparty risk.” Headon and others say that managers who are forced to be more transparent to keep their clients’ assets will inevitably deliver more accurate valuations.
Jan Frogg, UBP’s Geneva-based head of alternative investments, acknowledges that some managers who resist independent asset valuation may well be justified. If the review of their valuation processes reveals that a combination of internal and external administration is both accurate and robust, then the redemptions may well be reversed, he says.
But regardless of what UBP does, the shift of power from managers to investors provides a clear opportunity for valuation standards to be raised across the hedge fund industry.
