Valuation: An Operational Risk Due Diligence Perspective
By Mark McMahon & Alan Swersky, Duff & Phelps
As DNA is the building block of life, valuation is similarly important to any fund's Net Asset Value (NAV) calculation. While the increasing pressures placed on managers by regulators, auditors and other constituents have been well-documented, investors and allocators face similar demands to ensure that the NAV they are given is an accurate representation of fair value. This invariably leads to concerns regarding how managers approach, document and validate valuation, as well as the various roles played by fund personnel, administrators and other third parties throughout the process.
To address these concerns, both sides should start by preparing for a robust operational risk due diligence process. The following steps can help any investor gain the insights necessary to make informed decisions about the integrity of a fund's approach to valuation. They also provide important guidance to managers as they navigate through a post-crisis alternative investment environment, where a stronger emphasis on transparency continues to push managers to codify and disclose more essential activities every day.
The first step in understanding a manager's process is a thorough review of all documents relevant to valuation. This includes – but may not be limited to – due diligence questionnaires, offering memorandums and, of course, the valuation policy. Regardless of asset and portfolio complexity, a strong understanding of the valuation process, including documented policies and procedures that govern these activities, can provide investors with a measure of comfort that a manager strives to incorporate industry best practices. These documents should clearly describe all aspects of a manager's process for pricing securities on a period end basis and should accurately reflect the fund's strategy.
Importantly, a fund's dedication to a liquid strategy, such as long/short equity, does not excuse an investor from performing all critical aspects of due diligence related to valuation – nor does it excuse the manager from considering all scenarios that may impact value beyond the closing price “at the bell.” As recent financial market dislocations have taught us, an active market today can become inactive or distressed tomorrow, creating a problem for managers who do not have a robust process for marking illiquid investments. This issue can be particularly relevant for emerging market strategies, where poor information flow, regulation and market infrastructure can lead to varying degrees of liquidity, and challenge managers to evaluate pricing indications for these securities on an ongoing basis.
Similarly, investors also need to determine whether a manager has side pocket capabilities, which often exist despite a liquid strategy. Some funds have been criticized for abusing these structures, so it is important to be aware of the purpose, fees and any possible limitations regarding what portion of a portfolio's aggregate value the side pocket can represent. Managers are wise to include very specific terms and descriptions that clearly address how side pockets are handled in all appropriate documentation.
Verifying Information Sources
All sources of pricing information should be documented and auditable. Listed securities are typically priced using market standard sources, such as exchange feeds, Bloomberg and IDC. Non-listed securities, such as bonds and other fixed income securities, over-the-counter securities, and certain structured products are usually priced using broker quotes and proprietary pricing services. Verification of this data is often enhanced through a comparison of valuation inputs from multiple sources. For more liquid securities, several pricing feeds comparing closing or bid/ask quotes can be reviewed. For illiquid positions, support should be documented for critical valuation inputs, such as earnings multiples and volatility calculations..
From a manager's perspective, these sources could provide unique challenges when reconciling to a fund's valuation procedures. For example, managers relying on broker quotes must ensure that they understand what each quote represents. Often, managers will define a methodology for handling multiple quotes of varying degrees of reliability. This includes measuring the volatility of the population through a standard deviation calculation or excluding outliers and quotes that may be heavily influenced by hedging activities and exposure to other securities of the issuing company. A quote that is “actionable” is often more credible if it represents significant volume, if similar price quotes are available, and if it can be corroborated through a fundamental analysis.
For illiquid securities, where valuation often relies on significant judgment, best practices can be straight-forward, such as reliance on a Black-Scholes model for European-style options. However, the complexity of an asset manager's investments is often accompanied by additional tools with which to evaluate them. This can create additional challenges, not only to accurately source important value-driving inputs, but also in reconciling each methodology to the manager's policies.
Independence and Accountability
Despite significant investments in back-office infrastructure, many managers have engaged administrators to ensure that NAV incorporates an independent perspective. Consequently, investors should understand an administrator's role in pricing a portfolio. Typically, administrators simply verify the valuations, so the manager should clarify how this relationship effectively works. Does the administrator receive all dealer marks independently, or does the manager provide these marks directly? How often does a manager override the administrator's prices, and how are disagreements regarding valuation settled? Through the operational risk due diligence process, an investor can gauge the extent of the administrator's involvement in valuation by reviewing relevant email exchanges and related documentation.
If a fund relies on an independent valuation firm as a valuation agent, this relationship should be confirmed and reviewed. The degree of reliance on a third party is often a function of fund strategy, history, size, geographic focus and the investors' varying levels of sophistication. Investors usually require assurance that the provider is reputable, has adequate access to the relevant information and individuals, and provides clear conclusions that are consistent with the scope of the engagement. Depending on the engagement terms, the valuation agent may also be requested to comment on the adequacy of the manager's procedures, including policy issues influencing valuation.
Related to these efforts is a thorough review of the due diligence questionnaire and the valuation policy to identify those individuals involved in the valuation process. Investors should have full knowledge of who has responsibility for valuation, be they representatives of the deal teams, the chief financial officer or the valuation committee. Among the members of the valuation committee, there should be representation from a cross-section of investment and non-investment executives, including an independent observer. It is also important to understand the frequency of the valuation committee's meetings and whether the compensation of any committee member is directly or indirectly tied to the performance of specific securities.
The final step in the due diligence process is an on-site visit, which allows investors to conduct a first-hand review of the manager's portfolio valuation process. Investors should ask to review a random, month-end accounting package and should be able to compare and reconcile the manager's period end securities valuation to the stated valuation policies.
For liquid portfolios, a manager will often provide a pricing matrix that lists prices and quotes received for each investment, and the source of each. Depending on the manager's methodologies, the matrix should provide a roadmap for deriving the concluded price for each security. For illiquid portfolios, additional data is often required to substantiate the approach and conclusions of each valuation analysis, including information sources such as support provided by a valuation agent. Other items investors may want to view on-site are valuation committee minutes, which should be made easily accessible.
Volatility, fraud and regulation are among the many factors that have pointed an intense spotlight on alternative asset managers and their investors. This interest is unlikely to fade as capital flows return to their pre-crisis levels. Industry participants are eager to display a more comprehensive view of shared responsibility within the financial community and broader economy, and this effort has become evident within the operational risk due diligence effort, particularly regarding valuation.
The steps detailed above should help investors and managers alike to navigate this process, but it is important to realize that it is no longer acceptable to simply "do the right thing." Investors now demand that the solutions to certain fundamental concerns be institutionalized by managers. With this in mind, the documentation and execution of valuation policies that incorporate industry best practices can help ensure that this critical component of the operational risk due diligence process also serves to protect, and possibly enhance, manager reputations.
Duff & Phelps is a leading provider of independent financial advisory and investment banking services. Mark McMahon is a Director in the Portfolio Valuation Group, where he specializes in the valuation of illiquid securities for private equity, hedge funds, business development companies and fund of funds. Alan Swersky is a Director and leader of the Operational Risk Due Diligence Group, which provides investors with an independent third party assessment of hedge fund managers' operating policies and procedures.