Feffer and Kundro said: "Unless certain practices become more widespread, the industry faces a potential crisis of confidence with institutional and high net worth investors."

The Capco white paper is entitled "Valuation issues and operational risk in hedge funds". Valuation issues are already a factor in many headline-grabbing hedge fund blow-ups, and continue to be in the news as they increase in their frequency, severity and visibility.  Recent evidence includes coverage of the SEC's staff report on "Implications of the growth of hedge funds," and the recent market-timing scandals in the mutual fund world.  

A recent study by Capco on "Understanding and mitigating operational risk in hedge fund investments" found that valuation issues were a primary or contributing factor in approximately 35% of hedge fund failures.

The Capco white paper suggests that investors and fund managers insist that hedge funds follow three key principles in their valuation processes to ensure proper pricing:

• Insist on strict "independence and separation of duties" in the valuation process.  Long a fundamental principle of control in financial institutions, it is still unevenly applied in the hedge fund world.  In short, this means that portfolio managers and traders should not be principally responsible for valuing their own portfolios (which is often the case currently). Instead this should be performed or checked by someone who does not report to the portfolio manager and is not compensated based on the performance of the specific fund.
• Ensure consistency of application of sources, methods, rules, models and process in valuations.   When these are applied situationally, it is often a red flag for pricing problems.
• Increase the level of management supervision and oversight of the valuation process.  There should be documented policies and procedures at the fund, and a way of making sure that these policies and procedures are followed, usually through internal audit and testing.  There should be evidence of ongoing management review and actions taken when inevitable pricing discrepancies are found.

The white paper also discusses the common reasons for valuation problems, which include the inherent difficulties in valuing certain types of securities, as well as pricing mistakes, procedural problems, infrastructure issues, misrepresentation and fraud.

copyright hedgeweek 2004