Hedge fund administrators need to modify their current business and operational processes and to adopt new practices designed to provide greater insight and transparency into the value of derivatives, according to a recent whitepaper by OTC Valuations (OTC Val). The whitepaper, entitled Independent Pricing For Complex Derivatives and Illiquid, Hard-to-Value, Securities: Trends and Current Practices at Hedge Fund Administrators”, looks at the challenges facing this community as a result of the current market environment.
“With market and industry pressures calling for greater transparency into the valuation process, hedge fund administrators are faced with the stark reality of the implicit requirements that are placed upon them to provide independent and transparent valuations,” explains Bob Sangha, managing director at OTC Val. “While many have a valuation process, through an internal system or an outsourced service, in place for vanilla or liquidly traded derivatives, they lack the infrastructure, technical expertise, and vendor relationships to satisfy the independent valuation requirements for exotic derivatives, structured products, and illiquid securities.”
The whitepaper attempts to provide an insight into finding a balance between the build, buy or partner decision and the requisite expertise required to manage the valuation and market data processes. It highlights the investor and regulatory pressure for hedge funds to adopt industry best practices, such as third party independent derivative valuations and valuation transparency, which has renewed interest on implementing appropriate valuation controls.
The white paper examines recently issued best practice documents, including those provided by the Alternative Investment Management Association (AIMA) for hedge funds earlier this year and those of the International Organisation of Securities Commissions (IOSCO), which both recommend multiple pricing sources for valuation validation purposes. OTC Val suggests that this trend is due to the changing investor profile in hedge funds, with more traditional investors requiring greater levels of transparency with regards to pricing.
“In order to avoid the conflicts of interest that can arise from an investment manager’s influence over the valuation process in situations where a hedge fund is unable to establish appropriate levels of independent valuation and reporting lines within the hedge fund, IOSCO recommends consideration of the use of a qualified independent third party valuation vendor,” the white paper highlights.
Sangha explains: “In the past, it was common practice for administrators to use broker, counterparty, or fund manager quotes for most products, including the hard to price derivatives and securities. However, market dynamics have shifted the onus on hedge fund administrators to provide a level of transparency beyond broker quotes and independence by not relying on counterparty or fund manager quotes. This has created an unequivocal requirement for administrators to implement a robust and objective solution that enables them to provide independent and transparent valuations for vanilla and complex instruments.”
According to the white paper, many hedge fund administrators lack the necessary technical expertise and technology to value assets properly. This is especially the case when it comes to calculating net asset values (NAVs) for OTC instruments or other illiquid assets, says the vendor. “For OTC derivatives, it is not uncommon for administrators to use prime brokers, hedge fund managers, or counterparty marks as a substitute and in lieu of independent valuations,” the white paper states.
As the appetite for complex instruments continues to grow, so too will the requirement for administrators to facilitate transparent and independent valuations for these and other instruments, says Sangha. “This has led most administrators to address the strategic decision to build, buy, or outsource with respect to the valuation business. While each has its merits and purpose, an administrator’s decision will be contingent on its short and long term objectives.”
He continues: “For example, for an administrator that is looking for a flexible solution with minimal integration, implementation, or maintenance costs and does not require staff or expertise to manage the valuation process, outsourcing the valuations to a firm that can automate the valuation process and deliver custom reports can be a compelling solution.”
The white paper warns that a hedge fund administrator should be wary of the dangers of incorrect valuations, which could result in “a hedge fund’s total risk profile being mis-priced”. Thus the build, buy or outsource decision should be taken very carefully, says OTC Val.
Building a solution is the most complex option and can take “upwards of several years” to implement, says the paper. It also requires “significant” human and financial resources, which can make it unfeasible for some firms. “While maintaining control of the solution has its merits, the impracticalities of building, managing, and improving the solution do not warrant a build decision,” it contends.
The white paper also examines the buy option and recommends a number of factors that a hedge fund administrator should consider before purchasing a solution, including future requirements. “It is not uncommon for a system implemented by an administrator to become antiquated or a vendor being unable to keep pace with an administrator’s valuation requirements,” it warns.
However, the paper is very positive about the third option, which is seemingly where OTC Val is focusing its services for the hedge fund admin community. “Since this option requires no upfront investment or ongoing maintenance of a system, it is a cost effective solution that has great appeal. Furthermore, outsourcing enables fund administrators to utilise multiple derivative valuation vendors with minimal disruption to their ongoing operations. By relying on derivative valuation professionals that have the technical expertise to value vanilla and complex derivatives, it enables fund administrators to focus on their core functions,” the paper claims.