Hedge Fund Valuation: What Advisors Need to Know

Advisors with clients in hedge funds have a crucial job when it comes to due diligence and liquidation, experts say

The search for alpha can lead hedge fund managers away from traditional long-short strategies with listed securities. Depending on the fund’s strategy, the manager might invest in customized derivative contracts, illiquid securities that trade infrequently or assets that don’t trade at all.

These categories pose a valuation challenge, says Espen Robak, CFA, president of Pluris Valuation Advisors, a New York-based firm that specializes in portfolio and business valuation.

Fund managers can’t just pick a value on any given day based on the last trade, he explains: “There’s more analysis to be done. You have to look at what has happened in the market since the last trade. You also need to look at whether or not the last trade might have been an outlier and whether there is information from comparables that can be considered and so on and so forth.”

Why Valuation Matters

Accurate portfolio valuation is important for several reasons.

The fund’s estimate of net asset value (NAV) determines the value of investors’ limited partnership shares. When an investor requests a redemption during a liquidity window, an undervaluation of the fund’s assets means the investor will receive a smaller-than-accurate distribution.

Conversely, investors withdrawing funds from an overvalued portfolio will receive larger-than-accurate distributions, essentially short-changing the remaining investors.

The problem of inaccurate valuation can also distort managers’ compensation. “The annual management fee is determined as a percentage of assets under management,” Robak notes. “So, if that’s, in a classic hedge fund context, 2%, if you overstate assets by $100 million then you’re taking $2 million too much in the way of fees.”

Risk Analysis

Most advisors lack the time and expertise to substantiate the valuations assigned to a fund’s portfolio. Nonetheless, advisors can assist clients with due diligence.

There are two elements to due diligence, Robak explains.

The first is financial due diligence. This involves a review of the fund’s returns, Sharpe ratio, the consistency of the returns over time, and so on.

The analysis is also a search for red flags, such as suspiciously smooth returns due to a lack of volatility, as in the Madoff case.

The second element is operational due diligence. Taking on additional operational risk in a fund is a no-win proposition, according to Robak, because it provides no potential compensatory return.

Valuation risk is one of the most significant operational risks and a challenge to a fund’s valuation methods can paralyze management and damage returns, he explains. Advisors and investors should determine how a fund values its assets, whether it’s internally, with an expert third party or in some combination.

“If the operational due diligence is showing that management’s controls over the valuation process is lacking in some way, then that should give significant cause for concern when making an investment because you knew that that initial operational risk is potentially there and that can harm you and your investors down the line,” he says.

Valuation Firms

Pluris and other valuation firms add value by identifying operational risk exposures that an advisor or investor probably wouldn’t spot. The firm consults with funds to value portfolios and improve their valuation processes but also provides due diligence for high-net-worth private clients who are evaluating potential investments.

“For a particular investor that was considering an investment, we’ve done due diligence of the fund itself,” says Robak. “First of all, a review of the portfolio: Is the portfolio right now properly marked? If the portfolio, is say, a billion dollars, is that value correct or not as a matter of its fair value? But, also, what’s the process like? We know what a valuation process should look like. We’ve also been assisting funds with designing their valuation policies.”

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