Hedge funds start self-regulating

Date: Wednesday, April 25, 2007
Author: Sunday Times

As a mark of its growing maturity, the international hedge fund industry last month released two congruent sets of "sound-practice" principles relating to the valuation of hedge fund portfolios. According to local hedge fund administrator, FinSource, the good news is that the South African hedge fund industry already subscribes to most recommendations in the reports.

From Europe comes a report by the London-based Alternative Investment Management Association (AIMA), which provides 15 recommendations. These are based on a global survey of hedge fund managers, investors and administrators and relate to the use of independent administrators, the range of instrument pricing sources, governance over fund valuation and the various roles of those involved in the pricing function.

A separate report for public comment was issued in March by the International Organisation of Securities Commissions (IOSCO), containing a statement of nine principles relating also to hedge fund portfolio valuation. IOSCO is the leading international grouping of securities-market regulators. Its current membership comprises regulatory bodies from over 100 countries that have day-to-day responsibility for securities regulation and the administration of securities laws. South Africa’s Financial Services Board is a member.

FinSource chief operating officer, Veit Schuhen, says the reports are a clear sign of the growing importance of hedge funds to global capital markets.

"The global spotlight is turning to hedge funds. One of the areas under scrutiny is the valuation of complex illiquid financial instruments. In fact, while the debate around hedge fund regulation continues, the industry is in the meantime starting to self-regulate, as shown by the reports."

"Investor protection and investor rights are major drivers. The hedge fund industry is ’institutionalising’, moving from a previous somewhat opaque image to an alternative asset class attractive to both institutional and, increasingly, retail investors," says Schuhen.

According to IOSCO, portfolio valuation is critical to investors because it affects net asset value (NAV), financial reporting, performance fees, fees paid to hedge fund service providers, collateral requirements and risk profiles.

The valuation process can be fraught with potential conflicts of interest and structural concerns which are exacerbated in the case of difficult-to-value instruments.

For example, to avoid conflict of interest, managers should not take an active role in fund valuation. Yet they are often the only or most reliable of source of pricing information. In this case, the "triangular relationship" among manager, administrator and governing body of the hedge fund needs to be transparent and carefully structured and monitored.

Schuhen says this is precisely why most hedge fund managers in South Africa are already outsourcing portfolio valuation to an independent third- party administrator. "Not only are such administrators experts in the process, but the operational risk is spread for the manager. It is no coincidence that most hedge-fund debacles in former years were in funds with in-house administration."

AIMA’s South Africa chapter held a meeting in February at which there was a call for mandatory third-party administration of hedge funds. In a survey of some 40 members, 24 responded with 63% in favour of the move.