Private Investment Valuation: Protect Yourself with Documentation
Itís not just how you value hedge fund private investments, itís ensuring you have adequate and appropriate documentation to support those valuations so your firm is protected.
Private investments held by hedge funds are generally illiquid, which makes their valuation no easy task. This is different from private equity funds, which have long-term fixed lives, no subscription and redemption activity, and assets that tend to remain in their funds for a long period and therefore do not require frequent valuation. Hedge funds, after an initial lock-up period, generally permit periodic redemptions and subscriptions throughout the life of the fund. In addition, hedge funds tend to trade more frequently than private equity funds. That makes accurate valuation both more necessary and more difficult.
SEC examiners pay careful attention to valuation, since they know that it can be difficult for firms to grapple with and it involves issues of investor fairness and conflicts of interest, said WilmerHale of counsel Richard Jackson. That means hedge fund managers need to make sure they not only value private investments correctly, but that they can demonstrate to examiners that they did so.
If private investments are included in a fundís portfolio, valuation should be done often enough to match both the fundís publication of its performance results and the timing of subscriptions and withdrawals, which often will mean monthly, said Morgan Lewis partner Richard Goldman. If performance results are published less often, say quarterly, managers can match that frequency, said Shearman counsel Thomas Majewski, but at the least they should match the timing in which investors are allowed in and out of the hedge fund, whether that is quarterly or some other frequency.
Consider side pockets
Side pockets are a way to avoid the valuation trap. "By segregating the private investment in a side pocket, it takes the pressure off of valuation," Goldman said.
Just what are side pockets and how do they work? Put simply, side pockets are mechanisms that allow a private fund to put its illiquid investments aside and make them ineligible for redemption. The investments are held only for the benefit of the investors who were in the fund at the time the investment was made or, if later, at the time the investment is side-pocketed. If an investor redeems from the fund, it will still continue to own its interest in the side pocket. When the side-pocketed investments are eventually sold, the proceeds are then distributed among the investors that beneficially owned them. Fund managers typically charge quarterly management fees on assets that are side-pocketed, but no incentive allocation is usually taken until the asset is sold and the proceeds are distributed to the beneficial owners.
Hedge fund managers that choose not to offer side pockets must ensure that both their documentation and their valuation policies and procedures will satisfy examiners that the steps they have taken are "reasonable and consistent," Goldman said.
Itís when managers fail to demonstrate that the valuation steps they took were reasonable that examiners take notice and the possibility of enforcement cases raises its head, said Jackson. Managers would be wise to ensure that they considered, and that their documentation demonstrates that they considered, all facts reasonably relevant to the value of an instrument,
addressed relevant conflicts (such as reliance upon individuals who have a stake in the value
determinations), and have a process to re-evaluate securities that are being carried at fair value.
Hedge fund managers should maintain any documentation they feel is material to their valuation conclusions. For instance, if a firm receives quotes from three different brokers and uses the middle one, it should keep all three quotes in its records so it can show examiners its process, Goldman said. If quotes were not available, and the manager chooses to value some assets by pairing them against comparable publicly traded assets, it should keep records of those comparisons, when they were performed, and what the results were.
As an example of records to save that indicate reasonableness, advisers should ensure that they document the factors they considered in determining fair value of an issue. Majewski said. An investment might be valued using a variety of methodologies, such as discounted cash flow, a multiple of EBITDA (earnings before interest, taxes, depreciation or amortization), or comparative pricing. If a multiple of EBITDA is used, for instance, the adviser should maintain documents that show why that was the reasonable methodology to use (the answer might be because it is the norm used in valuing businesses in a particular industry, he said.)
Typical documents to save include those relating to the valuation process itself and how it worked, said Jackson, such as minutes and other records of the valuation committeeís considerations (see below), and the standards used in determining fair value. These standards typically include the type of security, the size of the holding, pricing of similar securities, and broker quotes, among other things, Jackson said.
Other documentation tips:
Obtain independent valuations. Multiple broker quotes would be an example of this. But even when broker quotes are not available, have an independent third party conduct its own valuation against your firmís valuation, said Majewski. Or have more than one independent source. Look for divergences and inconsistencies. "Ultimately, itís up to the hedge fund manager to make the right determination," said Jackson.
Be consistent in your methodology. When valuing, "donít change your valuation practices mid-stream" unless there are important reasons for doing so, said Goldman. Be consistent. Too frequent changes in valuation methodology "may start to smack of cherry-picking," said Jackson. Of course, there are occasions when a change in methodology would not only be perceived as reasonable, but warranted, he said. Examples would be a change in the circumstances involving the investment, a change in the investment assumptions, or a change in market conditions.
Use your firmís valuation committee. If your firm doesnít have such a committee now, consider creating one. The valuation committeeís role is to review managerís valuation recommendations to make sure they are reasonable, Goldman said. In addition, "a valuation committee will oversee the process, approve the methodologies to be used, as well as review the proposals," said Jackson. Donít let your committee become stacked with portfolio managers. It should represent a cross-section of your firm, including the chief financial officer, Goldman noted.
Policies and procedures
Well-thought-out policies should be broad enough to cover the valuation methodologies a firm might use, as well as circumstances for when valuation might need to be revisited, said Majewski. Your valuation policy should include the methodologies the firm might use to fair value an issue, such as a multiple of EBITDA or discounted cash flows, and the circumstances under which an independent third party might be used.
Overall, Goldman said, valuation policies and procedures need to do two basic things: 1) state how the firm prices different types of securities, and 2) make clear when and under what circumstances a firm may deviate from those policies and procedures. Any deviations need to be well documented.
The first step, how to price, is not difficult for a security that regularly trades and for which there is a readily determinable current market value. But for those securities that may be priced differently by various market participants, the adviser might want to get quotes from three brokers and accept the average of the three, or just use the middle quote, to determine what to use for fair value.
It is when there is no readily discernible market value that the second step, determining when fair value must be ascertained, comes in. A firmís policies and procedures should describe the role of the valuation committee, the circumstances under which fair value would need to be determined, any additional factors to be considered, and who would be responsible for carrying out the determination of fair value, such as a third-party administrator or custodian involved in the process and its responsibilities, Jackson said.