Hedge funds often make investments in complex securities. Subsequently, market activity for such investments may significantly diminish to the point that the market is no longer considered active. In order to determine the fair value of such investments for financial reporting purposes, management must possess sufficient knowledge of the specific terms of the investments and have the experience to value such investments, including understanding the valuation models, and the sources of information and assumptions utilized in determining fair value. Such knowledge and experience has become increasingly important as illiquidity for many securities has greatly increased.

It is recommended that management prepare an “Investment Valuation Policy & Procedures” framework setting forth the general principles for the valuation of portfolio investments. This framework can be critical in defining management’s process for determining which investments will need to be valued through use of a model and develop criteria for determining what type of model is appropriate. Such a framework will also help to address an auditor’s need to assess the knowledge and objectivity of management relating to the valuation process.

A comprehensive valuation framework should include the following:

• A governance structure that supports the valuation framework

• Valuation policies which address each asset class and the related valuation framework

• Controls and procedures in selecting valuation models that are consistent with market practice and the monitoring of the inputs into the valuation models

• Controls and procedures which provide for independent pricing and analysis of price differences

• Policies to address documentation of the valuation approach applied and the key assumptions used

Fair value estimates are based on assumptions about future conditions, transactions and events. Therefore, perfect information to develop assumptions to ultimately develop an estimate of fair value inherently may not exist. However, if the key drivers of value are understood reasonable assumptions can be obtained and/or developed. Valuation models will vary in complexity from a general framework to compare to “market” transactions with few key variables – such as a price-to- EBITDA multiple – to more complex cash flow based models with many inputs for asset backed securities and derivatives. Over-engineering a valuation model for which limited support for assumptions can be obtained doesn’t add “value” to the process. What is critical is to identify the appropriate model or valuation framework, know if it is a model or valuation framework that other investors would consider utilizing, and understand how the key drivers of value are reflected in the model.

Use of an external valuation expert

In certain cases, management may consider the use of an external valuation expert to provide additional support in determining the fair value of an investment. For example, in a market environment that has seen a significant diminishment in liquidity, certain investments, such as asset-backed securities, may have been valued based on a price derived from an active market and now must be valued utilizing a financial model. Therefore, an understanding of the issues impacting the value of these securities coupled with a market price derived from an active market at the time the securities were purchased may have been sufficient to assess value. But valuing the securities in an inactive market environment, with what can often be a complex financial model with unobservable inputs, is very different. In certain of these circumstances, the use of an external valuation expert may be appropriate.

Use of a third-party pricing service

When valuing securities that are not actively traded, management may also use a third party pricing service. Management must understand the sources of information and methods utilized by the pricing service and determine whether the pricing is based on market participant transactions, a model or both. If the value estimate is based on a model, either by a valuation expert or a pricing service, management must understand the significant assumptions (both observable and unobservable) utilized. It is recommended that the pricing service and/or management provide adequate support, including substantiating the underlying source, for the significant inputs (i.e., assumed forward interest rates, default rates, recovery rates, etc.) utilized in the model.

Reconciliation of values derived from different sources

Management should be able to provide explanation for, and be able to reconcile, different values obtained from different sources and/or methodologies. To the extent utilized, this may include prices from broker-dealers (considering the extent of specific knowledge the broker-dealer may have – do they make a market or just provide a price without sufficient knowledge or the inputs used to arrive at the quote), fund administrators, other hedge funds, third party pricing services, and/or valuation experts, as well as values derived from appropriate financial models utilized by management. Additionally, the reconciliation would also consider any differences in the specific rights relating to the security (but not specifically related to the holder), as compared to another a similar investment.

Adequate support for the underlying assumptions

Management must be able to provide support for the valuation analysis to the audit team on a timely basis. In evaluating the relevance of certain supporting information and underlying assumptions, management needs to consider the timeliness of when certain information may become available. For example, a year end financial statement (audited or unaudited) may not become available until a few weeks or even months after year end. The financial statement will reflect certain significant information that may reasonably be estimated as of year end as contrasted with other information that may not be anticipated as of year end but will impact fair value. What is known and knowable, including what is reasonably anticipated but can not be exactly quantified as of a particular valuation date, should be considered in valuing investments as of such date.

Monitoring the valuation process

The appropriateness of management changing a methodology to determine fair value needs to be evaluated and understood. The evaluation should consider the changes in market conditions and the extent to which objective supporting information is available as of the valuation date, as compared to earlier periods.

It is recommended that management develop an ongoing monitoring process to assess the effectiveness and reliability of their valuation methodologies, assumptions and sources of information. Back testing of valuations, prices or valuation estimates provided by a valuation expert, pricing service or broker-dealer should be considered in evaluating management’s valuation process.

By Michael Aronow
For more information, contact Aronow at: 212.891.4170, or: maronow@eisnerllp.com