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HEDGE FUND ASSET VALUATIONS AND THE WORK OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS (IOSCO)

Published online by Cambridge University Press:  13 February 2008

Harry McVea
Harry McVea
Affiliation:
School of Law, University of Bristol. Email: [email protected].
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Abstract

This article seeks to explore and subsequently critique the International Organisation of Securities Commissions's (IOSCO) attempt to devise a globally recognized set of benchmarks of good practice in valuing hedge fund assets as set out in its recent Principles For the Valuation of Hedge Fund Assets (A Consultation Report, March 2007). The outcome of the IOSCO's consultation process is almost certain to have an important bearing on the future provision of hedge fund valuation services globally and, thus, is likely to be viewed with great interest by regulatory and industry bodies throughout the world.

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Article
Information
International & Comparative Law Quarterly , Volume 57 , Issue 1 , January 2008 , pp. 1 - 24
Copyright
Copyright © 2008 British Institute of International and Comparative Law

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References

1 International Financial Services, London, ‘Hedge Funds, City Business Series’ (Apr 2007) <http://www.ifsl.org.uk/uploads/CBS_Hedge_Funds_2007.pdf>1. However, in view of the fact that hedge funds routinely employ leverage (ie borrow against their assets) their impact on the financial markets is greater than the assets they have under management. ibid.

2 ibid.

3 ibid.

4 S Gray, ‘London tightens grip as European hedge funds boom’ Hedgeweek Special Report (Dec 2006) <http://www.hedgeweek.com> 3–6.

5 London is also Europe's leading centre for prime brokerage, with over 90 per cent of European business: Report of the Alternative Investment Expert Group: Managing, Servicing and Marketing Hedge Funds in Europe (July 2006) <http://ec.europa.eu/internal_market/securities/docs/ucits/reports/hedgefunds_en.pdf>14. Prime brokers (often investment banks) execute hedge fund trades, grant lines of credit to funds and hold hedge fund assets on ‘margin’ account.

6 See, for example, the Alternative Investment Management Association (AIMA), Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry (Apr 2005, updated Mar 2007), and the Managed Funds Association (MFA) Sound Practices for Hedge Fund Managers (November 2007).

7 In the UK, see, for example, Financial Services Authority (FSA), Hedge Funds: A Discussion of Risk and Regulatory Engagement (Discussion Paper 05/4) (June 2005) <http://www.fsa.gov.uk/pubs/discussion/dp05_04.pdf>. See also, D Waters, ‘Hedge Funds—New Regulatory Challenges’ (Speech on behalf of the FSA 12 Apr 2007) (‘[To the extent that] operational failures have contributed to dramatic declines in hedge fund values, many of these operational failures [include] weaknesses [associated with] the valuation process.’) <http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2007/0412_dw.shtml>1. In the US, see, for example, Securities and Exchange Commission (SEC) Staff Report, Implications of the Growth of Hedge Funds (Sept 2003) <http://www.sec.gov/news/studies/hedgefunds0903.pdf>(hereinafter SEC, Staff Report) and Testimony of Randall K Quarles, before the Senate Banking, Housing, and Urban Affairs Subcommittee on Securities and Investments of (16 May 2006). At the international level, see, for example, the International Organization of Securities Commission's (IOSCO) work, which is the subject of this article.

8 According to a recently published report by State Street, almost two-thirds (64 per cent) of institutional investors claim that accurately valuing their hedge fund holdings is problematic: ‘Hedge Fund Valuations “Problematic” Say Investors’ (Apr 2007) International Custody and Fund Administration <http://icfamagazine.com/?id=me/37/news/105/44056/0/>.

9 At the European Union level, retail collective investment schemes are regulated under the Undertakings for Collective Investments in Transferable Securities Directive (UCITS), Directive 85/611/EEC, as amended, inter alia, by Directive 2001/107/EC (the ‘Management Company Directive’) and Directive 2001/108/EC (the ‘Product Directive’). The latter two Directives are generally known as UCITS III.

10 It is estimated by the Alternative Investment Management Association (AIMA) that today 23 cent of hedge fund strategies are in hard to value securities (eg distressed debt, emerging markets, fixed income arbitrage): Waters (n 7) 1.

11 FSA, Hedge Funds: A Discussion of Risk and Regulatory Engagement (Discussion Paper 05/04) 49 (hereinafter: FSA DP 05/04); and FSA, Hedge Funds: A Discussion of Risk and Regulatory Engagement (Feedback on DP05/4) (Mar 2006) 5 (hereinafter ‘Feedback Statement 06/2’). To the extent that fund managers deliberately issue false valuations criminal sanctions could follow (eg Financial Services and Markets Act, 2000 (FSMA), s 397). In the US, see, eg SEC, Staff Report (n 7) fn 257. For a more recent example, see ‘Hedge Fund Chief Accused of Overstating Assets by 2,500%’ The Times (London, 8 Feb 2007).

12 ‘The absence of any form of independent oversight over hedge fund pricing raises significant questions about the quality and fairness of the prices at which investors buy or redeem interests in some hedge funds’, SEC, Staff Report, ibid 79–80.

13 Prime brokers are usually investment banks who provide capital and risk management services to hedge fund managers, execute hedge fund trades and so on.

14 In the UK, for example, hedge fund managers do not as yet need a specific ‘permission’ under the Financial Services and Markets Act 2000, Part IV. Instead, hedge fund managers/advisers who are located in the UK—and who provide investment advice and make day-to-day investment decisions for offshore ‘master funds’—will be authorized to do so as a consequence of their permission to manage or advise on investments generally: Arts 37 and 53 of the Regulated Activities Order (RAO), respectively. Firms providing such services will be required to meet the threshold conditions under FSMA, 2000, Schedule VI. Failure to maintain the threshold conditions enables the FSA to vary or cancel the permission: FSMA 2000, s 45. An authorized person will also be required to meet the FSA's requirements on ‘Senior Management Arrangements, Systems and Controls’ (ie ‘take reasonable care to establish and maintain such systems and controls as are appropriate to its business’ (SYSC 3.1.1R)). And, in relation to private and intermediate customers, to abide by the FSA's dealing and managing Conduct of Business rules such as best execution and fair and timely trade allocation. In addition, any individuals performing ‘controlled functions’ in accordance with s 59 will require approval by the FSA. Though similar, a more extensive regime will apply in the wake of the implementation of the Markets in Financial Instruments Directive 2004 (MIFID). Unlike under the Investment Services Directive (ISD), MIFID makes both investment advice and dealing in commodity derivatives a core activity for which a passport will be available.

15 Technical Committee of the IOSCO, Principles for the Valuation of Hedge Fund Portfolios (Consultation Report, Mar 2007) 6 <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD240.pdf>. IOSCO Technical Committee Standing Committee on the Regulation of Market Intermediaries (SC3) was also consulted. See also, Waters (n 7) 3. For a discussion of these principles, see text accompanying (n 96).

16 The FSA regulates the UK's financial services industry (including banking, securities, derivatives and insurance). By virtue of FSMA 2000, s 2, the FSA has four main objectives: maintaining market confidence; promoting public understanding of the financial system; protecting consumers; and reducing financial crime.

17 The SEC regulates the US securities markets.

18 Waters (n 7) 1.

19 These are special ‘carveout’ accounts used for the purposes of segregating illiquid investments from the fund's other investments. These side pocket accounts are then used for the purposes of helping to calculate redemption rates and performance fees.

20 Nearly two-thirds of institutional investors allocate more than 5 per cent of their portfolios to hedge fund strategies. Only 4 per cent of institutional investors have no allocation at all: State Street survey. Reported in: ‘Hedge Fund Valuations “Problematic” Say Investors’ (Apr 2007) International Custody and Fund Administration <http://icfamagazine.com/?id=me/37/news/105/44056/0/>.

21 (n 5) 10.

22 In essence, short selling involves selling a financial asset that is not currently owned in the hope that it will fall in value.

23 For a discussion of the systemic dangers that hedge funds pose for financial markets, see, J Danielsson, A Taylor, and J-P Zigrand, ‘Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey’ (2005) 1 Journal of Financial Stability 522, 528–33.

24 SEC, Staff Report (n 7) 36.

25 ibid. Often compensation arrangements involve the use of ‘high water’ marks and ‘hurdle’ rates. Essentially these are predetermined thresholds which managers must beat before performance fees are paid. ibid 62.

26 FR Edwards and S Gaon, ‘Hedge Funds: What Do We Know?’ (2003) 15 Journal of Applied Corporate Finance 8, 17.

27 See, Danielsson et al (n 23) 533–5.

28 G Connor and M Woo, ‘An Introduction to Hedge Funds’ <http://www.lse.ac.uk/collections/accountingAndFinance/pdf/ConnorIntroToHedgeFundVv3.pdf>26. ‘Funds of funds’ hedge funds, invest in other hedge funds. The main benefit of this strategy is portfolio diversification.

29 Staff Report to the SEC (7) 34.

30 ibid.

31 JG Nicholas, ‘Introduction to Global Macro funds’ in S Drobny (ed), Inside The House of Money (John Wiley, New Jersey, 2006) 1.

32 (n 28) 26.

33 SEC, Staff Report (n 7) 34. Short selling, involves selling a financial asset that is not currently owned in the hope that it will fall in value.

34 ‘Event Driven Tops Hedge Fund Strategies, says Credit Suisse’ (1 June 2007) <http://www.investorsoffshore.com/asp/story/storyinv.asp?storyname=27469>.

35 SEC, Staff Report (n 7) 35.

36 ECB Occasional Paper No 34 (Aug 2005) 9.

37 ibid.

38 C Kundro and S Feffer, ‘Valuation Issues and Operational Risk in Hedge Funds’ [2004] Journal of Financial Transformation 41, 42. See also, Deloitte's Financial Services Group, ‘Precautions that Pay Off—Risk Management and Valuation Practices in the Global Hedge Fund Industry’ (3 May 2007) 8 <http://www.mondaq.com/article.asp?articleid=48142>(hereinafter ‘Deloitte Research Survey’). Gross Asset Value (GAV) meanwhile excludes the calculation deduction of any performance fees or other liabilities.

39 ‘Deloitte Research Survey’ ibid 7.

40 FSA, DP 05/04 (n 11) 49; and FSA, Feedback Statement 06/2 (n 11) 5.

41 Leverage can also exacerbate the impact of valuation errors on counterparties and in turn the financial markets generally.

42 C McCarthy, ‘Hedge Funds: What Should be the Regulatory Response?’ (Speech on behalf of the FSA 7 Dec 2006) <http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/1207cm.shtml>.

43 Nearly two-thirds of institutional investors allocate more than 5 per cent of their portfolios to hedge fund strategies. Only 4 per cent of institutional investors have no allocation at all: State Street survey. Reported in: ‘Hedge Fund Valuations “Problematic” Say Investors’ (Apr 2007) International Custody and Fund Administration <http://icfamagazine.com/?id=me/37/news/105/44056/0/>.

44 As the FSA recognizes, incorrect valuations are also likely to have implications for ‘margin’ requirements (ie the assets hedge funds must deposit with prime brokers in order to secure loans from brokers); ‘capital’ requirements (ie certain minimum levels of capital which must be maintained as a means of absorbing losses); and ‘reporting’ requirements (obligations which require financial entities, inter alia, to report certain trades to the regulatory authorities). For example, calculating margin levels will depend significantly on the value of the financial instruments under management by the fund. In so far as valuations are overstated, margin levels may be inaccurately calculated, thus exposing prime brokers to an increased risk of hedge fund default.

45 FSA, ‘Financial Risk Outlook 2006’ 5 <http://www.fsa.gov.uk/pubs/plan/financial_risk_outlook_2006.pdf>.

46 See Waters (n 7) 1 (though ‘an investor in a fund which focuses on just one of these strategies may have a 100% exposure to hard-to-value assets’). Spearheading this movement are private equity firms. Evidence indicates that the line between private equity/venture capitalists and hedge funds is becoming increasingly blurred, as hedge funds seek new opportunities from which to generate fees: D Townley, ‘Hedge Funds 2006: The Changing Regulatory Landscape—The Convergence of Hedge Funds and Private Equity Funds’ (Sept 2006) Practising Law Institute Corporate Law and Practice Course Handbook Series PLI Order No 8467, 217. See also, JE Tabak, ‘Private Equity/Hedge Fund Convergence, Hybrid Funds’ (10/11 July 2006) Practising Law Institute Corporate Law and Practice Course Handbook Series PLI Order No 8449, 297 (‘In an attempt to generate higher returns … [m]ore hedge funds are participating in private equity-type investments through side pockets or designated investments (hybrid funds).’ 302).

47 Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry <http://www.pwc.com/extweb/pwcpublications.nsf/docid/76A9FB7EC537CA7485257000003124CD/$File/aima.pdf> (hereinafter: ‘AIMA Global Survey’). ‘[To the extent that] operational failures have contributed to dramatic declines in hedge fund values, many of these operational failures included weaknesses around the valuation process. Moreover, the average loss given default, where operational weaknesses were present, has been in excess of 50% of investors’ capital.' Waters, ibid.

48 According to figures cited in a report commissioned by the European Commission, as of June 2005, Ireland domiciled administrators serviced in excess of 3000 hedge funds totalling assets of almost $0.5 trillion: (n 5) 14.

49 (n 38) 8.

50 (n 45) 5. See also (n 5) 31: ‘it is true that third-party vendors are increasingly trying to offer competent valuations in respect of complex assets; however, in the short to medium term, there remain doubts as to the reliability of the services provided by these participants.’

51 SEC Staff Report (n 7) 56; FSA, DP 05/4 (n 11) para 3.90: ‘In respect of assets for which there are no easy or robust valuation methodologies and counterparty quotes are unavailable, administrators usually accept the hedge fund manager's own valuation. This can sometimes mean that a significant proportion of the fund's assets are not subject to independent valuation. Hedge fund managers generally perform their own internal valuations of all positions and seek to reconcile these with the administrators at the end of the month. It would appear that the hedge fund managers may wield significant ability to influence the administrators’ “independent” valuations at this point in the process through their dialogue with administrator staff and the counterparties who are providing the quotes.' See also, Deloitte Research Study (n 38): ‘in many cases hedge fund advisers provide valuations to the administrators who then re-value the portfolio to assess the reasonableness of the valuations.’ 8.

52 Deloitte Research Study (n 38) 31.

53 ibid.

54 Kundro and Feffer (n 38) 42.

55 R Ehrenberg, ‘Information Arbitrage’. <http://www.informationarbitrage.com/2006/08/side_pockets_us.html>.

56 ibid.

57 ibid.

58 Surprisingly, evidence indicates that even for hard to value assets many hedge fund mangers rely heavily on exchange quotes. ibid 9.

59 ibid.

60 ibid.

61 Kundro and Feffer (n 38) 42.

62 Deloitte Research Study (n 38) 9. ‘[I]n the case of illiquid assets, it is virtually impossible to find a completely objective pricing source, forcing reliance upon models or observed or implied prices based upon the judgment of market participants, none of whom may be disinterested in the transaction.’ D Waters, ‘FSA Regulation and Hedge Funds: An Effective Proportionate Approach for a Dynamic, International Marketplace’ (Speech delivered on behalf of the FSA, 19 Oct 2006) 4, <http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/1019_dw.shtml>.

63 D Townley, Y Kawata, and L Landa, ‘The Convergence of Hedge Funds and Private Equity’ (June 2006) Practical Law Company (PLC) 2, <http://www.practicallaw.com/2-204-0965>. See also, ‘A Word on the Side (Pockets)’ [Aug 2006] Hedge Fund Review 12 <http://www.hedgefundreview.com>.

64 PM Rosenblum, ‘Private Investment Funds: Basic Structures And Current Developments’ American Law Institute—American Bar Association Continuing Legal Education ALI-ABA Course of Study (26 Jan 2007) 71. Though occasionally managers create a ‘separate class of fund interests with some investors only sharing in the liquid positions in the fund's portfolio, while others, with a longer-term appetite for commitment, participate in the side pocket portion of the fund as well.’ H Ordower, ‘Demystifying Hedge Funds: A Design Primer’ [2007] UC Davis Business Law Journal 323, 328.

65 Ordower, ibid 328.

66 ibid.

67 ibid.

68 Rosenblum (n 64) 71.

69 SEC, Staff Report (n 7) 65, fn 224.

70 Rosenblum (n 64) 71.

71 ibid.

72 I McMurdo, ‘Offshore: Cayman Islands’ (14 June 2005) <http://www.caymanfinances.com/news.cfm?view=51>.

73 ibid.

74 See also, P Cockhill, ‘A Word on the Side (Pockets)’ [Aug 2006] Hedge Fund Review 12, <http://www.hedgefundreview.com>.

75 ibid. That said, payments to the manager may be subject to a ‘clawback arrangement’ whereby mangers may be required to recalulate fees and compensate investors for any payments made as a resulted of over-inflated valuations which upon liquidation turn out to be incorrect. TA Hickey III and R O'Brien, ‘Convergence: The Buzzword for Hedge Funds and Private Equity Funds in ’06' <http://www.klgates.com/files/Publication/4f83eb54-fe33-4d57-9ebe-97a09955aa05/Presentation/PublicationAttachment/1666b427-19de-4c0b-a256-9c42077f5674/converge.pdf>.

76 See, FSMA, 2000, s 59.

77 For example, see SEC v Peter W Chabot, Chabot Investments, Inc, Sirens Investments, Inc, Sirens Synergy and the Synergy Fund, LLC, Litigation Release No 18214 (3 July 2003); SEC v David M Mobley, Sr, Litigation Release No 18150 (20 May 2003); SEC v Edward Thomas Jung, Litigation Release No 17417 (15 Mar 2002); and SEC v Jerry A. Womack, Litigation Release No 17293 (2 Jan 2002). See also, ‘Hedge Fund Chief Accused of Overstating Assets by 2,500%’ The Times (London, 8 Feb 2007).

78 In the Matter of John D Barry, Thomas P Daniels, John M Irwin, and Mark P Miszkiewicz (4 Nov 2004) <http://www.sec.gov/litigation/admin/ia-2320.htm>.

79 ibid.

80 Testimony of Susan Ferris Wyderko Director, Office of Investor Education and Assistance Before the Subcommittee on Securities and Investment of the US Senate Committee on Banking, Housing, and Urban Affairs (16 May 2006) <http://sec.gov/news/testimony/ts051606sfw.htm>. ‘Process, procedural or systems problems accounted for 30% of … valuations-related failures and mistakes or adjustments were implicated in … 13%.’ See also, Kundro and Feffer (n 38) 42.

81 William H Donaldson (Chairman of the SEC) Testimony Concerning Investor Protection and the Regulation of Hedge Funds Advisers Before the US Senate Committee on Banking, Housing, and Urban Affairs (15 July 2004).

82 (n 15) 9.

83 Deloitte Research Study (n 38) 8.

84 ibid.

85 The Organization's wide membership regulates more than 90 per cent of the world's securities markets <http://www.iosco.org/about/index.cfm?section=history>.

86 The IOSCO's members regulate more than one hundred jurisdictions and the Organization's membership is steadily growing.

87 An updated version of the IOSCO's Objectives and Principles of Securities Regulation (May 2003) can be found at <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD154.pdf>. In 2002, IOSCO adopted a multilateral memorandum of understanding (IOSCO MOU) designed to facilitate cross-border enforcement and exchange of information among the international community of securities regulators. The following year, the Organization endorsed a comprehensive methodology (IOSCO Principles Assessment Methodology) that enables an objective assessment of the level of implementation of the IOSCO Principles in the jurisdictions of its members and the development of practical action plans to correct identified deficiencies.

88 ‘IOSCO Historical Background’ <http://www.iosco.org/about/index.cfm?section=history>.

89 ibid.

90 ibid.

91 ibid.

92 (n 15) 6 (footnotes omitted).

93 ibid.

94 ibid 7.

95 ibid 6.

96 Waters (n 7) 1.

97 (n 15) 10.

98 ibid 13. The SC5 distinguishes between ‘policies’ and ‘procedures’. According to SC5 ‘policies’ refer to ‘high level’ valuation policies; while ‘procedures’ refer to ‘the pricing procedures which outline the detailed processes by which prices are obtained for valuing the financial instruments of an investment portfolio’: ibid 6 fn 2.

99 ibid 13.

100 ibid.

101 Deliotte Research Study (n 38) 10.

102 (n 15) 18.

103 <www.iosco.org/library/pubdocs/pdf/IOSCOPD187.pdf>.

104 ‘FSA supports IOSCO Principles for the valuation of Hedge Fund Portfolios’ (14 Mar 2007) <http://www.fsa.gov.uk/pages/Library/Communication/PR/2007/034.shtml>. This is hardly surprising since acting Chair of SC5 was in fact FSA Director, Dan Waters.

105 ‘AIMA Welcomes IOSCO's Endorsement of its Valuation Principles’ (27 June 2007) <http://www.hedgeweek.com/articles/detail.jsp?content_id=119838&livehome=true>.

106 MFA comment letter to the IOSCO on its Consultation Report on Principles for the Valuation of Hedge Fund Portfolios (21 June 2007) <http://www.managedfunds.org/downloads/IOSCO%20Valuation%20Letter%20June%2021%202007.pdf>.

107 Waters (n 7) 1. This may, however, overstate investors'—even sophisticated investors'—abilities to influence hedge funds. According to one US study: ‘[i]n practice, even very large and sophisticated investors often have little leverage in setting [the] terms of their investment and accessing information about hedge funds’ SEC Staff Report (n 7) 47 and sources cited there. To the extent that this is also true of the UK, many hedge fund investors are offered ‘membership’ of the fund on what effectively amounts to a ‘take-it-or-leave-it’ basis, rather than as the result of any form of ‘bargain’ in the traditional sense of that term. See, Schroder Music Publishing Co Ltd v Macaulay [1974] 3 All ER 616 per Lord Diplock. Self-protection—at least in the classical sense—is at best severely restricted and, at worst, wholly illusory. Furthermore, since ‘enforcement’ of the IOSCO's proposed Principles is clearly a weakness, it has been suggested that the ‘IOSCO and its members could permit hedge funds to cite adherence to the Principles as a means of indicating an ethical and verifiable approach to portfolio valuation. To receipt such sanction, funds would have to make their valuations verifiable to either local regulatory authorities or respected and independent third parties. In such situations, receipt of such an imprimatur could enhance the marketability of the fund and the manager to other investors. The loss of such recognition, on the other hand, could lead to the fund not having access to certain investment funds of entities such as pension funds, and thus potentially create a need for compliance with the Principles.’ CFA Institute Centre for Financial Market Integrity, ‘Re: Principles for the Valuation of Hedge Fund Portfolios’ (21 June 2007) 5 <http://www.cfainstitute.org/centre/issues/comment/2007/pdf/valuation_of_hedge_fund_portfolios.pdf>.

108 For similar arguments in relation to the FSA's new principles based regulation, see, FSA, Principles-Based Regulation (Apr 2007).

109 Waters (n 7) 1.

110 ibid.

111 SC5's work also ignores the valuation of instruments that have the effect of creating liabilities for the fund. Indeed, it has been suggested by the CFA that the Principles should be modified to call upon ‘funds’ governing bodies to direct third-party or in-house Appraisers to consider the valuation of debt instruments employed by the fund in order to provide a more accurate picture of a fund's financial condition.’: CFA (n 107).

112 CFA (n 107).

113 ibid.

114 ibid.

115 (n 100) and accompanying text.

116 According to the CFA ‘[t]he IOSCO report refers to a valuation committee, but does not elaborate on who this might consist of. In a small fund manager for example, how practical is the forming of a valuation committee which is independent from the valuations process?’ London Buy Side Forum, ‘Feedback on the Consultation Report “Principles for the Valuation of Hedge Fund Portfolios”’ (18 June 2007) <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD250.pdf>.

117 Waters (n 7) 2.

118 ibid.

119 ibid.

120 (n 39) and accompanying text.

121 Ehrenberg (n 55).

122 Waters (n 62) 4.

123 FSA, DP 05/4 (n 11) 50.

124 <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD180.pdf>.

125 FSA, DP 05/4 (n 11) 50.