Valuation problems remain unresolved
Some investors have begun to barter over fair price of assets to trade
The question of what a fund is worth is the one that, ultimately, the whole hedge fund industry turns on. But it is a question that became increasingly hard to answer through the financial crisis when liquidity dried up and it became difficult to find accurate market values for some assets.
One London-based investor in hedge funds said: “If you can’t reliably value the assets in your fund, you can’t let people out of your fund and you can’t let people in. Your business effectively stops until you can value things again. Valuations will always be a fraught issue for both managers and investors in funds.”
Last year, valuations were particularly difficult for those funds seeking returns in more exotic markets.
One investor said: “Hedge fund managers prided themselves on having an edge in fairly illiquid markets and instruments. But that came back to haunt them last year and at the start of this one.”
In September last year, at the height of the confusion in valuing portfolios, Sandra Manzke, an investor in hedge funds since the mid-1980s, said: “Managers might not want to value their portfolios at the moment, but that doesn’t mean they can’t do it, and then tell us ‘I can’t value what I’ve got’, and then just lock us into their fund. It’s our money, they have to work out a value, and give our money back based on that.”
However, this was a demand that many in the hedge fund industry failed to heed. By the end of the year, 25% of all funds had placed some restriction on redemptions, according to Credit Suisse. Many faced record redemption requests; others had acted because their chosen markets evaporated, making valuing portfolios all but impossible, they said.
One London-based credit manager said his firm had no option but to place a gate on redemptions. He said: “If you can’t find buyers for what you have to sell, you generally can’t value what you’re still holding.” Early this year Manzke shut down Maxam Capital, the fund of funds she had founded four years ago. She did so, at least in part, because she was disgusted by managers blocking exits from funds because they claimed markets were not providing fair value.
Deepak Gurnani, head of hedge funds at investor Investcorp, said: “Liquidity dropped late last year, but managers who put up gates either had too much leverage, too much concentration or too many illiquid instruments. Investors should not be rewarding managers who had those problems.”
Markets and investors have calmed since late last year. But there is evidence that even after trading flow has returned to some markets, problems with valuing assets held by some hedge funds have yet to be resolved.
Last month, nearly one in 10 hedge funds had not reinstated full rights of withdrawal, according to industry data provider Credit Suisse/Tremont. This is despite the fact that, on balance, investors now want to invest more money in hedge funds than they plan to withdraw.
David Blair, chief executive of hedge fund administrator Custom House Group, said: “There are still a lot of hard-to-value instruments, apart from fraught assets like a holding with Bernard Madoff. Some markets are taking a long time to come back to normality. A lot of credit funds still do not have liquidity, for example, and that’s still a big issue for investors.
“Some of the assets in hedge funds will take 12 or 18 months to work through, and managers might not get the returns they want when the investment matures.”
Blair said some managers had reduced or even removed the fees they charged on assets they locked in on valuation grounds. However, the rancour between managers and investors could persist.
One rival administrator said: “In some ways the issue of valuing your fund becomes even more of a focus for all parties when investors cannot get their cash out, though it should always be equally important to everyone. But investors feel it more keenly when the doors are closed on them.”
Rather than wait until markets come back and allow managers to price the most illiquid and difficult-to-value assets, and then allow redemptions from their funds once more, some investors have taken the task of valuation into their own hands. They have begun to barter over fair price between one another to trade assets on a price they can agree on.
One willing buyer of such assets said: “One man’s poison is another man’s meat. It’s a skill when the fair value of a fund is perhaps a little subjective, and you don’t have the markets to rely on. But you and the seller come to what you think is the fairest solution – normally a compromise on both sides – in terms of value. Trading is always a matter of supply and demand, and valuations are based on which there is more of at any time.”
Elias Tueta, founder of Hedgebay, a private exchange that facilitates the trading of illiquid assets, said: “The assets locked away in side-pockets can be very hard to value, and you have to know exactly what’s in them to value them precisely. But obviously, some people can see gems of assets stuck in there somewhere. The discounts to the face value are sometimes quite a bit larger than the discounts on value for more liquid portions [of funds].”
Blair said the issue of transparency and hedge funds was already prominent as regulators and investors sought greater insight into how the sector operated. He said: “Investors want greater transparency, and that includes around valuations. For example, you are seeing a lot of transactions that were made over the counter 12 months ago being able to be valued publicly on Bloomberg now.
“There has also been a light shone on the levels of responsibility held in valuing illiquid situations in the industry since last year. We will get advice from investment managers on valuations, but also from other counterparties involved with the manager, and from broker desks, too.”
Partly as a result of the increased focus by the industry on making sure valuations are fair, Custom House and its rivals are making greater use of third-party valuers of complex instruments, said Blair. Valuation services such as Markit and SuperDerivatives are likely to be among the key beneficiaries of investors’ thirst for third parties to help value what funds hold, according to Blair.
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