Principles for the Valuation of Hedge Fund Portfolios - Final Report

PRINCIPLES FOR THE VALUATION OF HEDGE FUND PORTFOLIOS FINAL REPORT A Report of the Technical Committee of the International Organization of Securities Commissions NOVEMBER 2007 1 Table of Contents I. Executive Summary II. Introduction III. Drivers of IOSCO’s focus on hedge fund portfolio valuation A. The increasing importance of hedge funds to global capital markets B. The complexity of some hedge fund portfolio strategies and their underlying instruments C. Central role of financial instrument valuations to hedge funds D. Conflicts of interest can exacerbate valuation difficulties E. Examples of how the jurisdiction of organization of a hedge fund causes differences in hedge fund structures IV. Scope of application of the principles V. The Nine Principles 1. Comprehensive, documented policies and procedures should be established for the valuation of financial instruments held or employed by a hedge fund. 2. The policies should identify the methodologies that will be used for valuing each type of financial instrument held or employed by the hedge fund. 3. The financial instruments held or employed by hedge funds should be consistently valued according to the policies and procedures. 4. The policies and procedures should be reviewed periodically to seek to ensure their continued appropriateness. 5. The Governing Body should seek to ensure that an appropriately high level of independence is brought to bear in the application of the policies and procedures and whenever they are reviewed. 6. The policies and procedures should seek to ensure that an appropriate level of independent review is undertaken of each individual valuation and in particular of any valuation that is influenced by the Manager. 2 7. The policies and procedures should describe the process for handling and documenting price overrides, including the review of price overrides by an Independent Party. 8. The Governing Body should conduct initial and periodic due diligence on third parties that are appointed to perform valuation services. 9. The arrangements in place for the valuation of the hedge fund’s investment portfolio should be transparent to investors. VI Conclusion Appendix A. Contributors Appendix B. Feedback Statement Appendix C. Bibliography 3 I. Executive Summary Executive Summary This paper is focused on principles for valuing the investment portfolios of hedge funds and the challenges that arise when valuing illiquid or complex financial instruments. The principles are designed to mitigate the structural and operational conflicts of interest that may arise between the interests of the hedge fund manager and the interests of the hedge fund. Hedge funds may use significant leverage in their investment strategies, the impact of which increases the importance of establishing appropriate valuations of a hedge fund's financial instruments. While preparing this paper IOSCO members have worked closely with a group of industry experts to gain practical insight from experienced hedge fund investors, hedge fund managers and firms that provide professional services to hedge funds. The chief aim of the principles is to seek to ensure that the hedge fund’s financial instruments are appropriately valued and, in particular, that these values are not distorted to the disadvantage of fund investors. This paper identifies the implementation of comprehensive policies and procedures for valuation of hedge fund portfolios as a central principle. It recommends general principles that should guide the hedge fund’s governing body and its manager in developing and implementing such policies and procedures. The paper also emphasizes that these policies and procedures should be consistently applied. In addition, it stresses the goals of independent oversight in the establishment and application of the policies and procedures in order to mitigate the conflicts of interest that managers face. IOSCO believes that investors will ultimately benefit if hedge funds follow these principles. Investors need to be vigilant with respect to any hedge fund that does not exhibit these principles throughout all aspects of its valuation process. Investors should satisfy themselves that the management and governance culture promotes the application of the principles to the extent practicable. While the adoption and compliance with these principles should benefit investors, the measures themselves will not reduce the need for inve