Pursuant to both AIMA’s Guide to Sound Practices for Hedge Fund Valuation and AIFMD, the Manager of a Fund-of-Funds (“FoF”) is required to ensure that appropriate and consistent procedures are in place for the valuation of Fund assets on at least an annual basis. Best practice and regulations relating to valuation measures to be implemented provide for the following:
- The Manager should ensure that for each managed Fund, the valuation policies and procedures and designated valuation models are applied consistently;
- The Manager must determine the valuation methodologies that will be used for each type of asset in which the Fund may invest;
- Where a pricing model is used, information describing the pricing model is required to be disclosed, including the reason for the choice of model; and
- The valuation policies and procedures should set out a review process for the individual value of assets where a material risk of inappropriate valuation exists.
The Valuation Service Provider, usually the Fund Administrator for a FoF, calculates its NAV by obtaining the underlying funds’ NAVs less FoF expenses. But what happens if some of the underlying funds hold illiquid positions in their portfolios? Further, what if some of the underlying funds stop providing NAVs? It is the responsibility of the FoF Manager to provide the proper valuation of Fund assets, and the calculation and reporting of NAV. The valuation policies and procedures manual should address the following situations:
- An underlying fund holds illiquid and/or hard-to-value investments that have been side-pocketed.
- One or more underlying funds have been suspended.
- One or more underlying funds are in liquidation.
In the case of side-pockets, prices for most FoF’s are not always known at month-end, so estimated prices are used instead. Such estimates have a decided bearing on the split between the fund and the side-pocket. FoF’s can use an estimated split followed by final split, once a “true up” between estimates and final prices is known.
As the Fund Manager is compensated via management fees and incentive fees based on NAV, an overstated NAV overstates fees owing to the FoF Manager. The SEC has increased its focus on pricing used by managers, especially when the manager’s compensation is affected or the fund results are used for marketing a new fund. A well written valuation policies and procedures manual must address these situations.
The Fund Manager has an obligation to determine fair value for underlying positions that have been suspended or are in liquidation. Items to consider include:
- Determine reason for suspension or liquidation.
- Obtain a list of underlying fund assets.
- Determine which of the assets are impaired in value.
- Create a cash flow model utilizing the following adjustments:
- Liquidity adjustments
- Credit risk adjustments
- Other risk adjustments
- Obtain a valuation from an independent valuation expert validating the inputs to the model.
Houlihan Capital can prepare a fund’s valuation policies and procedures and provide clients with independent valuations of diverse assets ranging from single investments to fund-of-funds investment portfolios. The firm has a history of working closely with regulators, auditors, third-party administrators, investors, and some of the world’s largest private investment funds.
Houlihan Capital is a leading, solutions-driven valuation, financial advisory and boutique investment banking firm committed to delivering superior client value and thought leadership in an ever-changing landscape. The firm has extensive experience in providing objective, independent and defensible opinions of value that meet accounting and regulatory requirements. Houlihan Capital is a Financial Industry Regulatory Authority (FINRA) and SIPC member, committed to the highest levels of professional ethics and standards.