GAIM Ops Paris: Growth in esoteric instruments leading to more self-administration
Growth in hard-to-value esoteric instruments, particularly high-yield collateralised loan obligations (CLOs) is leading to more hedge fund managers to self-administer chunks of their books leading to a blurring of the lines between self-administration and third-party administration.
“Investing in equities is not making managers money so a growing number are investing in illiquid, credit products. This means more managers are having to do more self-administration. While there is no limit per say on how much managers can self-administer, it could concern some of the more operationally conservative investors,” said Jason Scharfman, managing director at Corgentum, a New Jersey-based hedge fund operational due diligence specialist, speaking at GAIM Ops in Paris.
Issuance of high-yield instruments is soaring. Last year was the fourth highest year on record in terms of CLO issuance, for example, with $55 billion in new deals compared with $12 billion in 2011, and in 2009 and 2010 when there were practically zero. Nonetheless, the complexity of these instruments often makes it difficult for most administrators to accurately valuate them.
“While it is universally accepted hedge funds have moved beyond self-administration, there are questions as to how much of a portfolio a manager can mark before we question whether it is third party marked. This is something that happens in Asia a lot,” commented John Ward, head of operational due diligence at EIM, the fund of hedge funds.
One delegate, speaking on condition of anonymity, said fund administrators were also often reluctant to second guess valuations performed by the manager, although he added the due-to-be implemented AIFMD would change that because of its introduction of depositary and depo-lite oversight duties. “If an administrator is sourcing valuations on liquid assets from Bloomberg, they can make an error but they are making an assessment based on fact. When they are accepting valuation on assets marked by the manager, they have to take an opinion on whether it is correct, and some just do not want to take that opinion risk,” said the expert.
Institutional investors have varying levels of tolerance as to how much they will permit managers to self-administer. “Different investors tolerate different percentages of self-administration. Some investors will say if 1% or 0.5% of assets are manager marked, then that constitutes self-administration, while others will have higher thresholds,” said Scharfman.
Firms that trade in illiquid, hard-to-value assets will often create a formal valuation committee comprised of senior personnel in both the investment and non-investment sides of the business. A Deutsche Bank Markets Prime Finance survey of operational due diligence professionals revealed growing interest in third party valuation. Ninety-seven per-cent of respondents told Deutsche Bank they wanted to review and discuss the fund’s valuation policy and 100% will contact the administrator.
Institutional investors, by and large will tolerate managers having formal valuation committees although concede they are not perfect. “If a manager was marking a large proportion of its portfolio, then that is an automate red flag and we would veto the investment though,” said one operational analyst.
In October 2013, AIMA in conjunction with Citco Fund Services and PricewaterhouseCoopers updated its Guide to Sound Practices for Hedge Fund Valuation to reflect the number of changes in accounting standards since the previous edition was published in 2007.