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Hedge Fund Administrators Forge Way for Timely NAVs

While the trading scandal has put an increasing demand on mutual funds to provide more accurate fair valuation on their portfolios, hedge funds are also under increasing pressure to reveal their net asset values (NAVs) on a more timely basis. Investors Bank & Trust Senior Director Christopher Farias recently spoke with Money Management Executive on this and other critical issues facing hedge fund administrators. As product manager for the company's hedge fund administration services, which combined with other alternative investments totals $100 billion in assets, Farias is familiar with the topmost concerns at some of the leading hedge funds in the nation.

MME: What are the top operational challenges for hedge fund administrators right now, and how are service providers addressing these concerns?

Farias: I would place the need for timely and accurate asset valuation right at the top. Monthly and quarterly net asset valuations have been the industry norm, with many providers making their clients wait three to four weeks after the end of a month for a NAV. Nonetheless, we are seeing increasing pressure for more frequent and timely delivery, with some regulators and industry critics now pushing for daily net asset valuations.

There are a few firms that are ahead of the curve, including ours, which can provide NAVs within a few days after month's end. For hedge funds looking for daily net asset valuations, it isn't a problem if the portfolio is comprised mostly of listed or easy-to-price securities. The more difficult task, of course, is providing daily NAVs for more complex or thinly traded securities.

MME: What's driving the shift to more timely, accurate net asset valuations?

Farias: First, institutional investors' increased interest in hedge funds has translated into higher demand for more efficient operational support in all phases of the securities processing lifecycle, including valuations. Second, after completing its own report on the hedge fund industry, the Securities and Exchange Commission has become increasingly concerned about how hedge fund managers value their portfolio assets. The recent adoption of the new hedge fund advisor rule reflects the growing trend toward greater regulatory scrutiny.

MME: Who is in a better position to address the valuation issue - advisors or administrators?

Farias: Hedge fund managers are wrestling with who should assume ultimate responsibility for the NAV, be it the investment advisors, many of whom have historically handled this in-house, or administrators, who are becoming increasingly involved in valuations.

Regulators and consultants have been fairly vocal in calling for independent pricing of hedge fund assets. The SEC has openly identified the potential for incorrect valuations and has said that assigning this task to a third-party provides an effective answer to the question of pricing accuracy. Naturally, as an administrator, we are working very hard to address this issue. To meet the need for timely, accurate valuations, administrators must prove to advisors that they can step up to a very demanding and complex challenge. This involves hiring the appropriate people with expertise in pricing complex derivatives, as well as establishing procedures and modeling systems for determining final value where public information is not available.

MME: What are some of the changes administrators must make to effectively address the hedge fund valuation issue?

Farias: To address the servicing gap, many administrators need to view this as an equivalent to launching a whole new product. For most firms, this is a big commitment both in terms of investing in the right technology and acquiring the necessary level of expertise. For example, you need a system that can handle automated processing for swaps, futures, repos, as well as other derivatives. You also need specialists with the commensurate experience who understand the underlying investment strategies and pricing options. This is so specialized because the traditional pricing vendors simply do not offer valuation services for many complex derivatives. This increases the need for derivatives experts, who have experience in developing and running pricing models for these complex instruments.

MME: Is it fair to say that administrators need more specialized talent than ever before?

Farias: Administrators need to understand that as the industry grows and evolves, there is a heightened need for expertise across a variety of areas, including regulatory issues in the U.S., Europe and offshore jurisdictions. And besides being able to price various derivatives, they need to know how to process them and to understand all of the tax issues.

MME: Can you provide detailed insight into how the valuation process takes place?

Farias: Typically, administrators will use multiple, independent price feeds, which cover exchange-traded securities and sophisticated pricing services developed specifically for more complex instruments. In addition, administrators can obtain brokers' and other counterparties' marks. In some cases, the advisor may have put forth a valuation based on its internal pricing model.