The search for alpha can lead hedge fund managers away from traditional long-short strategies with listed securities. Depending on the fund's strategy, the manager might invest in customized derivative contracts, illiquid securities that trade infrequently or assets that don't trade at all.
These categories pose a valuation challenge, says Espen Robak, CFA, president of Pluris Valuation Advisors, a New York-based firm that specializes in portfolio and business valuation.
Fund managers can't just pick a value on any given day based on the last trade, he explains: "There's more analysis to be done. You have to look at what has happened in the market since the last trade. You also need to look at whether or not the last trade might have been an outlier and whether there is information from comparables that can be considered and so on and so forth."
Why Valuation Matters
Accurate portfolio valuation is important for several reasons.
The fund's estimate of net asset value (NAV) determines the value of investors' limited partnership shares. When an investor requests a redemption during a liquidity window, an undervaluation of the fund's assets means the investor will receive a smaller-than-accurate distribution.
Conversely, investors withdrawing funds from an overvalued portfolio will receive larger-than-accurate distributions, essentially short-changing the remaining investors.
The problem of inaccurate valuation can also distort managers' compensation. "The annual management fee is determined as a percentage of assets under management," Robak notes. "So, if that's, in a classic hedge fund context, 2%, if you overstate assets by $100 million then you're taking $2 million too much in the way of fees."
Risk Analysis
Most advisors lack the time and expertise to substantiate the valuations assigned to a fund's portfolio. Nonetheless, advisors can assist clients with due diligence.
There are two elements to due diligence, Robak explains.
