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.

The ultimate price used for a position will typically be based on an analysis of all of this data: the modeling results, the counterparty marks and the investment advisor's own pricing model. What is important is that the final price be determined in a way that can be supported and that is well documented.

MME: How do you resolve variances in valuations?

Farias: What's needed is an independent, unbiased valuation that is consistent with a fund's documented and approved pricing policies. That's where the administrator comes in. In cases where there are differences between counterparty results and modeling results, the administrator's role is to work with the counterparty to examine, reconcile and document the differences. The objective is to agree on a pricing method that is consistently applied to the securities in question.

MME: So, who has the final say?

Farias: This is a current debate in the industry. As administrators expand their role in valuations, advisors are weighing whether the administrator should assume full responsibility for the valuation of hedge fund securities reflected in the NAV. There is also the question of who has final say when differences occur.

Increasingly, we're seeing our clients and investors on board with giving the administrator final responsibility for determining fair value. That final say, however, can only be made in many cases when the valuation process is rooted in in-depth analysis and there is dynamic communication between the administrator and the advisor.

MME: Clearly, fair valuation is a hot topic. What are other major operational challenges for administrators?

Farias: No doubt, automated reconciliation with prime brokers is critical, especially since the administrator is the key conduit between the advisor and the prime broker. Before an administrator can calculate a reliable NAV, all assets and transactions of the hedge fund need to reconcile with the administrator's records, as well as those of third parties. The challenge has been that prime brokers have their own unique, and often proprietary, reporting system, which makes it difficult to automate the reconciliation process especially with complicated derivatives. This issue is compounded by many advisors who now maintain multiple prime brokerage relationships.

MME: If there are so many reporting systems, how can you possibly reconcile prices?

Farias: The solution lies in creating standardized interfaces for all of the data from brokers on all portfolio positions, including cash, equities, fixed income and derivatives. Although the hedge fund administration industry still has a way to go before we have fully automated reconciliation with prime brokers, there has been some tangible progress among a few providers. At Investors Bank, for example, we have established automated interfaces for all fixed income and equity positions, and for the majority of all derivative positions. We track our progress with each counterparty very closely and communicate the results to clients regularly.

MME: It sounds like technology plays a vital role in taking hedge fund administration to the next level. What are some of the "must-have" systems capabilities?

Farias: As we just discussed, your system needs to handle all asset types, including complex derivatives. But there's much more. For example, you need the ability to allocate income to investors in the U.S. and offshore, including capturing the multiple incentive and management fees that can apply. Overall, you want a system that minimizes the "human touches" of data. This means running a technology platform that can: take trades in automatically; reconcile to prime brokers and other counterparties in a timely and automated manner; perform all pricing and net asset calculations within the same system, including derivatives; and allocate income to investors.

And finally, you need Web-reporting capabilities for clients and statement production capabilities for investors using the same integrated system.

MME: How are the SEC's expanded regulations affecting the hedge fund industry?

Farias: It is interesting to note that many commentators have expressed skepticism that the rules, as they stand now, will become final, given the effective date of February 2006. Administrators and advisors in the hedge fund business must expend substantial resources to comply with the new regulatory requirements. Here is where it may be especially advantageous to work with an administrator who has a significant book of '40 Act business because they are more experienced in understanding the ins and outs of adhering to the '40 Act.

MME: What are some other core strengths that the administrator needs to have?

Farias: Given the regulatory climate, it is essential for the administrator to have effective accounting policies and controls. For example, the systems in place for tracking various items need to be documented, as well as the policies and procedures covering areas that are not completely automated. In addition, the administrator needs to continually enhance their technology as investment products change.

Given the global nature of hedge funds, the administrator should be able to service funds in multiple jurisdictions, while providing a consistent service approach regardless of location. This is especially important when considering compliance with the Anti-Money Laundering requirements in the U.S. and in other jurisdictions, as well as maintaining an effective business continuity program and technology infrastructure.

Finally, administrators increasingly need to offer a full range of services, from middle-office functions such as trade processing, data management, risk management, reconciliations and corporate actions, to back-office functions such as custody, fund accounting, fund administration, shareholder servicing and Web-based reporting. This would give advisors the flexibility to expand their product offerings, maintain multiple prime brokerage relationships and meet the reporting needs of institutional investors without the need to maintain these operations in-house.


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