Valuation expert observes "staggering amount of inconsistencies in how hedge funds mark their portfolios," warns "NAV valuations may be all wrong," publishes White Paper
Valuation expert observes “staggering amount of inconsistencies in how hedge funds mark their portfolios,” warns “NAV valuations may be all wrong,” publishes White Paper
In light of the recently-started subprime market troubles, which were partly due to more or less arbitrary ratings and valuations, Espen Robak, valuations expert and president of New York-based Pluris Valuation Advisors talked to Opalesque about the valuation of illiquid assets for hedge funds.
Pluris Valuation Advisors: valuations for hedge fund
“My firm is a pure valuation firm. We work mostly with hedge funds. The goal of our practice is to provide monthly updated valuations for all the illiquid securities that hedge funds have bought. We specialize in PIPE securities, which U.S. and European hedge funds invest in. Warrants, convertibles, anything issued in a private placement, being as illiquid as they are, are difficult to properly value. And if the valuations are wrong then that can lead to all kinds of problems down the line. That is why most of our clients come to see us.”
Remarkable inconsistency in how funds are valued
“We have seen a staggering amount of inconsistencies in how various hedge funds are marking their portfolio. NAVs can be severely overvalued or undervalued, plus the volatility can be significantly understated.”
“The size of the haircut for lack of liquidity depends on the volatility of the stock, the stock price itself, on the market capital of the company that issues the stock, etc. So in a downward market, when a portfolio is valued, it has a group of restricted securities and the stock price has gone down significantly; your discount for lack of liquidity should have gone up and lead to a magnifying effect – and that is what the empirical data is showing us. If you don’t do that and continue with a constant discount for lack of liquidity, then you really are understating your volatility and overstating your NAV – which is an even bigger problem.”
“What is remarkable is the inconsistency in how funds are valued. No one really knows how to value them; no one is very good at empirical trading data, as securities (like that) by definition do not trade very often. This is a problem in other markets as well.”
Re-learning to do proper valuations
“The most important thing is to is always look to the market. Illiquid securities must be valued at a significant discount for lack of marketability. In other words, whatever theoretical price you have, you have to look to analysis from transactions in illiquid securities and try to determine what the lack of marketability discount should be. That is the crucial point and it applies to all kinds of asset classes.”
“Specifically in the PIPE space, there is a secondary market developing for illiquid PIPE securities. In that market there are private transactions between buyers and sellers who are interested in either lightening up their position in a particular ticker or in increasing their position in a particular ticker. In those transactions, you will then be able to discover eventually what is the haircut for lack of liquidity that these parties experienced on the stock. At Pluris, we have access to a great deal of such data. The constant secondary market trades are very good ways of discovering how the market is viewing the size of the illiquidity discount.”
There have been talks recently, at the Financial Accounting Standards Board, of improving financial reporting standards through “forming a resource group to provide the Board with input on potential clarifying guidance on issues relating to the application of the principles of FAS 157. Articles from CFOdirect Network: ” Source, and from Forbes.com."
Mr. Robak also produced a white paper which provides a brief overview of the literature on restricted stock private placement discounts, discusses the shortcomings of traditional placement studies, proposes an alternative data-set and suggests a possible way forward. It is available on Pluris Valuation’ website.
On pension funds, such as the Ohio Police & Fire Pension Fund, which acquired AAA-rated asset-backed bonds, felt let down by rating agencies and are looking to sue the raters
“This is very interesting. Pension funds are heavily into hedge funds these days. We have had several inquiries from pension funds across the U.S. and Canada asking how to be certain that hedge funds are really marking their books at the correct NAV. The reality is that there is almost no way you can do that as an investor, unless you have access to the composition to the underlying portfolio, or if the fund has received independent outside valuation advice. If managements are marking their books without getting outside sign off or advice, then it is very hard to feel certain that those assets have been valued appropriately.”
No single way to evaluate
“Management has very significant leeway on how they want to value their own securities. When it comes to the most hard-to-value securities, such as PIPE securities, CDOs, etc., then one can combine management discretion with a very wide range of plausible values. That is a recipe for big problems and very large inconsistencies between how different funds are valued. Imagine two funds; one is reporting a very high rate of return for last year, and the other one is reporting a fairly low rate of return. But which fund is the best? You simply cannot know unless you know how to determine the value, because that goes into the performance calculation.”
Subprime market: On bond rating agencies rating mezzanine CDOs’ BBB tranches as AAA
“We do not get involved in valuing these securities. But whenever there is significant volatility, liquidity spreads always widen the difference in value between a theoretical market price for a fully liquid security and the actual fair value of an illiquid security is widened dramatically.”
The impact of Bear Stearns: pension funds are concerned
“Bear Stearns has made pensions funds much more concerned about whether or not they are getting the correct NAV reported from hedge funds. If the valuations they have been getting from hedge fund managers prove to be incorrect, then that is potential trouble coming down the line.” Contact: erobak@plurisvaluation.com