Valuation - Getting on Track
As an Accredited Valuation Analyst and long-time advocate of the notion that effective risk management and valuation go hand in hand, the release of two reports that emphasize good process in these areas is welcome news. See "Principles and Best Practices for Hedge Fund Investors" and "Best Practices for the Hedge Fund Industry." Click to read "PWG Private-Sector Committees Release Best Practicies for Hedge Fund Participants" (April 15, 2008) where "PWG" stands for the President's Working Group.
While I agree with Peter Schwartz that self-regulation and market discipline is ideal, I'd like to think that calls for reform are positive reactions to problems rather than "desperate" pre-emptive strikes against statutory mandates. Is that naive? Perhaps but hope springs eternal. (Read "Valuation is the Heart of the Matter," reprinted in "Money House of Cards or Disciplined Approach?" - April 17, 2008)
Where I part company with my colleague is that I believe one can (absent a once in a lifetime event) value complex securities if they are equipped with an analytical toolbox. If we peek inside, "hammers and nails" would include: (a) reasonable assumptions (b) appropriate and tested models (c) understandable and available data (d) identification of relevant risk factors that drive value (e) methodology that can be explained to others and reflects relevant economic considerations (f) disciplined, systematic process and (g) common sense.
Ultimately, value equals price when a willing (and hopefully informed) buyer and seller agree on terms. Until then, should we surrender to what some deem as villainous fair value accounting rules or roll up our shirt sleeves and get to work, acknowledging that a calculated "value" may differ from an eventual price?
I opt for the latter because I believe action beats passivity (though some may say nein to investing in the first place). Indeed there are numerous occasions that require an opinion of value for "official" reasons (tax reporting, account redemption, fund creation, determination of hedge size and so on.) What worries me is when alternative fund managers adopt an arbitrary stance or embrace a philosophy that discourages attempts to apply reason, discipline and care.
- Example One - Two or more appraisers may reasonably disagree on an exact identical DLOM ("discount for lack of marketability") for a particular economic interest. Yet a careful analysis of what contributes to a possible liquidity event is far superior to the X% times number of years formula in use by some alternative fund managers.
- Example Two - Appraisers cost a fund (or its investors, depending on which party pays) because they charge a fee to render independent, objective third party assessments. Are pensions, endowments and foundations better off by blithely relying on marks provided by traders, knowing that they are often compensated based on reported performance (inducing an inherent conflict of interest as a result)?
- Example Three - Should we accept that some instruments truly cannot be valued or instead identify economic and non-economic factors that impact the ability of an owner to eventually sell? Should we ignore emerging mechanisms that create markets in all sorts of "hard to value" business interests such as someone's client list or their employee stock options?
Mr. Schwartz is certainly right to warn that some situations are challenging at best. As this blog has emphasized (perhaps ad nauseum), suitability assessment is a critical first step. It makes no sense to invest other people's money (plan participants) or encourage direct allocation (as with 401(k) plans) unless decision-makers truly understand risk drivers (qualitative, quantitative, economic, non-economic).
This blog will continue to address valuation issues. Your feedback is welcome. Drop us a line.
Editor's Note: Check out www.securitiesmosaic.com and the family of related websites. It's well worth your time.
