Con Keating Weighs In About Pension Liability Valuation

I had the pleasure of meeting Mr. Con Keating a few years ago when I visited London on business. We had been introduced by the then CEO of a UK-based pension consulting firm who knew of our mutual interest in governance. Since that time, Mr. Keating has been consistently generous with his views about real problems faced by retirement plan fiduciaries. This is no small gift given the breadth and depth of his experience as an advisor, investment manager, board member and academic. Click here to read Con Keating's bio.

In response to my August 5 essay entitled "Valuing Public Pension Fund Liabilities" and a request for feedback from industry practitioners, Mr. Keating sent an interesting paper from 2013 that I have finally been able to read. Entitled "Keep your lid on: A financial analyst's view of the cost and valuation of DB pension provision," he joins co-authors Ole Settergren and Andrew Slater in advocating for the use of a pension's Internal Growth Rate ("IGR") as the appropriate discount rate to adopt for purposes of reporting the financial health of a defined benefit ("DB") plan. To do otherwise would "lead to over or under estimates, bias and volatility," in part because exogenous metrics such as a risk-free rate "do not reflect scheme arrangements and dynamics." Instead, this analytical trio offers up the IGR as the only benchmark that adequately considers contributions and the concomitant impact on obligations. As they importantly point out, similar to the message of their U.S. peers, getting an accurate valuation is essential as it drives other key economic outcomes such as potential tax hikes levied to fund government pension plans in deficit. Applied to corporate plans, bad pension valuations can lead to a diminution of enterprise value. This is something I addressed at length in my Journal of Corporate Treasury Management article entitled "Pension risk, governance and CFO liability." (My current affiliation is Fiduciary Leadership, LLC.)

The issue of valuation is far from trivial. According to Pensions & Investments, the Society of Actuaries will soon publish a paper that looks at alternative ways to assess public plan liabilities, "reversing a previous position prohibiting any release of the paper."

Stay tuned for more discussions about how to evaluate funding gaps. As I've long maintained, if you can't measure something, you can't manage it.

Valuing Public Pension Fund Liabilities

In 2006, I penned "Will the Real Pension Deficit Please Stand Up?" as a way to draw attention to the urgent need to understand what reported numbers mean. Ten years later, questions remain about how best to measure defined benefit plan obligations. This is not a good situation, especially now when more than a few retirement plans are struggling. Click to review's pension liability and funded status data for eighty plans.

Authors of a Citigroup paper entitled "The Coming Pensions Crisis" urge transparency regarding "the amount of underfunded governmental pension obligations." I concur but the challenge is knowing what information should be disclosed so that legislators, policy-makers, taxpayers and plan participants have confidence in what gets shared. I have often written that is hard to manage a problem if one cannot adequately measure the problem. 

In early July, Pensions & Investments' Hazel Bradford wrote about the Competitive Enterprise Institute's suggestion to use a "low-risk discount rate" tied to U.S. Treasury bond yields. Critics counter that this would grossly inflate the size of a deficit and perhaps lead to inappropriate actions. On August 3, it was reported that two actuarial groups disbanded a task force over the topic of how to best value public pension fund liabilities. (In terms of full disclosure, I co-authored a paper in 2008 with one of the groups mentioned, the Society of Actuaries. Click to read "Pension Risk Management: Derivatives, Fiduciary Duty and Process.")

As someone who has been trained as an appraiser, taught valuation principles and rendered opinions of value or reviewed those of others, I know firsthand that reasonable people can differ about inputs and assumptions. I likewise understand that snapshot pension debt levels do not necessarily convey a message about current or ongoing liquidity, debt capacity or the ability to tax. The goal is to reconcile differences so that anyone making decisions based on valuation numbers understands their strengths and weaknesses. 

Given the goal of this blog Pension Risk Matters to educate and share helpful information about the global retirement industry and investment risk governance, I welcome input from knowledgeable appraisers, accountants and actuaries. If you are interested in being interviewed or writing a guest blog post, please kindly email

Hard to Value Assets, Hedge Funds and Investment Fiduciaries

As I have pointed out on multiple occasions, valuation is an integral part of investment risk management for several reasons. First, fees paid to asset managers are frequently linked to performance and performance calculations depend on reported values. If values are artificially inflated, returns are likely to be inflated as well. Second, imprecise values can skew asset allocation decisions, lead to hedges being too big (or too small) and possibly cause an investor to breach trading limits that are part of an Investment Policy Statement. It's no surprise then that valuation process questions about who does what, when and how continue to surface.

According to a May 9 Wall Street Journal article, the U.S. Securities and Exchange Commission ("SEC") is investigating "the way hedge funds value their thinly traded holdings and how they respond when investors ask for their money back." The SEC has been vocal about its concerns regarding asset valuations for awhile. In December 2012, Bruce Karpati, then Chief of the Asset Management Unit of the SEC Enforcement Division (and now in private industry), talked about a focus "on detecting fraudulent or weak valuation practices - including lax valuation committees and the use of side pockets to conceal losing illiquid positions - and the failure to follow a fund's stated valuation procedures." Click to read "Enforcement Priorities in the Alternative Space." (As an aside, some hedge funds buy and sell actively traded securities for which there is a ready market and full price transparency.)

The U.S. Department of Labor ("DOL") regularly broadcasts its concerns about "hard to value" assets, including financially engineered products that show up in certain defined benefit and defined contribution retirement plans. In September of 2008, I spoke before the ERISA Advisory Council, by invitation, to address valuation issues from the perspective of a trained appraiser and fiduciary best practices expert. Click to read "Testimonial Remarks Presented by Dr. Susan Mangiero." I talked at length about valuation questions to ask of service providers and procedural prudence considerations for institutional investors.

A few weeks ago, senior attorney Fred Reish addressed monitoring and uncertainty in his April 19, 2016 newsletter. He directed readers to Fiduciary Rule preamble text that urges an advisor and his financial institution to install an adequate monitoring process before recommending "investments that possess unusual complexity and risk, and that are likely to require further guidance to protect the investor's interests." Click to read "Interesting Angles on the DOL's Fiduciary Rule #1." It doesn't take a rocket scientist to conclude that a "complex" and "risky" investment could be hard to value and not particularly liquid. (I have purposely not defined the terms in quotes herein as they are often related to facts and circumstances for a particular investor.)

Expect to read more about this important topic of valuation, especially as applied to those investors in search of higher returns. In a "no free lunch" world, risk and return go hand in hand. It's not necessarily a bad thing to take on greater risk as long as there is an understanding at the outset as to what gives rise to uncertainty and how risks are being mitigated.

Court Says Private Equity Funds Are Liable For Pension Liabilities of Portfolio Company

If you open a box and a dog pops out, your enthusiasm will be curbed if you were expecting something else. Surely this is how several private equity funds must feel now about one of their investments. According to "Private Equity Funds Liable to Union Pension Plan" by Jacklyn Wille (Pension & Benefits Daily, March 30, 2016), a federal judge recently ruled that several Sun Capital funds are "jointly liable for more than $4.5 million in withdrawal liability" that one of its portfolio companies, Scott Brass, "owed to a Teamsters pension fund." (You can visit Bloomberg Law to read the March 28, 2016 decision by clicking here.)

I will defer to attorneys to address the legal issues. So far, I found two commentaries on the heels of this 2016 legal decision. See "District Court Concludes Private Equity Fund Is Liable for Pension Obligations of the Portfolio Company" (Fried Frank Harris Shriver & Jacobson LLP, March 30, 2016) and "Private Equity Funds Held Liable for Pension Liabilities of a Portfolio Company" (Sullivan & Cromwell, March 31, 2016).

From my perspective as an economist, any surprise claim on future cash flows could be disastrous if it is large enough to jeopardize the ongoing viability of a business. Even if a business has sufficient resources to maintain itself as an ongoing concern, utilizing cash for something that was not planned for could lead to a lower growth rate than originally expected. Keep in mind that pension funds, endowments and foundations frequently allocate monies to private equity on the basis of expected returns for this asset class.

Projecting cash flows as part of due diligence is nothing new for many investors. That said, I am not convinced that all enterprise investigations fully address the impact of an underfunded defined benefit plan. I was recently contacted by a firm that was tasked to render a fairness opinion and wanted my views about pension math. The investment bankers were reviewing documents from bidders that radically differed with regard to the treatment of the target company's benefit plan burden. When I was asked to speak and also write about pensions and enterprise value, the invitation came from a senior valuation executive who felt that the topic was not being adequately addressed. See "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Dr. Susan Mangiero (Business Valuation Update, July 2013). Email me if you would like a copy of my 2013 slides about this topic.

In 2013, when this Sun Capital case originally made its way to the court, it struck me as an important issue. (I was not involved in this matter as an expert.) Several editors agreed and I ended up co-writing two articles with Groom Law Group partner David Levine. I've uploaded one of these articles to this pension blog. Click here to read "Private Equity Funds and Pension Plans: A Changing Dynamic" (CFA Institute Magazine, March/April 2014). At my request, Attorney Levine responded to this 2016 decision by emailing the following: "In short, while some private equity firms have already moved to evaluate and, in some cases, clarify their fund structures, this case is likely to lead to a second look at their structures and methods of involvement with their portfolio companies."

If certain limited partners are not already asking questions of their private equity fund general partners about the nature of portfolio company pension plans, controlling interest status and deal structure, their due diligence could quickly change in the aftermath of the 2016 Sun Capital litigation.

Interested persons can click on the links provided below to read earlier blog posts about this topic:

ERISA Investment Committee Governance

For those who missed the January 27 webinar entitled "ERISA Plan Investment Governance: Avoiding Breach of Fiduciary Duty Claims," click here to download the slides for this educational program. There were three presenters, each of us sharing a different perspective about this important topic. I spoke about economics and governance. Executive Rhonda Prussack (Berkshire Hathaway Specialty Insurance) provided information about ERISA fiduciary liability insurance. Attorney Richard Siegel (Alston & Bird) offered his takeaways for investment committee members as the result of recent litigation decisions.

As with most discussions about fiduciary considerations, there never seems to be enough time to address core concepts. So it was with this Strafford CLE event. Ninety minutes quickly came and went. Here are some of the highlights from my talk.

  • Expect more surveillance of ERISA investment committee decisions. A $25+ trillion retirement money pot and regulatory developments are two reasons. Just a few days ago, the Office of Compliance Inspections and Examinations ("OCIE") of the U.S. Securities and Exchange Commission ("SEC") emphasized conflicts of interest and disclosures as two components of its Retirement-Targeted Industry Reviews and Examinations Initiative.
  • It is a good idea to regularly review the Investment Policy Statement for each plan and either revise asset class limits or rebalance to reflect material changes such as rating downgrades of securities owned, changes in company ownership, large reported contingencies that could adversely impact cash flow or corporate recapitalization.
  • Consider crafting a companion Risk Management Policy Statement or beef up the risk sections in the Investment Policy Statement(s).
  • Document the process that dictates how new investment committee members are selected, whether they are trained (and by whom) and how they are reviewed, by whom and how often.
  • Consider installing a central figure or team to negotiate all vendor contracts and clarify exactly who does what. The goal is to avoid an expectation gap that arises when a contract is ambiguous or silent on tasks that an investment committee needs to have done but a service provider does not want to do or thinks it is not obliged to perform. 
  • Double check the compensation of investment committee members to minimize the risk of conflicts of interest. Suppose for example that a Chief Financial Officer ("CFO") sits on an ERISA plan investment committee at the same time that he is eligible for a bonus if he can cut costs.
  • Engage ERISA plan counsel to put together a "kick the tires" team of economists and attorneys who can render an objective assessment of existing internal controls, governance structure and investment policies and procedures and then recommend changes as needed. 

As with any exercise in good stewardship, taking (and documenting) relevant precautionary actions can be a good defense for an ERISA plan investment committee, especially at a time of heightened scrutiny.

Pension Plans, Valuation and Venture Capital

No sooner had I penned "Unicorns, Valuation and the Search for Investment Returns" for my compliance blog, I opened the New York Times this morning and discovered an article about so-called unicorns or companies with venture capital ("VC") backing and an estimated valuation of at least one billion dollars. According to the author of "The Hidden Risk of a Billion-Dollar Valuation in Silicon Valley," law school educator and pundit Steven Davidoff Solomon, venture capital firms want to get paid first in the event of a portfolio company sale which is why they negotiate hard to include a liquidation preference before committing capital. He cites a study by law firm Fenwick & West that confirms the prevalence of this downside protection and suggests that it is one reason why VC firms don't balk about what others may decry as valuations that are "too high." Interested readers can click here to download "The Terms Behind the Unicorn Valuations" by Barry Kramer, Michael Patrick and Nicole Harper (March 31, 2015). Professor Solomon points out that this kind of return insurance is a boon for venture capitalists but could be a disaster for founders who may end up with little or nothing if a liquidity event yields too few dollars. In an attempt to avoid this unhappy outcome, founders with sufficient voting power could nix a potential sale. Should that occur, investors then face greater risks due to less liquidity.

What is missing from the various analyses about unicorns and jumbo valuations of private companies overall is a discussion about the potentially adverse impact on institutional investors. In the event that valuation numbers are truly disconnected from economic reality, a limited partner may well end up paying too much in fees to its venture capital fund manager(s). Moreover, any institutional investor that allocates money to venture capital as part of its grand strategic asset allocation design may well fall short of its goals if valuations are "too high." Failure to realize a target return, satisfy a minimum funding ratio rule and/or diversify its portfolio are a few of the "nasties" that could ensue, thereby putting investment committee members at risk for allegedly breaching fiduciary duties.

One response, proffered by researcher Ashby Monk, is for institutions to invest directly and cut out the middlemen. This tact is likely to appeal to the bigger endowments, retirement plans and sovereign wealth funds that can afford to hire staff and put the requisite due diligence and technology infrastructure in place to vet and then monitor its investments. Even then, there is the peril of improperly relying on imprecise valuations that in turn drive so many other decisions.

As Dame Agatha Christie declared, "Where large sums of money are concerned, it is advisable to trust nobody." Investment fiduciaries need to understand how asset managers come up with the valuations they report to their limited partners and how their valuation numbers are revised over time to reflect changing conditions.

Pension Risk Governance Blog Still Going Strong After Nine Years

Nine years today marked the debut of Since then, I am proud to say that traffic has steadily grown, with continued feedback and suggestions about all sorts of topics. I am deeply grateful to visitors to this independent website for their time and encouragement. While the specific feedback tends to vary by issue or job function, a central theme is clear. Ongoing education about topics such as due diligence, fees, risk management, asset allocation, hedge funds, liquidity and valuation is both needed and desired. In 2015, this award-winning blog will continue its focus on providing objective and helpful information about important subjects that challenge investment stewards and their advisors, attorneys and regulators who oversee the management of more than $30 trillion.

As I point out in "Financial Expert Susan Mangiero Celebrates Ninth Year as Lead Contributor to Pension Risk Governance Blog" (Business Wire, March 25, 2015), "There is never a shortage of subjects to discuss, thanks to ongoing suggestions and contributions from readers and the significant realities of changing demographics, market volatility and new accounting rules."

To date, there are over 900 published analyses, research updates and guest interviews that can be readily accessed by category and keyword. Simply click on the Archives section of For a complimentary subscription to this blog, as posts are published, click here to sign up. Click here to read our Privacy Policy. If you are interested in contributing an educational essay or letting us know about a relevant news item or rule change, please email

Until the next blog post, thank you for your interest!

Detroit Swaps, Counterparty Risk and Valuation

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain's Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.

Alternatives and Retail Retirement Account Owners

The prospect of being part of millions of retail retirement plans has some financial advisors and hedge fund managers giddy with excitement. The 401(k) market alone is huge. According to the Investment Company Institute, as of Q3-2012, these defined contribution plans held an estimated $3.5 trillion in assets. In 2011, over fifty million U.S. workers were "active 401(k) participants." This compares favorably to an approximate $2.66 trillion hedge fund market size in 2013, up from $2.3 trillion one year earlier. Private equity, real estate and infrastructure comprise the rest of the alternatives investment sector according to a press release issued by Preqin, a financial research company. See "Alternative Assets Industry Hits $6tn in AUM for First Time" (January 21, 2014).

CNBC contributor Shelly K. Schwartz explains that alternative investment strategies are appearing in the form of 400 plus mutual funds and exchange-traded funds ("ETFs") that employ "complex trading strategies" such as managed futures, long/short trading in stocks and multiple currency exposures. Allocating to leveraged loans, start-up ventures and global real estate are other ways that these relatively new funds seem to be mimicking the approach taken by hedge funds and private equity funds that traditionally have catered to institutional investors and high net worth individuals. Notwithstanding regulatory differences relating to diversification, percentage of "illiquid" investments, redemption, daily pricing and how much debt can be used to lever a portfolio, statistics suggest a growing interest on the part of smaller investors to get in on the action. See "Seeking safe havens? Analysts, advisors point to liquid alternative funds" (November 24, 2013). Also check out "Goldman pushes hedge funds for your 401(k)" (Fortune, May 22, 2013) in which reporter Stephen Gandel describes new funds being offered by various financial institutions, some of which invest in mutual funds that mimic hedge fund investing strategies and others that invest in hedge funds directly.

Not everyone is an ardent fan. In "FINRA warns investors on alternative mutual funds," Reuters reporter Trevor Hunnicutt (June 11, 2013) describes regulators' concerns that "not all advisers and investors understand the risks involved," especially with respect to whether a retail-oriented fund is truly liquid. In its "Alternative Funds Are Not Your Typical Mutual Fund" publication, the Financial Industry Regulatory Authority ("FINRA") cautions investors to assess investment structure, strategy risk, investment objectives, operating expenses, the background of a particular fund manager and performance history.

Given the ongoing search for the next big thing, we are likely to see a lot more activity in the alternative investments marketplace - for both institutional and high net worth clients as well as for individuals with modest wealth levels. will return to this topic in future posts. There is much to write about with respect to fiduciary implications, risk management and valuation.

In the meantime, I want to thank ERISA attorney David C. Olstein with Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates for apprising me of a 2012 U.S. Department of Labor grant of individual exemption for Renaissance Technologies, LLC ("Renaissance").  Described as a "private hedge fund investment company based in New York with over $15 billion under management" by (September 26, 2013), Renaissance holds a large number of equity positions in stocks issued by household name companies. Click to see a recent list of their transactions. The "Grant of Individual Exemption Involving Renaissance Technologies, LLC," published in the Federal Register on April 20, 2012 makes for interesting reading for several reasons. First, it describes policies relating to important topics such as valuation, redemption and disclosures for "privately offered collective investment vehicles managed by Renaissance, comprised almost exclusively of proprietary funds" and the impact on retirement accounts in the name of Renaissance employees, some of its owners and spouses of both employees and owners. Second, as far as I know, there are not a lot of publicly available documents about proprietary investment products that find their way into the retirement portfolios of asset management firm employees and shareholders. Third, as earlier described, there is evidence of a growing interest on the part of the financial community in bringing hedge funds or hedge fund "look alike" products to the retirement "masses."

Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends

Mark your calendars to attend "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends."

At a time when unfunded pension and health care obligations are accelerating the budgetary crisis for some municipalities, experts fear that current problems are the tip of the iceberg. A new focus on accounting rules, the quality of disclosure to muni bond investors and the due diligence practices of underwriters, portfolio managers and advisers could mean heightened liability exposure for anyone involved in the nearly $4 trillion public finance marketplace. Add the history-making Detroit bankruptcy decision to the mix and attorneys have the makings of a perfect storm as they attempt to navigate these unchartered waters. The U.S. Securities and Exchange Commission has made no secret of its priority to sue fraudulent players in the public finance market. Insurance companies are reluctant to underwrite policies for high-risk government entities at the same time that municipal fiduciaries are more exposed to personal liability than ever before, especially as the protection of sovereign immunity is being challenged in court. Litigation that involves how much monitoring of risk factors took place is on the rise.

Public finance and securities litigation counsel, both in-house and external, can play a vital role in advising municipal bond market clients as to how best to mitigate litigation and enforcement risk or, in the event that an enforcement action has already been filed, how best to defend such litigation. Please join Orrick, Herrington & Sutcliffe LLP partner, Elaine C. Greenberg, and retirement plan fiduciary expert, Dr. Susan Mangiero, for an educational and pro-active program about the complex compliance and litigation landscape for municipal bond issuers, underwriters, asset managers and advisers. Topics of discussion include the following:

  • Description of the current regulatory environment and why we are likely to see much more emphasis on the disclosure activities of public finance issuers and the due diligence practices of underwriters and advisers;
  • Overview of hot button items that impact a bond issuer’s liability exposure, to include valuation of underlying collateral, rights to rescind benefit programs in bankruptcy and the use of derivatives as part of a financing transaction;
  • Explanation of GASB accounting rules for pension plans and likely impact on regulatory oversight of securities disclosure compliance and related enforcement exposures;
  • Discussion about trends in municipal bond litigation – who is getting sued and on what basis; and
  • Description of pro-active steps that governments and other market participants can take to mitigate their legal, economic and fiduciary risk exposures.

Featured Speakers:

Ms. Elaine C. Greenberg, a partner in Orrick, Herrington & Sutcliffe LLP’s Washington, D.C., office, is a member of the Securities Litigation & Regulatory Enforcement Group. Ms. Greenberg’s practice focuses on securities and regulatory enforcement actions, securities litigation, and public finance. Ms. Greenberg is nationally recognized for producing high-impact enforcement actions, bringing cases of first impression and negotiating precedent-setting settlements, she possesses deep institutional knowledge of SEC policies, practices, and procedures. Ms. Greenberg brings more than 25 years of securities law experience, and as a Senior Officer in the SEC's Enforcement Division, she served in dual roles as Associate Director and as National Chief of a Specialized Unit. As Associate Director of Enforcement for the SEC's Philadelphia Regional Office, she oversaw the SEC's enforcement program for the Mid-Atlantic region and provided overall management direction to her staff in the areas of investigation, litigation and internal controls. In 2010, she was appointed the first Chief of the Enforcement Division's Specialized Unit for Municipal Securities and Public Pensions, responsible for building and maintaining a nation-wide unit, and tasked with overseeing and managing the SEC's enforcement efforts in the U.S.’s $4 trillion municipal securities and $3 trillion public pension marketplaces. Ms. Greenberg recently gave a speech entitled “Address on Pension Reform” at The Bond Buyer’s California Public Finance Conference in Los Angeles on September 26, 2013.

Dr. Susan Mangiero is a CFA charterholder, certified Financial Risk Manager and Accredited Investment Fiduciary Analyst™. She offers independent risk management and valuation consulting and training. She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors. Dr. Mangiero has served as an expert witness as well as offering behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary on matters that include distressed debt, valuation, investment risk governance, financial risk management, financial statement disclosures and performance reporting. She has been actively researching and blogging about municipal issuer related retirement issues for the last decade. She has over twenty years of experience in capital markets, global treasury, asset-liability management, portfolio management, economic and investment analysis, derivatives, financial risk control and valuation, including work on trading desks for several global banks, in the areas of fixed income, foreign exchange, interest rate and currency swaps, futures and options. Dr. Mangiero has provided advice about risk management for a wide variety of consulting clients and employers including General Electric, PriceWaterhouseCoopers, Mesirow Financial, Bankers Trust, Bank of America, Chilean pension supervisory, World Bank, Pension Benefit Guaranty Corporation, RiskMetrics, U.S. Department of Labor, Northern Trust Company and the U.S. Securities and Exchange Commission. Dr. Mangiero is the author of Risk Management for Pensions, Endowments and Foundations  (John Wiley & Sons, 2005), a primer on risk and valuation issues, with an emphasis on fiduciary responsibility and best practices. Her articles have appeared in Expert Alert (American Bar Association, Section of Litigation), Hedge Fund Review, Investment Lawyer, Valuation Strategies, RISK Magazine, Financial Services Review, Journal of Indexes, Family Foundation Advisor,, Expert Evidence Report, Bankers Magazine and the Journal of Compensation and Benefits. Dr. Mangiero has written chapters for several books, including the Litigation Services Handbook and The Handbook of Interest Rate Risk Management.

Financial Executives Address De-Risking and ERISA Benefit Programs

According to "Balancing Costs, Risks, and Rewards: The Retirement and Employee Benefits Landscape in 2013" (CFO Research and Prudential Financial, Inc. - July 2013), numerous changes are underway. The opinions of senior financial executive survey takers validate the continued twin interest in expanding defined contribution plan offerings and managing the liability risk of existing defined benefit ("DB") plans. The strategic import of benefits as a way to attract and retain talent is recognized by "nearly all respondents in this year's survey." Regarding the restructuring of traditional pension plans, this report states that nearly four out of every ten leaders have frozen one or more DB plans yet recognize the need to manage risk for those plans as well as for active plans. Liability-driven investing ("LDI") programs are being adopted by "many companies". Transfer solutions are being "seriously" considered by roughly forty percent of companies represented in the survey. Almost one half of respondents agree that a return to managing its core business could be enhanced by doing something to address pension risk.

None of these results are particularly surprising but it always helpful to take the pulse of corporate America with respect to ERISA and employee benefit programs. I have long maintained that the role of treasury staff will accelerate. There are numerous corporate finance implications associated with the offering of non-wage compensation. As I have added in various speeches and articles echoing what numerous ERISA attorneys cite (and I am not an attorney), plan sponsors must carefully weigh their fiduciary responsibilities to participants against those of shareholders in arriving at a particular decision.

For a copy of the study, click here.

Interested readers may also want to check out the reference items listed below:

If you have further comments or questions, click to email Dr. Susan Mangiero.

Pension Plan Economics and Corporate Finance

Just published is an article I wrote about the urgent need for appraisers and deal-makers to make sure that they have adequately assessed the economics associated with defined benefit plan funding. Entitled "Pension Plans: The $20 Trillion Elephant in the (Valuation) Room" by Susan Mangiero (Business Valuation Update, July 2013), the objectives of this article are threefold: (1) shed light on the magnitude of the pension underfunding problem and the possible dire impact on enterprise value; (2) remind appraisers of the need to thoroughly understand and evaluate pension plan economics or engage someone to assist them; and (3) explain the adverse consequences on deal-making and corporate strategy when pension plan funding gaps are given short shrift. CEOs, Chief Financial Officers, private equity, venture capital, merger and acquisition and bank lending professionals will want to read this article as it showcases this timely and urgent topic.

Click to read my article about pension plan valuation.

In a related post, ERISA attorney Stephen D. Rosenberg wrote a commentary on his "Boston ERISA & Insurance Litigation Blog" (June 17, 2013) about why he believes that appraisers should not be designed as ERISA fiduciaries. He expresses doubt about whether imposing a fiduciary standard on appraisers will "improve the analysis provided to plan fiduciaries." He suggests that such a move by regulators could create a reluctance for valuation professionals to assume the liability associating with appraising a company with an ERISA plan.

For those who missed our program about appraiser liability, visit the Business Valuation Resources website to obtain a copy of "Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser." The program took place on May 14, 2013. Speakers included myself (Dr. Susan Mangiero), ERISA attorney James Cole with Groom Law Group and Mr. Robert Schlegel with the Houlihan Valuation Advisors.

Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser

An esteemed panel of experts will speak on May 14, 2013 from 1:00 PM EST to 2:40 PM EST as part of a webinar that is sponsored by Business Valuation Resources. Entitled "Valuation and ERISA Fiduciary Liability: Traps for the Unwary Appraiser," Dr. Susan Mangiero, CFA, FRM and Accredited Investment Fiduciary Analyst, will be joined by Mr. Robert Schlegel, ASA, MCBA and ERISA attorney James V. Cole II. Dr. Mangiero is a Managing Director with Fiduciary Leadership, LLC. Mr. Schlegel is a principal with Houlihan Valuation Advisors. Attorney Cole is a principal with Groom Law Group.

Why You Should Attend

As retirement, healthcare, and other employee benefits continue to grow, they are placing new stresses on firms of all sizes, whose commitments to these funds are beginning to outpace their revenues. Regulations and lawsuits are now challenging the defined responsibilities and liabilities of the financial professionals who create, manage, and even analyze these entities. This means that every appraiser now needs to assess risk, and the extent to which employee benefit plans impact enterprise value.

In this webinar, Dr. Susan Mangiero, Mr. Rob Schlegel, and ERISA attorney James Cole discuss existing, emerging, and proposed disclosure rules, an understanding of which are imperative to navigate the maze of actuarial, accounting, and regulatory numbers. Learn why estimating future expected cash requirements to service a plan(s) is imperative if an appraiser wants to opine whether a firm can realize its growth targets, and how benefit plan economics, such as withdrawal liabilities, change when derivatives or annuity transactions are in place. Appraisers need to understand emerging discussions now taking place at FASB and other regulatory agencies that will affect market participant activity relating to exchange value. Markets are waking up to this emerging area, and appraisers can no longer afford to remain asleep of these issues.

According to Mr. Blake Lyman, Professional Program Manager with Business Valuation Resources, LLC, "BVR is thrilled to be offering this program with Susan, Rob, and Jim. As the go-to resource for all professionals involved with business valuation, we always seek to present the most in-depth content on the most pressing issues for the many experts who rely on us. With Susan, Rob, and Jim's experience and expertise, this program is sure to surpass the high standards we set for ourselves and that our customers have come to expect."

To register, visit the Business Valuation Resources website.

Hard to Value Assets and Pension Funding

Add wine and cheese to the picnic basket and the pension fund too. According to "Companies Substitute Tangibles, Like Cheese, for Investments" by Mary Williams Walsh (New York Times, April 19, 2013), gaps in funding status are tempting some sponsors to add "unusual assets" to their portfolio. Her list of in-kind contributions includes cheese, whiskey, water rights, precious stones, oil wells, a restaurant, a brewery and a slaughterhouse.

An obvious advantage to a plan sponsor is the preservation of cash when an intangible or tangible asset is instead contributed. Another benefit is the potential upside associated with an asset poised for capital growth. This is especially true if cash contributions would be parked in a low-interest rate security or fund.

The downside is that an expectation of higher returns almost always means a greater uncertainty of realization.

Requisite approval by the U.S. Department of Labor may or may not mandate the hiring of an independent fiduciary to in turn engage someone to assess the value of an intended in-kind contribution. As a trained appraiser, I would tell anyone who asks that there are multiple items that must be assessed as a precursor to determining fair market value of the asset in question. Some of the items are listed below. This is not an exhaustive tally by any means.

  1. Control - If there are multiple owners of an asset, it is important to assess the extent to which the ERISA plan can exercise authority over how an asset is used, disposed of and/or managed for purposes of adding to the asset's value.
  2. Priority of Economic Claims: Understand whether the pension fund will be first in line to receive cash from the service and/or subsequent sale of the item being considered for contribution.
  3. Collateral: If the value of the intended in-kind contribution item is supposedly dependent on other assets, it is critical to know whether that collateral is fungible and if there are sufficient assets in place.
  4. Customer Diversification: If all or part of an operating business will be contributed to an ERISA plan, someone must make sure that revenue is generated from a sufficiently large number of clients so that if one or more large customers disappear, the value of the asset being contributed will not be adversely diminished.
  5. Marketability: Not all assets trade in an active secondary venue. Discounts for lack of marketability need to be carefully examined so that the ERISA plan does not overpay.
  6. Legal Protection: The appraiser must know whether an item such as a trademark or patent or other type of intangible or tangible asset is protected under law in terms of ownership and/or restricted use.
  7. Quality of Management: If the pension fiduciaries are tasked with running a business or maximizing the value of an intellectual property asset to be contributed to a plan but do not have the time or requisite knowledge, someone may cry foul if the item loses value.
  8. Maintenance: The value of an asset such as real estate, a building or piece of heavy equipment will go down if not cared for in a timely fashion. The cost of upkeep and/or the speed of obsolescence are two of many considerations that cannot be ignored. If an asset requires significant cash to keep it in tip top shape, it could be a drain on scarce pension plan resources.

Besides the valuation-related issues, an objective third party needs to assess the prudence of including a particular asset in the plan's portfolio. Then there is the issue of how the intended in-kind contribution will impact regulatory reporting, financial statement representation and actuarial requirements, not to mention future cash inflows and outflows.

The decision to contribute an in-kind asset is far from trivial. Like any other decision for an ERISA plan, care and diligence must be demonstrated before taking action.

Dr. Susan Mangiero Speaks About ERISA Plan Valuation and Appraiser Liability


I am delighted to co-present on May 14, 2013 from 1:00 pm to 2:40 pm EST for Business Valuation Resources about the urgent need to properly assess pension fund economics as part of any opinion of value.This is a particularly timely topic as the U.S. Department of Labor seeks to designate appraisers as a fiduciary for an assessment they render about an ERISA plan such as an Employee Stock Ownership Plan ("ESOP"), 401(k) plan and/or defined benefit plan.

The session is entitled "Valuation and ERISA Fiduciary Liability: How to Protect Yourself." Speakers include:

  • Dr. Susan Mangiero, CFA, certified Financial Risk Manager, Accredited Investment Fiduciary Analyst, trained appraiser and past president of the Connecticut chapter of the National Association of Certified Valuation Analysts (Fiduciary Leadership, LLC;
  • Mr. Robert Schlegel, ASA, MCBA and past president of the Indiana chapter of the American Society of Appraisers (Houlihan Valuation Advisors); and
  • Senior ERISA attorney James V. Cole II, with the Groom Law Group.

Click here to register for this ERISA valuation program.

Fiduciary Shortcuts To Valuation Can Be Dangerous

Despite a plethora of information about how to implement shortcuts to enhance workplace productivity, fiduciaries need to ask themselves whether a "jack in the box" approach that equates speed with care and diligence is worth pursuing.

This topic of shortcuts came up recently in a discussion with appraisal colleagues about the dangers of using a "plug and play" model to estimate value. Although New York Times journalist Mark Cohen rightly cites the merits of having a business valuation done, he lists all sorts of new tools such as iPhone valuation apps that some might conclude are valid substitutes for the real thing. Rest assured that punching in a few numbers versus hiring an independent and knowledgeable third party specialist to undertake a thorough assessment of value is a big mistake, especially if the underlying assumptions and algorithms of a "quick fix" solution are unknown to the user. See "Do You Know What Your Business is Worth? You Should," January 30, 2013.

It's bad enough that a small company owner opts for a drive-in appraisal. It's arguably worse when institutional investors do so, especially as their portfolios are increasingly chock a block with "hard to value" holdings. In the event that a valuation incorrectly reflects the extent to which an investment portfolio can decline, all sorts of nasty things can occur. A pension, endowment or foundation could end up overpaying fees to its asset managers. Any attempts to hedge could be thwarted by having too much or too little protection in place due to incorrect valuation numbers. Asset allocation decisions could be distorted which in turn could mean that certain asset management relationships are redundant or insufficient.

Poor valuations also invite litigation or enforcement or both. As I wrote in "Financial Model Mistakes Can Cost Millions of Dollars," Expert Witnesses, American Bar Association, Section of Litigation, May 31, 2011:

"Care must be taken to construct a model and to test it. Underlying assumptions must be revisited on an ongoing basis, preferably by an independent expert who will not receive a raise or bonus tied to flawed results from a bad model. Someone has to kick the proverbial tires to make sure that answers make sense and to minimize the adverse consequences associated with mistakes in a formula, bad assumptions, incorrect use, wild results that bear no resemblance to expected outcomes, difficulty in predicting outputs, and/or undue complexity that makes it hard for others to understand and replicate outputs. Absent fraud or sloppiness, precise model results may be expensive to produce and therefore unrealistic in practice. As a consequence, a “court or other user may find a model acceptable if relaxing some of the assumptions does not dramatically affect the outcome.” Susan Mangiero, “The Risks of Ignoring Model Risk” in Litigation Services Handbook: The Role of the Financial Expert (Roman L. Weil et al, eds., John Wiley & Sons, 3d ed. 2005).

In recent months, it is noteworthy that regulators have pushed valuation process and policies further up the list of enforcement priorities. Indeed, in reading various complaints that allege bad valuation policies and procedures, I have been surprised at the increased level of specificity cited by regulators about what they think should have been done by individuals with fiduciary oversight responsibilities. Besides the focus of the U.S. Department of Labor, the U.S. Securities and Exchange Commission has brought actions against multiple fund managers in the last quarter alone. Consider the valuation requirements of new Dodd-Frank rules (and overseas equivalent regulatory focus) and it is clear that questions about how numbers and models are derived will continue to be asked.

For further reference, interested readers can check out the following items:

New PCAOB Report Finds Pension Valuation Numbers Wanting

According to a new report just published by the Public Company Accounting Oversight Board ("PCAOB"), valuation of pension plan assets was one of the audit areas with "deficiencies attributable to failures to identify and test controls." Given the importance of having proper pension valuations carried out by knowledgeable and experienced persons, it is no surprise that this oversight organization devoted an entire section of its findings to the topic of valuation of pension plans assets. The problems they found include the following:

  • Insufficient testing of controls over how pension plan assets are valued;
  • Testing of controls that were imprecise and therefore did not allow for an assessment of the risk of material misstatement by plan auditors;
  • Failure to properly test the valuation of pension plan assets; and/or
  • Relying on management or the person(s) who performed the reviews without seeking an independent assessment as to why "variances from other evidential matter" were occurring.

In response to these findings, a prominent ERISA attorney commented that the cited deficiencies were not surprising and that valuation problems will continue to grow for those retirement plans that are allocating more money to "hard to value" funds.

In his 2011 speech before the AICPA National Conference, Jason K. Plourde with the Office of the Chief Accountant, U.S. Securities and Exchange Commission ("SEC"), talked at length about the role of pricing services and how securities that are not actively traded should be valued. He suggested that management "may need to perform different procedures and controls when considering the information from pricing services regarding the fair value of financial instruments..."

Concerns about how best to value pension plan assets and regularly test methodologies and controls related to said valuations took center stage in 2008 when the ERISA Advisory Council working group on "Hard to Value Assets" met to discuss how best to improve things. This blogger - Dr. Susan Mangiero - testified on the topic of "hard to value assets," emphasizing that poor valuations lead to a cascade of problems. For one thing, inflated valuations translate into higher fees paid by ERISA pension plans. Second, incorrect valuations make it difficult to properly review and revise any of the items listed below, each of which are critical to proper fund management such as:

  • Asset allocation;
  • Exposure to a particular sector or fund manager;
  • Fee benchmarking for appropriateness of compensation paid to a manager;
  • Type and size of hedges;
  • Hiring and termination of an asset manager(s);
  • Regulatory funding ratio and related cash financing; and
  • Cost of pension plan de-risking for some or all of current defined benefit plan participants.

If you missed reading Dr. Susan Mangiero's September 11, 2008 testimony before the ERISA Advisory Council Working Group, click to read about "hard to value" assets in the context of ERISA fiduciary duties and pension risk management.

With more pension plans reporting large scale deficits, don't be shocked if further questions are asked about the integrity of asset and liability valuation numbers.

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds


Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.


With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.


  • ERISA fiduciary duties for institutional investors
    1. Hedge funds and private equity funds compared to traditional investments
  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans



The panel will review these and other key questions:

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans
  • What are the regulatory concerns for ERISA pension plans that allocate assets to hedge funds and private equity funds?
  • What are the potential consequences for service providers that fail to comply with new fee, valuation and service provider due diligence regulations?
  • What can counsel to pension plans and asset managers learn from recent private fund suits relating to collateral, risk-taking, pricing, insider trading and much more?
  • How should ERISA plans and asset managers prepare to comply with expanded fiduciary standards?


Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.


Susan Mangiero, Managing Director
FTI Consulting, New York

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Alexandra Poe, Partner
Reed Smith, New York

She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.



CFOs Fund Pension Plans With Intellectual Property

In "How Creative CFOs are Funding Pension Plans with IP" (Valuation Researcher Alert, June 2011), its authors describe how some Chief Financial Officers are transferring intellectual property assets to their respective pension plans. To add up to 275 million Great British Pounds to its UK defined benefit plans, "TUI Travel PLC is utilizing a partnership arrangement, backed by its Thomson and First Choice brands."

The idea is novel as was Diageo's use of "whiskey" assets to top off its retirement plan funding status. See "Diageo pledges whiskey against pension deficit" by Cecilia Valente, Reuters, July 1, 2010.

As with any "hard to value" security, there is merit in using an independent third party appraiser who can objectively incorporate risk factors in projecting future expected cash flows associated with an intangible asset like a trademark or patent.

Increasingly, expert work with which I am involved has focused on questions about whether an illiquid instrument was properly valued. As I stated during my September 11, 2008 testimony on this topic before the ERISA Advisory Council, bad valuations and related poor policies and procedures can have a costly domino effect because valuation numbers directly impact asset allocation and risk management decisions over time, not to mention fees that are paid to service providers. This is not good news for fiduciaries who are already faced with numerous challenges, each of which puts them squarely in the spotlight of regulators and litigators who see many ERISA plans as needing to do much more in the way of best practices. In the United States, should the U.S. Department of Labor expand its definition of a fiduciary to include appraisers, it may discourage valuation professionals from working with ERISA plans. This itself could be a problem.

Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

Hedge Fund Lock Ups and Pension Inflows

Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

Hedge Funds, Private Equity Funds and ERISA Pension Plans

Alternative fund managers and regulators will convene in Washington, D.C. from July 19 through 21, 2011 to talk about pension investing in hedge funds and private equity funds. Over several days, those who present before the ERISA Advisory Council will be asked to address questions such as those listed below:

  • What differentiates a hedge fund from other types of investments?
  • What differentiates a private equity fund from other types of investments?
  • How are hedge funds and private equity funds, respectively, correlated with the returns of traditional equity and fixed income investments?
  • How can defined benefit and defined contribution plan sponsors mitigate "the lack of liquidity that is characteristic of these investments?"
  • How can fee transparency be enhanced?
  • "Are there any unique diversification benefits offered by hedge funds and private equity investments as opposed to a fund of funds?"
  • What is the view of target date fund managers with respect to including hedge funds and/or private equity strategies within their funds?

According to U.S. Department of Labor documents, the aim is to create best practices guidance in areas such as leverage, liquidity, transparency. valuation, operational due diligence, client and asset concentration and offering documents. Click to download "2011 ERISA Advisory Council: Hedge Funds and Private Equity Investments." Click to read the June 22, 2011 U.S. Department of Labor news release about the forthcoming meetings to address hedge funds and private equity investments by ERISA plans.

Interested readers may want to check out the following of many items that are available for further research:

Financial Model Mistakes Can Cost Millions of Dollars


It's been awhile since I've blogged. Work has been busy and then I took off ten days to visit Paris. The City of Lights is amazing indeed. Now that I'm back, I will try to blog more frequently. There is certainly no shortage of topics about risk, governance, litigation, valuation and so on.

For those who don't know, I created a sister blog a few months ago. See Nearly all of the time, the posts on each blog are different. However, I decided to reprint a post from here since the topic is hugely important. After all, for those defined benefit and defined contribution plans that are exposed to "hard-to-value" investments, leverage and perhaps higher than expected volatility, model risk could be the hidden alligator that bites if left unchecked. As always, I welcome your comments at

Here is the post that was originally posted on June 2, 2011 by Dr. Susan Mangiero.

In a recently published article about financial models entitled "Financial Model Mistakes Can Cost Millions of Dollars" (American Bar Association, Section of Litigation, Expert Witnesses, May 31, 2011), Dr. Susan Mangiero defines model risk and explains why it is so important. Referencing the recent $242 million enforcement action by the U.S. Securities and Exchange Commission as a result of model mistakes made by a well-known asset management firm, this financial expert cites the heightened regulatory and litigation imperatives with respect to risk and valuation models. She concludes the article by listing some of the ways to mitigate risk. These include, but are not limited to the following:

  • Hire knowledgeable programmers with capital market experience;
  • Create and follow a set of policies and procedures that govern how and who will validate financial models over time and what will trigger revisions in a model(s);
  • Avoid conflicts of interest that would reward managers for ignoring problems and would potentially preclude an independent and objective assessment of problems and related corrective action(s);
  • Test assumptions for validity in stable markets as well as extreme circumstances;
  • Stress a model using a sufficient number of economic scenarios to gauge its predictive power and whether results can be relied upon in both good or bad times;
  • Educate personnel about how a particular model is supposed to work;
  • Establish a response strategy should a problem occur and investors need to be informed before things get out hand;
  • Scrap models that are overly complex and expensive to replicate;
  • Don't be afraid to ask questions about inputs, data quality, results, and concerns; and
  • Invite informed outsiders to offer an independent and regular critique on a confidential basis.


Public Pension Risk Management and Fiduciary Liability

A few weeks ago, Attorney Terren B. Magid and Dr. Susan Mangiero jointly presented on the topic of pension risk management and fiduciary liability with a particular emphasis on public plans. Attorney Magid's insights reflect a particularly unique perspective inasmuch as he served as executive director of the $17 billion Indiana Public Employees' Retirement Fund ("PERF"). Dr. Mangiero shares her views as an independent risk management and valuation consultant, author, trainer and expert witness.

Click to download the 25-page webinar transcript for public pension fiduciaries entitled "Are You Properly Mitigating Risk? Assess Your Fiduciary IQ" with Attorney Terren B. Magid (Bingham McHale LLP) and Dr. Susan Mangiero (Fiduciary Leadership, LLC). Comments about ERISA plans are provided when applicable.

Topics discussed include, but are not limited, to the following:

  • Public Pension Transparency Act
  • Discount Rate Choice
  • Dodd-Frank Wall Street Reform and Municipal Advisor Registration
  • Expanded Definition of ERISA Fiduciary
  • Fee Disclosure Under ERISA 408(b)(2)
  • Failure to Pay and Actuarially Required Contribution ("ARC")
  • Benefit Reductions
  • RFP Process
  • Fiduciary Audits
  • D&O Policy Review
  • Vendor Contract Examination
  • Qualitative and Quantitative "Investment Risk Alphabet Soup"
  • Interrelated Risk Factors
  • Key Person Risk
  • Hard to Value Investing
  • Model Risk
  • Stress Testing
  • Pension Litigation
  • Fiduciary Breach Vulnerability
  • Characteristics of a Good Model
  • Side Pockets and Investment Performance.

Comments are welcome.

Risk Management and Valuation Blog Launches

Recognizing the continued need for actionable information about institutional investment best practices, Dr. Susan Mangiero offers analysis of critical issues affecting the $30+ trillion global buy side industry. This unique investment risk management and valuation blog at serves as a resource for trustees, board members, attorneys, money managers and financial advisors with asset allocation, governance, risk management and fiduciary oversight responsibilities.

According to Dr. Mangiero, “Investment risk governance is more important than ever before. As billion dollar losses continue to make headlines, fiduciaries and their counsel continue to be challenged with volatile markets, a slew of new mandates and investment complexity that requires rigorous due diligence. Litigation is increasing at a fast clip and investment professionals must absolutely embrace and demonstrate an understanding of risk management and valuation issues. Post-Madoff and the credit crisis, there is no room for complacency.”

Click here to read the February 10, 2011 press release about

Note to Readers:, soon to celebrate its fifth year anniversary, focuses on the many challenges confronting retirement plan decision-makers. takes a broader view of the industry and includes commentary, insights and analysis about important issues for pension funds and other types of institutional investment industry participants such as endowments, hedge funds, mutual funds, private equity funds and sovereign wealth funds. The coverage is slightly different and the access is complimentary. Readers are encouraged to get email updates for each of these two unique websites. Visit and type your email into the box by the green GO button or click here to add to your RSS feeder.

Model Risk Costs One Asset Manager $242 Million

According to a February 3, 2011 document released by the U.S. Securities and Exchange Commission ("SEC"), AXA Rosenberg Group ("AXA") and various related entities have settled a matter relating to model risk for $242 million in economic damages and penalties. In a company letter dated April 15, 2010, several AXA executives describe an error with an investment model as having been "discovered in late June 2009" and "corrected between September and mid-November." While there are issues about the disclosure of said problems, the official message to investors at that time was a continued commitment to risk management.

Investor fallout has occurred nevertheless with various press accounts reporting the withdrawal of monies from AXA by pension plans such as the School Employees' Retirement System of Ohio, Los Angeles Fire and Police Pensions, the City of Fresno Retirement System, Florida State Board of Administration, the Marin County Employees' Retirement Association and the Montana Board of Investments. 

As I've written before, valuation (and by extension, model risk assessment) is a key element of the due diligence of asset managers. For a list of some of the "must ask" questions about model reviews, click to read "Asset Valuation: Not a Trivial Pursuit" by Susan Mangiero, PhD, CFA, FRM (FSA Times, The Institute of Internal Auditors, Q1-2004).

Email if you want to further discuss model review best practices.

Valuing Positions in Alternatives - New DOL Scrutiny

According to "DOL rule could raise pension funds' costs: Proposed fiduciary requirement would hit appraisers of alternative investments" by Doug Halonen (Pensions & Investments, November 15, 2010), those who provide independent valuations could soon be declared fiduciaries. Remembering that there is no free lunch and that every new rule has unintended consequences, third party pricing experts are already running for cover. Some say they may exit the appraisal business at the same time that ERISA plans are enlarging their positions in alternatives and also being called upon to provide more information in their Form 5500 filings.

In case you missed it, click to access my comments on this topic, entitled "September 11, 2008 Testimony Presented by Dr. Susan Mangiero before the ERISA Advisory Council Working Group on Hard to Value ("HTV") Assets."

I had the pleasure of presenting on the same topic of risk management and valuation to the OECD and International Organization of Pension Supervisors in Paris in June 2010.

Clearly, pension plan decision-makers and their advisors, attorneys and consultants are going to be challenged to find the right balance between return and risk (with valuation questions being one type of risk). Not every alternative investment is "hard to value." Indeed, some mutual funds and other "traditional" choices have their own challenges in terms of pricing and liquidity.

Click to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know" by Susan Mangiero, Journal of Compensation and Benefits, July/August 2006.

Pension Audit and Reporting Webinar Slides Now Available

Slides and the audio recording of the May 18, 2010 webinar about new pension audit and reporting rules are available now to subscribers. Simply click here. You will be prompted to log in. Enter your email address and password and you will be taken directly to the slides and audio recording page. If this is the first time that you are logging into, you will be prompted to read and agree with the Terms of Use.

Email if you have questions about the Terms of Use or need help in getting access to

If you are not yet a subscriber and are an institutional investor or have institutional investors as clients, register now for a free subscription to Go to

We look forward to having you join us in the global conversation about investment best practices. Enjoy our content library, Virtual Reference Desk and social network. Connect with peers. Read cutting edge thought leadership and search for document templates that save you time and money (and it's free to you - our compliments)!

Hedge Fund Valuation and Performance Reporting

According to "Offshore hedge fund is trouble for Seattle's pension fund" by Rami Grunbaum (Seattle Times, April 11, 2010), the Seattle City Employees' Retirement System ("SCERS") got a nasty surprise when they asked again for overdue financial information about a hedge fund in which it had invested. According to various records, the U.S. Securities and Exchange Commission has similar questions about "true" value versus reported performance numbers. Contacted by deputy news editor Grunbaum for a general comment about hedge fund valuation and performance reporting, I stated that "Pension trustees shouldn't allow hedge funds to hide behind a veil of secrecy" and that "If a hedge-fund manager is unwilling to explain their valuation process - and related procedures and internal controls - run, do not walk for the nearest door."

If you missed some of my earlier writings on the important topic of valuation, I've included several items below:

Email if you would like more information about hedge fund risk management and valuation productivity tools from an institutional investor perspective.

U.S. SEC Significantly Steps Up Enforcement

In case you missed it, the U.S. Securities and Exchange Commission announced significant enforcement initiatives on January 13, 2010. These include a focus on due diligence and valuation issues with a particular emphasis on due diligence, investment advisors, investment companies, performance and valuation.

Read "SEC Names New Specialized Unit Chiefs and Head of New Office of Market Intelligence" (U.S. Securities and Exchange Commission, January 13, 2010).

This follows on the heels of our January 7, 2009 blog post wherein we reported that the FBI is hiring over 2,000 professionals with backgrounds in accounting and finance. See "FBI Hiring Spree - More Financial Fraud Expected?" and "Wanted by the FBI: Talented Professionals to Serve the Nation."

The View From The Other Side - Regulatory Insight

Sometimes seeing over the other side of the desk is difficult, if not impossible. That's too bad because regulators and those they oversee have a lot to learn from each other. This is especially true if you embrace a primary goal of ultimately allowing for complete self-governing as a way to ensure more efficient markets.

"Pension Funds' Risk-Management Framework: Regulation and Supervisory Oversight" by Fiona Stewart (Working Paper No. 11, International Organisation of Pension Supervisors, November 2009) gets us part of the way. This new compendium of rules and regulations categorizes pension risk rules for Australia, Brazil, Germany, Kenya, Mexico, Netherlands and the UK in four areas - "management oversight and culture, strategy and risk assessment, control systems and information, reporting and communication." An audit checklist that pension supervisors can use in their examination work is offered as an appendix as is a convenient summary table that lays out country-specific risk management regulations about things such as the role of the Chief Risk Officer.

The two sides of the fence may never shake hands but studies like this enhance the understanding as to what is expected of plan sponsors by regulators.

Return, Liquidity and Valuation


More than a few of our recent conversations with pension, endowment and foundation decision-makers focus on hard-to-value investing. At a time when 2010 beckons with the hope of a buoyant market, institutions seek returns from alternatives such as hedge funds, private equity and venture capital. According to "The Endowment & Foundation Market 2009," put out by the Spectrem Group, about six out of ten organizations seek to rebuild by emphasizing non-traditional asset allocations. Other recent studies confirm the same sentiment with the caveat that liqudity is key.

Therein lies the rub.

  • Can you invest in "hard to value" assets and satisfy a need for ready cash at the same time?
  • Who should monitor valuation of "hard to value" assets?
  • What areas of concern are most acute from the investment decision-maker perspective?
  • What elements are "must have" with respect to effective policies and procedures?

In my September 11, 2008 testimony before the ERISA Advisory Council on the topic of hard to value investing, I emphasized the need to subsume pricing as part of pension risk management (though the concept transcends retirement plans, with full applicability to endowments, foundations, college plans, sovereign wealth funds and other types of buy side executives).

Click to access the United States Department of Labor Advisory Council report on hard to value investing. 

Participate in a short survey entitled "Hard to Value Investing Policies and Procedures." The questionnaire consists of twelve multiple choice queries. For those interested in receiving survey results, be sure to include your name and email address before you hit the "Submit" button.

Financial History Can Be a Good Teacher

In response to "Quandary of Transparency" (April 7, 2009) by guest blogger Doug Miles, Ms. Maryls Appleton agrees that the past can be a good teacher, but only if we are open to learning. Read what governance professional Marlys Appleton has to say:

<< Doug, thanks for the reminders of these past events, particularly the Penn Central bankruptcy. Transparency and disclosure are sure to be the guide-phrases and values that will be operational as a result of this crisis. However, disclosure and transparency do not necessarily lead to accountability. A massive failure of governance has contributed to the current situation. I am interested in any thoughts you have as to how we can help assure that in a world of better transparency and increased disclosure, we also get better governance and accountability. What is that link between transparency and accountability? I am in total agreement that FASB's "bending" makes more less transparency, not more. It is the politicians, not just the executives, who have bullied the FASB into rethinking mark-to-market issues. This is akin to us looking at our 401(k) statements and saying, 'Well, they really are at par or 95, not where our statement puts them.' The lack of liquidity needs to be part of the pricing process. It is also necessary to acknowledge the dismal state of both the residential and commercial real estate markets, as well as the availability of credit. >>

Without a desire and willingness to improve when warranted, we are destined to go around and around, rather than moving forward.


The Quandary of True Transparency

Transparency and disclosure seem to be the sine qua non of regulatory reform these days. What this means exactly is yet unknown but certainly worth a lively debate. After all, new mandates for more information will require someone, somewhere to do more work. Our guest blogger, Mr. Doug Miles, provides some interesting insight. CEO of, Miles leads a team of independent pricing experts. Here are Doug's remarks:


Almost two years into the global credit crisis, we all yearn for it to be over. Piercing the 8.5% unemployment level last week, not seen for 25 years in the United States, represents one of many aftershocks in a chain reaction throughout 2008. This is a realized metric, unthinkable by any respected economist, as recently as two years ago.

Trillion dollar stimulus packages commit us to years of obscene budget deficits. When combined with the already committed bailout monies, the result is an unfathomable sense of dread and gloom. We wistfully pretend that all of the hot spots of balance sheet and leverage quicksand have now been identified and are being addressed. Sadly, we await the other shoe to drop in the form of additional larger losses. Can we learn from history or are we destined to repeat it?


Recall the bankruptcy of Penn Central. Triggered by the default of its AAA commercial paper in 1970, ensuing problems badly damaged investors' confidence. Not a single Initial Public Offering ("IPO") came to market for seven years. The financial world was smaller then and capitalism in places like China, Brazil, Russia and India did not really exist. There were no derivative markets. Yet market psychology and human reaction remain little changed 38 years later. Balance sheet surprises in the form of imprecisely measured liabilities wreak havoc on cash flow for large and small companies alike, accelerating their need for credit when ready money is a memory of the past.


One remedy is an open asset pricing system, recognized by corporate management as a way to stabilize, if not reverse, a slide in equity levels. Just as it did a century ago with the Panic of 1907, true transparency has the power to calm and heal. Then JP Morgan and his syndicate openly embraced and bolstered the balance sheet investments of a half dozen or more banks as their respective share prices more than halved 52 week highs. Two years later, as asset prices recovered, those financial stocks returned to within 10 to 15 percent of pre-panic highs. The same restoration of confidence and transparency may be achieved in today’s climate but only if corporate executives acknowledge financial measurement problems (rather than blame accounting rule-makers) and busy themselves with economic solutions.


Pensions Query Private Equity and Venture Capital Funds

According to Wall Street Journal reporter Heidi N. Moore, investing in certain private equity funds may no longer be a walk on the beach. Not content to sit passively on the sidelines, "Pension Funds to Private Equity: ABCD. Always Be Closing Deals." (March 13, 2009) describes a desire to shift power to pensions, endowments and foundations, away from portfolio managers. Cited reforms include: (a) contracts that mandate the return of money to limited partners within a pre-specified period, thereby truncating fees earned by private equity funds (b) clawback arrangements that allow general and limited partners to equally participate in big wins and (c) detailed evidence that committed monies are being invested rather than left idle.

In a related article entitled "Venture Capitalists Chart a New Course" (March 13, 2009), Wall Street Journal reporter Pui-Wing Tam writes that some venture capitalists may be moving outside their comfort zone by investing in distressed assets and public companies via "registered directs" and private investments in public equities ("PIPES"). Brandon Park, a financial professional who invests in venture capital funds on behalf of institutional investors is quoted as saying that "many venture funds have charters that allow a certain percentage of assets -- typically 10% to 15% -- to be invested in assets other than private start-ups."

Indeed, there are many changes afoot in the private capital arena. They potentially impact if, and how much, pensions, endowments and foundations allocate to this asset class.

  • The credit crisis has made it difficult to do deals that depend on leverage.
  • The time period before which a company is likely to go public or be acquired has lengthened, often forcing a general partner to (a) hold onto a portfolio company for a relatively longer period of time and/or (b) possibly requiring additional cash infusions by that general partner as a result of a longer holding period.
  • Some private capital partnerships are not establishing new funds. As a result, their need to preserve cash (i.e. to keep existing companies afloat) may create even more friction for limited partners which want to see new investments being made.
  • If passed into law, a proposed rule to change the way carried interest is taxed for general partners could impact fees charged to limited partners.
  • FAS 157 applies to many alternative funds and remains a due diligence item for institutional decision-makers who must understand valuation policies and procedures for "hard to value" asset pools. 

A big plus is that some private equity and venture capital funds find themselves in an enviable position to pick and choose from a bevy of investments as entrepreneurs find more traditional funding paths closed to them. Ultimately, realized returns, ownership privileges and qualitative practices will influence how much money pensions, endowments and foundations continue to plow into non-public opportunities.

Editor's Note: Here are a few resources for interested readers.

Valuation Policies and Procedures

Tomorrow marks our second in a series of webinars about valuation. The March 9 event focuses on the creation of valuation policies and procedures. If you need help with your "hard to value" asset process, email Our valuation experts represent years of academic training, "roll your shirt sleeves up" practical experience and lots of common sense.

In the meantime, please take our short survey. We will be announcing the results soon. Click to answer a few questions about "Hard to Value Asset Policies and Procedures." Preliminary answers enlighten with 80 percent of respondents answering "Yes" to replacing an asset manager if the manager cannot properly value financial instruments. Three quarters of survey-takers cite concerns such as "auditor's ability to properly model financial instruments," "data quality," and "fiduciaries' ability to properly model financial instruments for oversight purposes."

Hard to Value Assets and Fiduciary Duties

Pension Governance, Incorporated will soon release two webinars on the important topic of valuation and investment fiduciary duties. In the spirit of providing impartial thought leadership and insight, our team has created a short survey about valuation policies and procedures and their relationship to asset allocation and manager selection, respectively.

Click here to take the survey entitled "Hard to Value Asset Policies and Procedures." The survey should only take about 3 or 4 minutes to complete. Results will be aggregated and published in several weeks. Individual responses will not be published nor will information about any respondent be made public.

In advance, many thanks for your time.

Valuation Fundamentals - Going to the Dogs

According to Venture Deal (February 11, 2009), raised $4 million in venture capital to "improve its website and expand its management team." Founded by actress Glenn Close and her husband, the company has heretofore been privately funded. Dogs are big business. The Morning Sentinel reports that pet owners are significant spenders with approximately $43.4 billion in 2007 sales for Rover and Fido, "up 88 percent from 1998." See "Portland in growth mode..." by Ann S. Kim (February 10, 2009).

Wow and congratulations to

For those plan sponsors with allocations to venture capital ("VC"), one has to ask lots of questions about the big 3 fundamentals - economy, industry, company, right? Shouldn't an Investment Policy Statement require VC and private equity managers to explain how a company is expected to make money? It sounds straightforward enough but recent articles suggest that some VC fund managers have shelled out cash first and asked questions about business models later. In some cases, it's worked but halcyon days are long gone. The IPO market is closed for all practical purposes and easy money makes it harder for acquirers to purchase companies with debt.

What kinds of questions do you ask your VC and private equity managers about the fundamentals, a la Graham and Dodd and then some?

Financial Engineering, Forensics and Pension Shareholders

My dad was an aerospace engineer who later switched to mechanical engineering. My sister is an electrical engineer. My husband was an electrical engineer until he earned his PhD in finance and became a professor. They have each advised me in their own way that every problem has a solution. It is a question of digging deep for answers, assimilating sometimes massive amounts of data and then applying a big dose of common sense.

Influenced by these important persons in my life (and many others who have a similar "can do" attitude), I use a building block approach to financial engineering. Having worked in two treasury departments, on four trading desks, as an expert witness, fiduciary trainer and consultant, I know that it is important to ask many questions, understand the context and attempt to connect seemingly disconnected dots.

Applied to pension risk management, what you see is not what you necessarily get. It is critically important for institutional shareholders to understand whether and how much their portfolio companies (either through direct or indirect investing) use leverage (possibly in the form of derivative financial instruments) and how related risk is managed. (I was recently interviewed by a major broadcasting company on this very topic, given some of the lawsuits being filed against companies that allegedly did not do "enough" in the area of risk management. The piece will air in the next several weeks.)

In the meantime, these articles I authored several years ago may be of interest to readers of The principles still apply today.

"The Role of the Financial Expert in Valuation of Derivative Instruments" (Expert Evidence Report, February 2004)

"Derivatives valuation: One size does not fit all" (Shannon Pratt's Business Valuation Update, December 2004)

"Derivatives and their impact on company value, part 1" (Shannon Pratt's Business Valuation Update, March 2005)

"Derivatives and their impact on company value, part 2" (Shannon Pratt's Business Valuation Update, April 2005)

Private Equity and Derivatives - Double Whammy or Blissful Combo?

According to the U.S. Government Accountability Office, nearly 4 out of 10 surveyed pension plans say they allocate monies to private equity. Allowing that some managers have turned in acceptable returns, respondents also cited numerous "challenges and risks beyond those posed by traditional investments." Valuation and limited transparency are two issues cited in "Defined Benefit Pension Plans: Guidance Needed to Better Information Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity" (GAO-08-692, August 14, 2008).


To shed light on some of the intricacies associated with private equity investments, I authored a case study for the February 2009 issue of PEI Manager, a private equity and venture capital focused publication. The bottom line is that institutions that invest in private equity funds are directly impacted by their portfolio companies' use of derivatives.


"Swapping out" by Dr. Susan Mangiero, an Accredited Valuation Analyst and CFA charterholder, is reproduced below. Email Ms. Jennifer Harris, Associate Editor - PEI Manager, for permission to reprint the case study.


                                                                       * * * * * *




Private Equity Holdings (“PEH”) is required by its charter to avoid companies that use derivative financial instruments to speculate. In reviewing numbers for FAS 157 reporting purposes, a PEH managing partner notices that one of its portfolio companies, ABC Incorporated (“ABC”), recently included a FAS 133 entry for a $20 million interest rate swap hedge. During a call to the company to query about how the swap is being used, the PEH managing partner is informed that its counterparty is Global Bank Limited (“Global”). Not only has Global just reported a $30 billion loss due to poor valuation of its structured product portfolio, it posted no collateral in favor of ABC while ABC was required to pledge $2 million in U.S. Treasury Bills in order to protect Global in the event that ABC could not make its contractual swap payments to Global. Not being too familiar with derivative instrument pricing and default risk analysis, PEH hires an expert to investigate whether the swaps reflect a hedge versus a market bet and to further assess how PEH should adjust the valuation of its equity stake in ABC. What does the expert need to look at and how should she arrive at an appropriate conclusion?




This fact situation, ripped from the headlines, raises several important valuation questions, including, but not limited to the following:


  • Notwithstanding FAS 133 numbers, is the company exposed to changes in interest rates that could adversely impact cash flow, liquidity and net income?
  • Was the swap correctly valued?
  • How might ABC be impacted by Global’s deteriorating health?
  • What adjustments, if any, should PEH make to its initial valuation of ABC equity?

There are several critical issues here, all of which could seriously hamper the fortunes of both ABC shareholders and PEH investors. An inaccurate valuation of the swap leads to a flawed accounting representation for ABC and may lull treasury staff into thinking that the hedge offers full protection against unexpected moves in interest rates. PEH may report a bad FAS 157 number which in turn could lead to flawed asset allocation decisions made by institutional limited partners or the overpayment of performance fees to PEH. A poorly constructed hedge (in economic versus accounting terms) that exposes ABC to negative market conditions could force PEH to violate its prohibition against speculative trades being executed by portfolio companies. If Global does not meet its swap obligations and/or files for bankruptcy protection, ABC may not be able to recover its collateral quickly or could lose it altogether, depending on its standing vis-à-vis other creditors.


Swap pricing models can differ depending on the complexity of the transaction. However, for standard fixed to LIBOR swaps, the secondary market is large ($111 trillion, according to the Bank for International Settlements). Active trading makes it easy to readily obtain prices for various maturity interest rate swaps with quotes reflecting the discounting of future projected fixed and floating swap payment amounts. In contrast, the assessment of credit worthiness varies, sometimes considerably, across banks. Unfortunately for ABC, even if they posted more collateral than should have been required, the fact remains that they have no immediate recourse in the event that Global’s distress prevents the bank from paying what it owes to ABC. If Global defaults, ABC will then have to decide on a course of action that could include any or all of the following:


  • Enter into a second interest rate swap to replace Global at a now higher fixed rate
  • Attempt to sell the initial swap in the open market and consider another way to hedge against rising interest rates though few will be willing to accept the Global risk
  • Take legal action to reclaim its collateral
  • Write down the value of the swap on its books

There is no ideal situation. The expert will necessarily have to ask ABC what they plan to do in the event of swap non-performance and how it is expected to impact its cash flow, cost of money (which in turn affects capital budget decisions), balance sheet, dividend payments and interest coverage. Once that scenario analysis is conducted, both the expert and PEH will be able to quantify how much of an adjustment downward they will need to make for both accounting and performance reporting purposes.

Hedge Fund Valuation - Dead or Alive?

A key element of any valuation engagement is an assessment of "premise of value." Said another way, an appraiser must determine whether an economic entity is likely to remain in business (and therefore should be treated as an ongoing concern) or instead be put in the "not going to make it" bucket. If operations are thought to soon cease, imminent liquidation is almost sure to follow, (wherein the business sells assets and tries to make good on outstanding obligations, to the extent that proceeds are available.) According to a recent article, the "alive or dead" litmus test may be needed now, more than ever before. reporter Ben Rooney cites a recent Hedge Fund Research study that documents 344 liquidations or "more than three times the 105 liquidations in the third quarter of 2007" or "77 more than the previous record of 267 liquidations in the fourth quarter of 2006." On an annual basis, failed hedge funds may reach nearly 1,000 for the full year or more than "the previous record of 848 of 2005." (See "Hedge fund graveyard: 693 and counting," December 18, 2008.)

Redemptions, wild market swings and idle cash, sitting on the sidelines, are a few likely culprits with respect to which hedge funds survive or fail. What this means to institutional investors is profound. Due diligence must address whether and for how long a particular hedge fund might be expected to be a viable commercial enterprise (and so much more). Without stating the obvious, who wants to plunk down good monies for a fund that has a low probability of being around for the foreseeable future?

In a related article, Financial Times reporter James Mackintosh reports that Switzerland's Union Bancaire Privée has told "managers of the $56bn it has allocated to hedge funds to put in immediate redemptions for any fund that does not have independent administrators and custodians." The article goes on to say that some hedge fund notables are on the redeem list while others have decided to appoint independent third parties. (See "Investor demands fund checks," December 23, 2008.)

Anecdotally, I've heard that institutional investors (either through the audit or compliance functions or both) are requiring more documentation (read "transparency") from their hedge fund managers. To date, they say they have had little push-back. One wonders if there is a balance of power shift underway, favoring institutional investors. After all, how many of us have heard some asset managers decline (sometimes vehemently so) to implement what they deem to be expensive and time-consuming procedures UNLESS pensions, endowments and foundations demand such?

Editor's Note: Valuation of a hedge fund as a business is not the same thing as assessing the worth of instruments inside the hedge fund's portfolio. Consider a particular hedge fund that successfully invests in distressed securities.

Hard to Value Assets: Hide and Seek Creates Stir for Investors

As this blogger has long maintained, what you see is not necessarily what you get and what you don't see could come back to bite you. It is therefore troublesome to think that billions of dollars of assets are likely to be classified as Level 3 or the international equivalent of FAS 157 "hard to value" items.

According to "Financial groups' problem assets hit $610bn" (December 10, 2008), a significant trend is already underway for banks to move securities to third tier status. Financial Times reporters Aline van Duyn and Francesco Guerrera cite a Standard & Poor's study that shows an increase in illiquid assets by more than 15 percent from Q2-2008. Difficulty in finding buyers for mortgage-backed securities and collateralized debt obligations accounts in part for the increase. Somewhat alarming, the article adds that "level-three assets are many times bigger than the market cap of the banks."

In "Running the Fund: Alternative Realities" (November 2008), PlanSponsor reporter Judy Ward quotes me extensively on the topic of valuation of "hard to value" assets from the investment fiduciary perspective. As regular readers will recall, the U.S. Department of Labor has made no secret that it would like to see pension decision-makers do a good job of vetting valuation numbers that are provided by its asset managers.

Litigation, sub-par asset allocation, anemic risk management, overpayment of fees and eventual losses due to hidden economic pot-holes are just a few of the possible nasties when valuation process is ignored. If true that banks themselves are struggling as to how properly classify a holding(s), how will plan sponsors need to respond? As I said to Ward, The number is important, but it is more important to know why that valuation number is what it is, and if the factors that contributed to that valuation number are likely to change. People take a sense of false security from that one number."

If regulatory filing statistics portend more recategorizations to "hard to value" status, there will be an awful lot of nervous pension decision-makers, deciding what to do next.

Editor's Note: Click to read a "Summary of Statement No. 157," provided by the Financial Accounting Standards Board. Wall Street Journal reporter Mark Gongloff provides a nice overview of the FAS 157 hierarchy, defining Level 3 assets as those for which inputs are not directly observable. See "A FAS 157 Primer" (November 15, 2007.)

Pension Magic

I had the pleasure of speaking on October 23, 2008 in Stamford, CT about "New Directions for the Financial Services Industry." Part of the "Securities Forum 2008: Weathering the Economic Storm," sponsored by the State of Connecticut Department of Banking, panelists addressed the litany of current financial problems, proposed reforms and the likely future for investors and service providers alike.

I was asked to address FAS 157 and international equivalents. In doing so, I urged audience members to make a clear distinction between accounting representation and economic reality or accept the consequences. Unless one truly understands what reported numbers say (or just as importantly don't convey), poor decisions made on the basis of incomplete or even illusory information can lead to costly outcomes (GIGO = Garbage In, Garbage Out).

I've long maintained that disclosure about process is arguably more important than single numbers, derived at a particular point in time. For example, if I'm a pension fund decision-maker who has allocated monies to a manager that in turn invests in "hard-to-value" assets, which information is more helpful to me in understanding my risk exposure to that asset manager - (1) a FAS 157 disclosure that describes possible changes that could affect results or (2) identified likely risk drivers and the controls that have been established to mitigate risk accordingly?

Said another way, am I properly discharging my fiduciary duties by evaluating risk ex poste or instead assessing uncertainty ex ante? I think the answer is obvious, isn't it? After all, no one can respond to "what was" but can certainly act in anticipation of "what might be." By the way, I do believe there is merit in regularly conducting a post-audit of what went wrong and trying to learn lessons as a result.

According to FORTUNE Magazine senior editor Allan Sloan, critics of FAS 157 allege real harm is being done when illiquid securities are marked-to-model at "artificially low market prices." Call me clueless but finger-pointing seems to answer the wrong question. Instead of focusing on FAS 157 as the culprit because it supposedly forces reporting entities to document "bad" economic numbers, why not create a standard that instills confidence in financial statement users? Sloan writes "It's easier to blame accountants for your problems than to admit you made your institution vulnerable by overleveraging its balance sheet and buying securities you didn't understand." Click to read "Playing the blame game: Will 'mark to market' accounting take the fall for the Wall Street mess?" (October 27, 2008).

Just like the magic impossibility of growing a silver dollar into four years of college tuition, accounting representation should be more than smoke and mirrors.

New Study Addresses Pension Risk Management Gaps

 At a time of great market turmoil, plan participants, shareholders and taxpayers want to know whether their retirement plans are in good hands. Risk is truly a four-letter word unless plan sponsors can demonstrate that a comprehensive pension risk management program is in place. Unfortunately, there is little information that details if, and to what extent, plan sponsors are doing a credible and pro-active job of identifying, measuring and mitigating a variety of risks. The risk alphabet includes, but is not limited to, asset, operational, fiduciary, legal, accounting, longevity and service provider uncertainties.

While no one could have predicted the extreme volatility that characterizes the current state of global capital markets, it has always been known that poor risk management can make the difference between economic survival and failure. Applied to pension schemes, ineffective risk management could prevent individuals from retiring at a certain age and/or leaving the work force with much less than anticipated. Others pay the price too. Taxpayers worry about rate hikes that may be inevitable for grossly underfunded public plans. Shareholders could find themselves on the hook for corporate promises or experience depressed stock prices due to post-employment benefit obligations.

In an attempt to shed some light on this critical topic area, Pension Governance, LLC is pleased to make available a new research report that explores current pension risk management practices. In what is believed to be a unique large-scale assessment of pension risk practices since the publication of a 1998 study by Levich et al, this survey of 162 U.S. and Canadian plan sponsors seeks to: (1) understand why and how pension plans employ derivative instruments, if they are used at all (2) identify what plan sponsors are doing to address investment risk in the context of fiduciary responsibilities and (3) assess if and how plan sponsors vet the way in which their external money managers handle investment risk, including the valuation of instruments which do not trade in a ready market. The report was written by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM, with funding from the Society of Actuaries.

Each survey-taker was asked to self-identify as a USER if he/she works for a plan that trades derivatives in its own name. A NON-USER works for a plan that does not trade derivatives directly but may nevertheless be exposed indirectly if any of the plan's asset managers trade derivatives.

In answering broad questions, a large number of surveyed plan sponsors describe themselves as doing all the right things to manage investment, fiduciary and liability risks. However, answers to subsequent questions - those that query further about risk procedures and policies at a detailed level - do not support the notion that pension risk management is being addressed on a comprehensive basis by all plans represented in the survey sample.

Key findings include the following points:

  • Plan size seems to be one factor that distinguishes USERS from NON-USERS, with 39% of USERS managing plans in excess of $5 billion versus 14% of NON-USERS associated with plans larger than $5 billion.
  • Pension decision-making appears to vary considerably by job function, with 48% (37%) of USERS (NON-USERS) choosing "Other" rather than selecting from given titles such as Actuary, Benefits Committee Member, CFO or Human Resources Officer.
  • Time allocation varies considerably with 64% (40%) of USERS (NON-USERS) saying they devote 75 to 100 percent of their work week on pension issues. In contrast, 37% of NON-USERS say they spend 0 to 24% of their work week on pension issues.
  • A majority of USERS (64%) and NON-USERS (48%) have had discussions about the concept of a fiduciary duty to hedge asset-related risks. A smaller number say they have discussed the concept of a fiduciary duty to hedge liability-related risks.
  • Few plans currently embrace an enterprise risk management approach with 59% (57%) of USERS (NON-USERS) responding that their organization does not use a risk budget. When asked if their organization has or is planning to hire a Chief Risk Officer, 57% (64%) of USERS (NON-USERS) answered "No."
  • NON-USERS cite numerous reasons for not using derivatives directly, including, but not limited to, "Lack of Fiduciary Understanding" (25%), "Perception of Excess Risk" (31%), "Considered Too Complex" (23%), "Prohibition Against Possible Leverage" (19%) and/or "Defined Benefit Plan Risk Not Considered Significant" (28%).
  • A query about whether survey-takers review external money managers' risk management policies results in 70% (58%) of USERS (NON-USERS) responding "Yes." Fifty-two percent (57%) of USERS (NON-USERS) say they review external money managers' valuation policies. This survey did not drill down with respect to the rigor of questions being asked.
  • Survey respondents seem to rely mainly on elementary tools to measure risk. Eighty-three percent (64%) of USERS (NON-USERS) rank Standard Deviation first in importance. Seventy-nine percent (63%) of USERS (NON-USERS) rank Correlation second. Only one-third (38%) of NON-USERS cite Stress Testing (Simulation). Four out of 10 USERS cite Value at Risk in contrast to 23% of NON-USERS who do the same.
  • Survey respondents worry about the future with 58% (60%) of USERS (NON-USERS) ranking "Accounting Impact" as a concern. Other concerns were also noted to include "Regulation," "Longevity of Plan Participants" and "Fiduciary Pressure."

Click to download the 69-page study, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Susan Mangiero. Given the large file size, readers are encouraged to (a) first save the file (right mouse click) and then (b) open the file from wherever you have saved the file. Otherwise, you may receive an error message, depending on your computer configuration. 

The study is also available by visiting Send an email to if you experience any difficulty in downloading the pdf file and/or want to comment about the study.

Low-touch regulation, not black letter rules

I had the pleasure of speaking twice at the annual SIBOS conference last week in Austria. (The 2007 event was in Boston. The 2009 forum will be held in Hong Kong.) The first panel could not have been more timely, given the current regulatory frenzy underway. Sure to cause a stir on any day, you can imagine the lively banter as market prices tumbled. Here is a summary of what ensued. This article was first published in Sibos Issues, SWIFT's daily newspaper devoted to reporting the Sibos conference sessions. You can view more articles and download each issue from SWIFT's website.

                           Regulation that fails to keep up could damage the funds market

Panelists at Wednesday's session on whether regulation helps or hinders the investment funds industry claimed to see no threat from regulation as such but plenty from sledgehammer regulation that failed to keep up with the market.

"We work in an industry that prefers light-touch regulation to black-letter rules," said moderator Bob Currie, editor of FSR. "It has good reason to." Overall, the question for panelists was not whether but how much and what kind. "Regulation creates trust and makes the system work. It's a fiduciary business with a risk asymmetry between investor and provider," EFAMA chairman Mattias Bauer pointed out. "But regulators need to ensure they create a level playing field between products, with no regulatory arbitrage."

In the UK, that's precisely what regulators had failed to do, claimed EU Consumer Representative Mick McAteer. By treating insurance products and mutual funds differently, he said, UK regulators had "failed to improve market conditions, increase confidence in the market, or create a level playing field for consumers."

A.P. Kurian, chairman of the Association of Mutual Funds of India, took a contrarian position, urging "regulatory activism" as an approach and posing as a metric for existing regulations, "whether it had survived the test of a crisis." He claimed "strict regulation and strict compliance" had helped the funds industry in his native India minimize the impact of current economic volatility.

In contrast, Pension Governance CEO Susan Mangiero warned that over-regulation counterproductively increased risk because it impeded the transfer of information between buyers and sellers. "When you have excess regulation, it becomes difficult to reward good people and penalize bad ones because everyone's concerned with compliance rather than best practice in risk management. The result is that they have no incentive to do what they should be doing," she said.

A compromise came from Jack Gaine of the Management Funds Association, who cited what he described as a "compact" between regulators and the US hedge fund industry whereby hedge funds exclusively target institutions and high net worth clients in return for a waiver on short-selling restrictions.

In any case, Mangiero suggested finally, the debate was most likely academic. "I advocate a free market approach but what I expect is more regulation," she said.

                                                                            * * * * * *

Editor's Note: While I realize that espousing capitalism during a horribly tough economic environment is inviting verbal tomatoes, it is critical to acknowledge both sides of the argument. Check out the video entitled "The Resurgence of Big Government" by Yaron Brook, September 18, 2008. Dr. Brook is the President of the Ayn Rand Institute and a former finance professor.

Risk Management Adventures

Thanks to financial planner David Boczar for sending along a thought-provoking quote from famed commodities trader Ed Seykota. Described as someone who turned $5,000 into $15 million over a dozen years, this uber trend follower Seykota cautions: "Surrender to the reality that volatility exists, or volatility will introduce you to the reality that surrender exists."

As I've written many times, risk management is not the same thing as risk minimization. Risk is neither inherently "good" or "bad" but rather a reality, with potentially crushing economic impact if ignored or given short shrift. As we've seen in recent days, some attempts to tame the risk lion have resulted in serious casualties.

It is no surprise then that pundits and reporters are asking about the whereabouts of risk managers, part of the frenzied blame game afoot. (Is there a "Where's Waldo" equivalent here?) New York Times blogger Saul Hansell pressed a lot of hot buttons with his September 18, 2008 post entitled "How Wall Street Lied to Its Competitors." My response, now one of more than 100 posted responses, is shown below.

<< I concur with much of this article. Effective risk management is much more than quantitative analysis. Many individuals are lulled into false security when given a bunch of computer printouts, accepting numbers as gospel truth. Like the fictional Detective Columbo, decision-makers must search for “hidden” information, not reflected in computer printouts. I recently testified before the ERISA Advisory Council about “hard to value” assets. Click here to read my comments.

P.S. Some of the quants sat on boards of financial institutions. It would be helpful to know more about their role as relates to oversight of risk management activities. >>

To my last point (above), it should be noted that litigation risk could be a deterrent for prospective directors with risk management experience. For example, Ms. Leslie Rahl (who is quoted in Hansell's blog post about the perils of underestimating risk of complex mortgage backed-securities) is, according to the Financial Post, named in a lawsuit filed against Canadian Imperial Bank of Commerce (CIBC), along with others such as the former Chief Risk Officer and the current Chief Risk Officer. Journalist Jim Middlemiss quotes the bank as denying allegations and expressing confidence that their conduct was appropriate. (See "CIBC hit by suit over subprime lending," July 24, 2008.) Additionally Rahl, a former Citibank derivatives division head, is listed on the Fannie Mae website as a "Fannie Mae director since February 2004."

For interested readers who want to follow the mounting litigation related to sub-prime activities, check out attorney Kevin LaCroix's blog entitled The D&O Diary. Be forewarned that Kevin posts volumes about Director and Officer (D&O) liability. Should we be disturbed that he has so much news about which to write?

What does this mean for institutional shareholders? Run, don't walk, to the closest risk management analysts who can help you decipher whether a company is doing a "good" job of identifying, measuring and managing a panoply of financial and operational pain points. Send us an email if you want some help.

On the topic of models, my article entitled "Asset Valuation: Not a Trivial Pursuit" (FSA Times, The Institute of Internal Auditors, 2004) still rings true. Check out the 10 prescriptives discussed therein. (This is by no means an exhaustive list.)

  1. Gain an intuitive understanding of the model.
  2. Ask questions of the model builders.
  3. Determine whether or not a model meets regulatory requirements.
  4. Inquire whether or not different models are being used for tax reporting versus financial statement presentation.
  5. Understand the data issues.
  6. Ask about model access.
  7. Evaluate the asset portfolio mix.
  8. Ascertain the extent to which a model incorporates embedded derivatives.
  9. Determine the simulation approach used to value path-dependent securities.
  10. Enlist senior management to assign someone from the finance team to work closely with the auditing team.

Testimony of Dr. Susan Mangiero About "Hard to Value" Assets


At the invitation of the ERISA Advisory Council, I presented testimony about "Hard to Value Assets" on September 11, 2008 in Washington, D.C. Some of the questions I was asked to answer are listed below:

  • Should valuation issues play a role in the selection of plan investments, and in achieving proper asset allocation and diversification?
  • What, if any, modifications to plan investment policies and guidelines should plans consider when utilizing "hard to value assets?"
  • As fiduciaries, what do you deem to be or what do you expect to be "hard to value assets?"
  • Who can the fiduciary rely upon when ascertaining the value of "hard to value assets" when the fiduciary is incapable of valuing, in order to fulfill their fiduciary responsibility to plan participants?
  • What valuation policies and procedures should a fiduciary adopt when holding "hard to value" assets?
  • What disclosures and education measures are required or suggested for participants and fiduciaries with respect to plans which invest in "hard to value" assets?

Given the recent tumult in the global financial markets, it seems as if an eternity has passed since the September 11 hearing date. Valuation continues to be a hugely important topic. I hope that my comments are informative and helpful to readers. Let me know what you think. Click here to read "Testimonial Remarks Presented by Dr. Susan Mangiero." 

Hedge Fund Valuation Survey

Business Valuation Resources and Pension Governance, LLC just completed a joint survey on business valuation firms that currently provide valuation services to hedge fund clients. It appears that relatively few hedge funds are reaching out to the business valuation profession, despite regulatory and legal pressures to improve valuation practices. Some highlights are summarized below:

  • Of the few survey respondents who currently provide services to hedge funds, appraisers say that 55% of their clients have a formal valuation process in place.
  • Appraisers who took the survey say that almost half of their hedge fund clients generate valuation numbers internally. A quarter of their clients rely on third party administrators. Relatively few used certified business appraisers.
  • Many reasons were given by appraisers as to why hedge funds procure a valuation. These include, but are not limited to: auditing (33% of respondents), asset allocation (27%) and performance reporting (24%), redemption (18%) and risk management (18%).
  • Eight out of 10 appraisers with hedge fund clients say they’ve never been called in to assist their hedge fund clients with the development of a valuation policy.
  • When asked about standards (guidelines), 48% of survey respondents claim their clients cite fair value accounting rules, 23% of respondents say their hedge fund clients use no standards and 23% of survey-takers cite the Private Equity Industry Group Guidelines (PEIGG) as a guide for their hedge fund clients.
  • For those survey respondents who choose not to pursue hedge fund valuation work, appraiser liability is cited as the primary deterrent (77% of respondents), followed by 54% of survey-takers who say they are unfamiliar with the hedge fund industry.

Editor's Note: Thirty-nine persons answered the survey. Additional research is underway.

Regulators Tell Pensions to Independently Value Positions

According to reporter Doug Halonen, Beantown regulators have launched an inquiry into how corporate plan sponsors value their alternative fund investments. Upset with plans that have no process in place to verify mark-to-model or mark-to-market numbers from general partners, the head of the U.S. Department of Labor, Boston office, offers a warning. "It is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan." An absence of good process could be a violation of ERISA (Employee Retirement Income Security Act). The July 1, 2008 letter references parts of this federal law such as sections 402(a)(1), 103(b, 3(26), 404(a)(1)(B), 502(1) and 504(a). Invitation to scrutiny by the Internal Revenue Service might likewise occur if identical book values and market values show up on Form 5500s. (We've already seen this occur and puzzle over why plan sponsors think this is an appropriate way to disclose positions in alternative investments.)

Click to read "DOL targets plan valuation of alts" by Doug Halonen, Pensions & Investments, August 8, 2008.

This admonition is hardly news to this blogger. I've long been advocating (a) the use of an independent third party pricing professional and (b) the need for fiduciary training in this area. (Note: Email Pension Governance, LLC if you want to learn more about our pension risk management and valuation training programs and/or our abilities to assist plans with risk management/valuation process creation and review).

Several things come to mind.

  • How many pension fiduciaries feel comfortable doing a second check on the valuation of complex financial instruments, especially those that seldom trade? (As an Accredited Valuation Analyst, I can say firsthand that certification requires hours of specialized training  and case work.)
  •  If an alternative fund manager (hedge fund, private equity, commodities, real estate, etc) refuses to provide full transparency about its holdings, won't plan sponsors find themselves in the uncomfortable position of being unable to properly vet values?
  • How will pension consulting firms respond, especially if their teams do not include valuation savvy experts?
  • Will ERISA plan fiduciaries remain vulnerable to allegations of breach if they employ outside service providers such as consultants, appraisers and so on and do not conduct their own review?
  • If a plan sponsor conducts its own review, might they still be liable if they fail to do so regularly?
  • For positions that infrequently trade, how often should such a review take place?
  • Will valuation mandates (and the possible dire consequences of not having a "good" valuation process in place) discourage pensions from investing in alternatives?

Check out some of this blog's many posts about valuation, authored by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM.

Send an email if you would like articles about valuation issues.

SEC Issues Compliance Alert About Sloppy Valuation Process

Hat tip to fellow blogger gal Wendy Fried for news about the recent release of an important ComplianceAlert, issued by the U.S. Securities and Exchange Commission. Click to read "Sloppy subprime valuations on Wall Street?..." (, July 25, 2008)

According to the SEC website, a ComplianceAlert letter highlights results of examiners' audits in an attempt to "encourage" institutions to better their current compliance and supervisory efforts. In its July 2008 letter that starts "Dear Chief Compliance Officer," the SEC staff provides a laundry list of concerns, including, but not limited to:

  • Inadequate monitoring of personal trading by advisory staff
  • Weak oversight of mutual fund boards to "confirm that the proxy service providers' recommendations were consistent with funds' policies and procedures"
  • Stale valuations of high yield municipal bond fund holdings
  • Poor or no disclosure of the increased valuation and liquidity risk when "the percentage of illiquid securities held by a fund dramatically increased"
  • Questionable quality of price verifications of collateral held by certain broker-dealers
  • Inexperienced staff who were nevertheless tasked to validate model prices
  • Lack of documentation as to valuation standards relied upon by some broker-dealers.

The letter concludes with a variety of recommendations, including but not limited to:

  • Improvement of price verification and assessment of "modeled inputs and the calibration of valuations against trades or trade information inferred from activity in similar securities and or the derivative markets"
  • Retention of records "used in determining value"
  • Getting independent product control groups involved in "monitoring collateral valuations"
  • Creating and maintaining a database that "serves as the internal repository for security position information, including periodic valuations, in order to ensure consistency amongst various inventory trading accounts and collateral valuations."

I hate to say "we told you so" but this blog has been on a tear about proper valuation process for a long time. Check out a few of our many past posts. 

With FAS 157 and international equivalent accounting rules forcing change, pension fiduciaries need to take a hard look at their external service providers' trading controls and valuation policies and procedures, if not already. Check with legal counsel but likely they will remind plan sponsors that delegation does not absolve one of the fiduciary duty to properly select and oversee vendors.

What is your biggest concern about how "hard to value" instruments are currently being assessed by banks and broker-dealers? Send us an email with your opinions.

Dr. Susan Mangiero Will Give Hedge Fund Conference Keynote

Join me at the 6th Hedge Fund Accounting & Administration Forum 2008 on July 22, 2008 at the Harvard Club. I will be giving the second day keynote presentation entitled "Hedge Fund Risk Management and Valuation - No Time for Shrinking Violets."

More about this presentation is excerpted below.

"Explore key questions and challenges facing hedge fund professionals in these turbulent times. Join appraiser and risk manager, Susan Mangiero, for a topical discussion about the fast changing operating environment for buyers and sellers alike. Always important topics, portfolio valuation and operational controls are front and center as fund managers, and their service
providers, deal with new rules and regulations and the continuing fallout of credit-related problems. Dr. Mangiero will share her insights about:

  • Regulatory enforcement hot buttons
  •  Valuation and risk management litigation trends
  • Best practices for evaluating key risks and managing exposure
  • Institutional investor impact as pensions/endowments/foundations allocate more money to alternatives.

To learn more about this FRA, LLC sponsored two-day conference (July 21-22, 2008), download the flyer.

UK Pension Fund Goes Green

According to Institutional Investor ("Buying into Green Investing" by Henry Teitelbaum, June 2008), green is good for at least one large UK pension fund, the Universities Superannuation Scheme Limited ("USS"). Joined by three other organizations (Alliance Trust PLC, SNS REAAL N.V. and Mitsui & Co Ltd), this trustee company with 30+ billion GBP in assets is part of a 56 million GBP financing round for the Climate Change Capital Group, a London investment bank "dedicated to the low carbon economy." Teitelbaum adds that the USS is already sold on the commercial viability of environmentalism, demonstrated by its membership in the Enhanced Analytics Initiative. According to research done by this blogger, the USS is credited with taking "ethical, social and environmental considerations" into account when "assessing the merits of investment in a given company" as early as 2001. (See "Pension funds can get more from 'green investing' - SRI expert" by Nat Mankelow, bfinance, May 12, 2001.)

While few dispute the merits of considering a Socially Responsible Investing ("SRI") component for portfolio diversification purposes, it would be helpful to know how USS determines its strategic commitment to SRI economic interests as a separate asset class. Moreover, how does this pension giant consider "green" or "vice" factors before taking direct equity stakes in oil or tobacco companies? Top 100 USS equity holdings, as of March 31, 2008, include Royal Dutch Shell (position 1 with an estimated market value of 705.8 million GBP), BP (position 3 with an estimated market value of 625.2 million GBP) and British American Tobacco (position 14 with an estimated market value of 194 million GBP). This blogger is not maing a value judgment about investing in the stocks of these or other companies but rather simply thinking out loud about diversification analysis as it relates to SRI exposures.

Valuation is yet another consideration. As pension plans invest in environmental companies, how do (should) they properly determine the probability (and amounts) of revenue realization for start-ups and/or firms that depend on relatively new technologies to generate income? In the absence of accounting rules (across countries) or new regulations that mandate periodic assessments of value, the challenge is significant. Add the time pressures of compliance and these already important questions demand good answers.

Editor's Note: According to the EAI website, membership is "open to institutional investors and asset managers who commit to allocate individually at least 5% of their brokerage commissions to extra-financial research" or said, another way, the assessment of externalities on long-term investment performance. Most members are non-US organizations. The New York City Employees' Retirement System ("NYCERS") is a member.)

Hedge Fund Liquidity - Maybe...

According to "Hedge Funds Gird for Withdrawals As Redemption Requests Roll In, Principals Scramble to Soothe Anxieties" (June 12, 2008), Wall Street Journal reporter Jenny Strasburg describes June 30 as a date to watch. Anticipating a flurry of requests, she writes that hedge funds are bracing for a slew of redemption requests, reaching unprecedented levels. Unfortunately for investors, requests to withdraw partially or fully from a fund may not necessarily equate to cash in hand.

As reporter Grace Wong wrote last summer ("Hedge-fund redemption shock
Investors looking to cash out this fall may be met with an unpleasant surprise
"), a liquidity event may be wishful thinking in some situations. For one thing, myriad hedge funds have long "lock-up" periods during which no withdrawals are permitted. Second, some require that advance notice of 45 to 90 days be given. When markets are volatile, even a day may seem like an eternity. Third, hedge funds may slow withdrawals or ignore them altogether, urging investors to be patient. In certain cases, the goal is to forestall a collapse that could occur if a manager has too little cash on hand. Fourth, even when redemptions are permitted, they don't always take the form of cash.

For pension funds, problems with redemptions might potentially cascade, wreaking serious havoc in other areas. For example, suppose a plan sponsor has combined an interest rate swap with an investment in a hedge fund (perhaps as part of a Liability-Driven Investing strategy). If the portable alpha generator falls short and the retirement plan wants out, the all-in performance likely suffers, for everyone. What then?

  • Does the plan sponsor move away from LDI?
  • Does the plan sponsor lick its wounds with the first hedge fund and find a substitute?
  • How does the plan sponsor take transaction costs into account?
  • Do fiduciaries switch to a different, more redemption-friendly asset allocation mix?

Other questions abound. If a hedge fund cannot easily redeem shares because its portfolio consists of "hard to value" assets, do pension investors make matters worse by pulling out? What are the fiduciary implications related to liquidity risk? (Hint: Fiduciaries don't get a free pass. Most legal experts will confirm that decision-makers MUST ask hedge fund managers lots of questions about the redemption process and worst case liquidity scenarios.)

Liquidity risk is real. To pretend otherwise, makes no sense. The ability to unwind a stake in a hedge fund is very much a function of negotiating favorable terms at the outset. Equally important, fiduciaries are urged to pay attention to hedge fund liquidity risk drivers along the way. What you see on paper may not be what you get later on.  

Dr. Susan Mangiero Speaks About Hedge Fund Valuation

Dr. Susan Mangiero, AIFA, Accredited Valuation Analyst, CFA and FRM addresses an audience of valuation practitioners on June 10, 2008 as part of the 15th annual conference sponsored by the National Association of Certified Valuation Analysts.

Part of its 15th annual conference, this mini workshop is a unique offering that combines information about hedge fund industry structure with core valuation concepts. The course will examine the overall structure of a hedge fund, including standard partnership terms, revenue structure, liquidity restrictions, and impact of hedge fund strategy on the value of hedge fund business itself. Special issues such as side pockets and high water marks will be discussed, along with a description of regulatory and accounting initiatives with respect to hedge fund valuation.

Editor's Note: A later posts will cover changes in regulations that directly impact the valuation process, including appraisal penalties now part of the Pension Protection Act of 2006.

Can You Spell "Bad Valuation Practices?"

Kudos to Sameer Mishra for winning the Scripps National Spelling Bee 2008 after a momentary setback. Initially confusing numnut ("one of little intelligence or thought") with numnah ("a pad that goes under the saddle to keep the saddle clean and to cushion the horse's or pony's back"), this smart 13-year old recovered with aplomb. Click to view his funny response.

Proper spelling remains a passion of mine. I won a dictionary in a national writing contest while in high school, passed AP English with flair and continue to find delight in the written and spoken word. By the way, for those who rely on your computer's spell check function, take note of Janet Minor's homage lesson in poetry. "Bad spellers, untie."

"I have a spelling checker
It came with my PC;
It plainly marks four my revue
Mistakes I cannot sea.
I've run this poem threw it,
I'm sure your pleased too no,
Its letter perfect in it's weigh,
My checker tolled me sew."

Making innocent mistakes occurs. Hey, we're all human. What about errors of judgement when one should allegedly know better? According to New York Times reporter Gretchen Morgenson ("First Comes the Swap. Then It's the Knives," June 1, 2008), UBS and Paramax Capital are duking it out in court over credit default swaps, now a $62 trillion market (based on statistics provided by the International Swaps and Derivatives Association). At the heart of UBS AG v. Paramax Capital Intl., No. 07604233 (NY Supreme Court, NY County, filed Dec. 26, 2007) is whether this large Swiss bank had the right to demand additional collateral from a Fairfield County, Connecticut hedge fund as market conditions moved.

According to Morgenson, "UBS would pay Paramax 0.155 percent of the $1.31 billion in notes annually for its insurance and Paramax would deposit collateral to back the swap, increasing it if the value of the underlying notes declined." What's astonishing is not that the value of the notes declined (credit crisis anyone?) but that the hedge fund (with "just $200 million in capital") found itself facing a shortfall far in excess of the original $4.6 million it used to capitalize the swap. 

Our team is trying to get the complaint filed by UBS and the counterclaim filed by Paramax so we can verify who supposedly said what. One assertion (according to the June 1 New York Times article) has a bank executive citing a policy of setting "its marks on the basis of 'subjective' evaluations that permitted it to keep market fluctuations from impacting its marks." Does this mean that positions were artificially valued, regardless of changes in risk drivers? If true, such a policy would be mind boggling at best.

In researching this case, I came across a January 23, 2004 press release in which Paramax Capital Group (presumably the same entity as cited in the lawsuit) announces the launch of a "new multi-seller asset-backed commercial paper program." Part of an effort to satisfy a "need and demand for thirdy party conduits in this new structured finance paradigm," the then Chief Investment Officer for Paramax adds "we think we can provide a high value service and funding to our institutional client base as a complement to their structured finance and funding efforts." One wonders if institutional investors (assuming there were some), allocating monies to Paramax, asked any or all of the following questions:

  • How did the hedge fund represent its process of valuing complex instruments?
  • Did either the bank or hedge fund employ an independent third party pricing service?
  • Did the hedge fund have an appropriate capital risk budget in place?
  • How did the bank measure its credit exposure to the hedge fund and to the swap class?
  • Who established internal controls (at the hedge fund and bank) to avoid undue leverage?
  • How did the hedge fund (bank) measure leverage?
  • How did the hedge fund (bank) monitor collateral exposure?

Ultimately, only the trier of fact can and will determine fault (if any) and related damages. "Numnut" was the wrong word for our young spelling champion but it may end up being an apt description for someone, in what sounds like an ugly mess.

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 and the family of related websites. It's well worth your time. 

Money House of Cards or Disciplined Approach?

Courtesy of fellow blogger and technology entrepreneur, I am reprinting "Valuation is the Heart of the Matter" by Peter Schwartz  (founder and president of Knowledge Mosaic).

<< Business and financial regulation in the United States builds upon two worthy traditions - self-regulation and self-disclosure. By design, these traditions preempt and represent lightweight alternatives to more heavy-handed and prescriptive direct regulation by government agencies. When the SEC deputizes private organizations such as the NYSE to police its members, it is adhering to the time-honored tradition of deputizing private citizens to maintain public order. When the SEC requires electronic disclosure, it respects the dependence upon, and responsiveness of, financial markets to the flow of information - to the idea that, indeed, markets are little more than the flow of information.

However, when industries themselves call for more self-regulation and more self-disclosure, it is always an act of desperation, not merely because they want to avoid direct government oversight, but because they are acknowledging that they can no longer survive without some measure of public accountability and public trust. They are acknowledging that the open markets to which they pay fealty now threaten to consume them.

In that spirit of desperation, today we are privileged to experience the much-anticipated release to the President's Working Group on Financial Markets of two private sector reports on hedge fund best practices - one from the hedge fund industry and one from institutional hedge fund investors (primarily pension funds, endowments, and foundations). These reports represent responses to the meltdown in the financial services industry that has led to the evaporation of more than $245 billion in asset write-downs and credit losses since the beginning of 2007, and to market instability that the hedge fund industry no longer trusts it can manage.

What strikes me in reading these reports, and observing the conversation about the recent financial crisis from a distance, is the centrality of the problem of valuation. Both reports combine reference to valuation with other key aspects of hedge fund management and investment - disclosure, risk management, taxation, accounting, liquidity, trading, and compliance. But there is a palpable sense that the other practices and conditions are secondary - that all would be well if we only knew how to value structured securities and derivatives.

The bottom line is that we don't. The credit rating agencies don't. The banks don't. The hedge funds don't. Institutional investors don't. And in the absence of robust valuation data, methods, and models, there is no floor to the risk that financial institutions face when they toy with structured securities and derivatives.

Both reports carve out special sections for the discussion of valuation challenges. The institutional hedge fund investors' report - which starts by affirming that "valuation is ultimately at the core of any investment" - is more discursive on this subject than the hedge fund industry report. This may be indicative of general differences in stylistic approaches to the subject matter. Or it may suggest an entirely different perspective on the depth of the issue, with anxiety about valuation reflecting investor concerns more than the concerns of asset managers.

While both reports focus on the need for better valuation methods, valuation policies, valuation committees, and valuation governance, neither really grapples with the core reality - which is that huge dollar volumes of assets simply cannot be valued. There is insufficient liquidity and inadequate data, and in their absence, values depend upon someone simply assigning a value that has no relation to anything except the interest in making a market out of vapor. Until the hedge fund industry, and government regulators and policymakers, acknowledge this deep emptiness at the heart of the financial industry, all the reports in the world will amount to nothing more than a rearrangement of the deck chairs on the Titanic. >>

Hedge Fund Investing: Change is Good, You Go First

Thanks to Scott Adams and his popular Dilbert for continued wisdom in the work place.  I own a few Dilbert tee shirts, including one that says it all - "Change is Good, You Go First." It's rather apt when you consider the flurry of news about hedge fund investing by pension funds. As we reported on February 29, the U.S. GAO study takes a serious look at billions of dollars flowing into hedge fund coffers. (See "Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed.)" In the UK, the Hedge Fund Working Group published "Hedge Fund Standards: Final Report" in January 2008. With over 130 pages of suggested guidelines about risk management, valuation and investment policy, it reminds institutions, consultants and managers that due diligence is a weighty endeavor.

A read of these and other attempts to shed light on the growing hedge fund industry begs several central questions, ones that arose many times during the February 28 master class I led on hedge fund risk management and valuation.

  • Who is responsible for writing the checks to hire an independent third party who can review valuation policies and procedures - the investor or the fund manager or both?
  • Should a pension/endowment/foundation hire a consultant or fund of funds manager or both?
  • What if neither the consultant or fund of funds manager is willing to vet mark to model numbers for complex securities? (As we've discussed before, more than a few organizations are declining to review valuation numbers and instead accepting marks from traders who are seldom impartial since their compensation is tied to reported performance.)
  • Who properly bears the liability of poor decision-making with respect to hedge fund risk management and valuation? In "Illiquid Assets Expose Fund Directors to Legal Risk," Hedgeworld reporter Bill McIntosh cites Baronsmead Insurance Brokers as saying that fund directors "may be taking on personal liability for the fair valuation of highly illiquid assets." What about pension fiduciaries who delegate oversight? What is the extent to which they are liable?

If Dilbert is correct, change is impossible unless someone makes the first move. With respect to hedge fund investing, identifying who pays for what and when is a big deal.

Hedge Fund Valuation Goes Global

Just as US banks and hedge funds are coming to grips with a maze of pricing rules in the form of FAS 157, other countries are joining the fray. It's no surprise that institutional investors and their regulators favor more disclosure and evidence of tighter policies and procedures (if they don't already exist at a particular firm). Private and government plan sponsors from around the world will be convening in Sydney next week to discuss alternatives, strategic asset allocation, valuation, global regulation and pension risk management techniques.

This blog's author looks forward to participating in the Asset Allocation Summit. (Pension Governance, LLC is a conference media sponsor.) I will be leading the master class entitled "Global best practices in hedge fund valuation and risk management" and another workshop on 130/30 strategies. Click here to learn more. If you need to find a speaker or want to provide investment risk/valuation training for your team, we'd love to hear from you. Drop us a line.

Until then, look for news from Down Under this coming week!

AIG Auditors 1, Traders 0 - Round 1

February 11 was a bit of an equity rollercoaster. Reports of another big price gap were to blame. According to Reuters, PricewaterhouseCoopers LLP, external auditors for AIG, "concluded that the company had a material weakness in its internal control over financial reporting relating to the fair valuation of credit default swap portfolio obligations of AIG Financial Products Corp." Those in the know estimate the unrealized valuation loss relating to credit default swaps as being close to $5 billion, much bigger than originally believed. The stock closed down 12 percent lower. (Click to read "AIG discloses hole in derivatives valuation" by Lilla Zuill.)

Several questions come to mind, not the least of which is whether internal auditors came to the same conclusion at the same time and by the same route. How did the outside auditors decide on the adjustment? What models did they use? (AIG's Form 8-K, filed with the SEC as of February 11, 2008, mentions the Binomial Expansion Technique and Monte Carlo Simulation.) How often did auditors and traders kick the proverbial tires? On the business development front, how will this news impact organizations on the other side of AIG trades? Will they ask for more collateral? Will trade size fall to reflect a reappraisal of default risk?

To be sure, AIG is not the only name in the headlines. Irrespective of any particular company, and as we've mentioned many times before, pension funds are duly exposed when they transact derivatives, buy financial company stock or bonds or allocate money to multi-purpose behemoths. Now is not the time to be shy about asking tough questions as regards risk management and valuation policies and procedures of firms such as AIG. This holds true even when a consultant is engaged. Legal experts remind. Fiduciary oversight remains.

Awhile ago, this blogger authored "Asset Valuation: Not a Trivial Pursuit" for the Institute of Internal Auditors. Topics discussed include model risk, model validation and the internal auditor's role. Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments." Yes Virginia, there is lots of litigation as a result of markdowns, disclosure questions and risk management process (or lack thereof). 

On March 5, 2008 (in case you missed our earlier announcement), Pension Governance, LLC is proud to sponsor a webinar entitled "Fiduciary Risk, Trading Controls and External Asset Manager Selection." Persons who attend this 75-minute webinar will learn the following:

  • What Constitutes "Must Have" Elements of Effective Risk Management Systems
  • Ways to Detect Deviation from Management Style and/or Excess Position Concentration
  • Red Flags Regarding Possible Rogue Trading
  • Industry Best Practices for Trading Controls and Lessons Learned About What to Avoid.

We hope to have you join us!

Investing in Hedge Funds? Check Out Valuation Process

Featured in the January 2008 issue of Emerging Manager Focus ("People to Know"), this blog's author reiterates the need for investors to verify how a hedge fund marks its positions to market (or model). An excerpt is provided below. To read more, download the pdf file by clicking here.

"Mangiero admonishes institutional investors to steer clear of any fund that provides their own marks for infrequently traded instruments. “Traders are encouraged to inflate asset values if their bonus emphasizes return and ignores the risk side of the equation. Those responsible for due diligence cannot look the other way. Independent third party providers must be involved in the valuation process. Surprisingly, this message is only beginning to resonate because it’s not always clear who is doing what. A pension fund may hire a consultant or fund of funds manager, thinking that they are investigating how numbers for ‘hard to value’ assets are determined, only to discover that neither they nor the administrator, custodian or prime broker do anything more than accept inputs from the traders.” Other elements of good valuation process are addressed in her newly developed course on hedge fund valuation for the National Association of Certified Valuation Analysts, including an overview of the part of the Pension Protection Act of 2006 that addresses valuation."

Private Equity Returns Appeal to Pensions

According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

Private Equity Valuation - Discount Dilemmas


                             Commentary by Doug Miles, CEO of, Inc.

For the first 15 years of my investment banking career, the typical rule of thumb for pricing private equity assets was to apply a 25 percent discount to a publicly traded comparable company or adjust the relevant industry multiple. New accounting rules such as FAS 157 make it difficult to take this easy way out.

An analyst is sometimes hard pressed to find data about public offerings that closely mirror the economic characteristics of a particular private equity investment. When that occurs, news announcements that convey buying interest can be helpful. Recent headlines about CALPERS' purchase of a 9.9 percent stake in technology buyout fund Silver Lake Partners illustrate. No longer sitting on the sidelines, CALPERS has a chance to recover 10 percent (or more) of its net cost in allocating to non-public companies by participating in deal-related income such as acquisition loans originated by Silver Lake.

Playing the role of private equity banker is not new. Ontario Teachers illustrates this "soup to nuts" with its furnishing of both debt and equity for Bell Canada. (See "Bell Canada Agrees to Purchase by Ontario Teachers - July 2, 2007.) General partners save on fees they pay. Moreover, they have flexibility to take a company public again or sell to a strategic buyer for many times the original commitment. Being an operator additionally empowers the "new paradigm" owner on the governance front. Did the Bell Canada deal improve the IRR for Ontario's plan participants? You bet.

Capital market players benefit too since such deals arguably enhance liquidity and promote valuation transparency. Given the brave new world of valuation compliance (FAS 157 and international equivalents), anything that gets us closer to marketability is a good thing. Anecdotally, we see an emerging consensus among our private investor clients to access better numbers. Applying arbitrary discounts is ill-advised. Being open to better process may explain why we've seen recent private company discounts narrow to 6.5 to 7 percent, relative to public comparables, for some sectors. In our own work (creating synthetic data prices for "hard to value" instruments such as whole loans), we employ an algorithm that estimates the private-public company differential by examining factors such as the rate of completed private company asset buyouts, how they are financed and the change in IPO values over the last twelve months.

Discounts vary over time. The current environment  (i.e. depressed high yield bond prices and fewer M&A transactions) could lead to the widening of lack of marketability discounts, particularly in those industries hard hit by credit problems. Monitoring performance by industry or sector, and for a variety of cycles and calendar time periods, is paramount. Global consolidation when steel or aluminum production sectors are hot (e.g. RUSAL) reduces the liquidity premium attached to public companies as increased deal flow sheds light on when and where buyers are willing to sign checks. Will this be true next year? Only time will tell. That is why it is so important to track the changing behavior of valuation adjustments.

With a need to enhance returns, alternatives like private equity will continue to attract retirement plan money. Look for more announcements as other pension funds follow the lead of CALPERS and Ontario Teachers. Hedge funds may even seek to organize groups of pension funds to execute large M&A deals, thereby adding to their treasure chest.

Editor's Note: As pension plans become even bigger players in global capital markets, it will be interesting to watch the inevitable fiduciary schizophrenia unfold. How will pension general partners deal with doing the right thing for limited partners when doing so conflicts with their duties to plan participants?

4P's - Pensions, Private Equity, Performance and Placement

As 2008 rolls in, uncertainty is on the minds of many. Will there be a recession? Will market volatility persist? Will asset prices continue to converge, making it more difficult to diversify? One question in particular is oft-discussed, notably the issue of strategic asset allocation for defined benefit plans. In a December 17, 2007 news release, the California Public Employees’ Retirement System Board of Administration announced its intent to invest nearly 70 percent of its $250 billion under management to stocks. Private equity will account for 10 percent, up from 6 percent. According to Charles P. Valdes, Investment Committee Chair, “These revised allocation markers reflect the promise of our private equity, real estate, and asset-linked investment classes."

In stark contrast, the Pension Benefit Guaranty Corporation went in the opposite direction a few years ago, now bearing the burden of a positive equity risk premium. In a December 20, 2007 article entitled "The $4 billion trade-off: PBGC misses out by eschewing stocks in favor of LDI," Financial Week reporter Doug Halonen points out the perils of allocating a high percentage of assets to fixed income. He rightly points out "the irony" that numerous companies are seriously investigating the economics of adopting a liability-driven investing strategy which almost always entails a shift away from stocks to bonds and/or interest rate derivatives.

Importantly, the decision to invest in alternatives, including private equity, must reflect a careful analysis of the likely risk-return tradeoff, mapped to the objectives and constraints of a particular pension plan. A short-term focus could create upset for those exposed to holdings that more logically lend themselves to a long-term commitment. In today's "Wall St. Way: Smart People Seeking Dumb Money," New York Times reporter Eric Dash writes that investors in Ohio Public Employees Retirement System and Fidelity Investors "would have made more money this year investing in an old-fashioned index fund that tracks the S&P 500-stock index" rather than plunking down money for the IPO of "private equity powerhouse" Blackstone Group. Perhaps that's true but does it matter if their respective goals are to realize capital gain over the next five to seven years? (Note that this blog's author has no knowledge of the intent of either investor.)

Allowing for upside potential (and statistics do validate a big move into private equity by pensions, endowments and foundations), lack of liquidity and valuation difficulties are harsh realities. However, barriers are starting to soften. Barry Silbert, CEO of Restricted Stock Partners, operates the Restricted Securities Trading Network, a mechanism for trading insider stock options, convertible bonds and private investments in public equity. A recent venture capital injection is arguably a validation of this attempt to enhance fungibility of otherwise "infrequently traded" instruments. The PORTAL Alliance, brings together the Nasdaq Stock Market and leading securities firms to "create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs")." If successful in allowing for ready buys and sells, institutions may be more open to kicking the private equity tires.

For further reading, these websites (a few of many) may be of interest:

Bank Risk Managers - Missing in Action?

In a recent interview on the John Batchelor show,, Inc. CEO Doug Miles described the current credit crisis as a "black swan" event. This summer, Miles predicted the valuation fallout associated with complex derivative instruments. Adding that banks can't know the extent of their problems anytime soon, an uncertain interest rate environment, new valuation accounting rules such as FAS 157 and infrequent trading in instruments such as Collateralized Debt Obligations make life very uncomfortable. Click here to listen to the November 11, 2007 interview with John Batchelor and Doug Miles.

In his bestselling book, The Black Swan: The Impact of the Highly Improbable, essayist Nassim Nicholas Taleb assigns three attributes to a black swan event in business. "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable." Click here to read the first chapter, as reprinted by the New York Times on April 22, 2007. In his video interview entitled "Learning to Expect the Unexpected," Taleb describes the human brain as "designed to retain, for efficient storage, past information that fits into a compressed narrative." He adds that "this distortion, called the hindsight bias" makes it difficult to learn from past mistakes.

If true that the sub-prime situation is a black swan as Miles asserts, and taking a page from Taleb, we embrace the notion that we are blind to randomness, what then is the proper role of risk management? According to Financial Week reporter Matthew Quinn, inquiring minds are asking "Where were the risk managers?" He avers that some pundits debate whether technology can keep up with product innovation or adequately assess leverage. He suggests that, even if rocket scientists raise their hand, warnings may go unheeded, especially given banks' dependence on proprietary trading. See "Risk managers return (belatedly) to Street: Chastened banks, brokerages get religion on minimizing exposure to hidden bombs. Coulda, woulda, shoulda?" (Financial Week, November 19, 2007). 

In an article I wrote in mid 2003, I commented that the life of a risk manager is challenging to say the least. In addition to a plethora of data analysis skills, a Chief Risk Officer ("CRO") or someone with similar functional duties must be a diplomat, a motivator and a keen student of human behavior. Most people don't want to hear bad news since it usually means more work for them, not to mention the added stress and the potential damage to one's career of being tainted with a problem. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange, July/August 2003).

Unfortunately, for retirement plan decision-makers, risk management is going to be impossible to ignore. Pension funds that include allocations to bank stocks or equity in bank-like financial organizations are already feeling the pinch. Plan sponsors who hired bank asset managers or hedge funds/mutual funds that invested in banks are going to be asked tough questions about the due diligence they performed. Did they sufficiently kick the tires with respect to understanding how the banks managed risk? Fiduciaries of banks' 401(k) plans who recommended company stock are getting sued for allegedly having done too little to assess the attendant risks. Just last week, a complaint was filed against the Federal Home Loan Mortgage Corporation ("Freddie Mac"), citing poor controls that encouraged the acceptance of "risky" loans and inappropriate appraisals of those loans. Click here to read the class action complaint against Freddie Mac.

Black swan or not, the current credit crisis is going to get nastier. Expect many more litigation complaints in the ensuing months.

FAS 157 is Heeeeere!

As of November 15, 2007, those organizations who did not adopt FAS 157 early on will be obliged to disclose much more information about their "hard to value" assets and liabilities. Despite industry's attempts to forestall compliance for another year, the Financial Accounting Standards Board reiterated its intent to force implementation for financial assets and liabilities. Read "FASB Rejects Deferral of Statement 157 for Financial Assets and Liabilities" (November 14, 2007 FASB press release).

For those seeking a user friendly version of this new accounting rule, check out "A FAS 157 Primer" by Mark Gongloff (Wall Street Journal, November 15, 2007). Also check out "A Summary of Statement No. 157" on the FASB website. One important element of FAS 157 is the requirement that items be categorized as belonging to Level 1, 2 or 3 in order of ease of valuation with respect to observable prices (or lack thereof). Predictions abound that FAS 157 will force larger asset write-downs, creating jitters for pensions, endowments and foundations who invest in Level 2 and Level 3 sensitive funds. In a November 15, 2007 CNBC video, economist Nouriel Roubini warns of an impending global recession and a financial meltdown that could roil financial markets for months to come. He is not alone.

In "Why FAS 157 strikes dread into bankers - Just when we hoped the worst was over," William Rees-Mogg (The Times, November 12, 2007) cites research by financial analyst Martin Hutchinson. Financial giants such as Bear Stearns, Lehman  and J.P. Morgan Chase account for more than $100 bilion of FAS 157 Level 3 assets, requiring mark to model information not heretofore provided. The author adds "Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two, and they have an interest in placing as little in level three and as much in level two as they reasonably can." Noteworthy is Hutchinson's analysis that Goldman Sachs has disclosed $72 billion of Level 3 assets. That number is relatively big or small, depending on the point of comparison - a $900 billion asset base but capital of $36 billion.

Lest pension decision-makers think they are immune from valuation issues, nothing could be further from the truth. Decision-makers for both 401(k) and defined benefit plans are squarely on the hook for vetting external money managers. This absolutely includes asking copious questions about managers' valuation policies and procedures. A poor job, or ignoring the issue altogether, is going to keep the plaintiff's bar busy indeed.

Can Banks and Pension Clients be Friends When It Comes to Valuation?

In his November 11, 2007 blog entry, New York Times reporter Floyd Norris describes an interesting tidbit of information, tucked inside the just filed 10-Q by Wachovia Corporation. On page 27, it reads "In the third quarter of 2007, we purchased and placed in our available for sale portfolion $1.1 billion of asset-backed commercial paper from Evergreen money market funds, which we manage. We recorded a $40 million valuation loss on this purchase, which is included in our market disruption-related losses." As Norris explains, while the regulatory filing adds that Wachovia is "not required by contract to purchase these or any other assets from the Evergreen funds" they manage, a loss of that magnitude would "break the buck." When the $1 Net Asset Value typically associated with a money market fund no longer prevails, Wachovia or any other financial institution in a similar position is arguably obliged to stem the financial tide or risk loss of investors or worse. Click here to access the 10Q report.

In today's article entitled "SEI, Rival Money Funds Go on Offense to Avoid 'Breaking the Buck'," Wall Street Journal reporters Diya Gullapalli and Tom Lauricella write that money manager SEI Investments has said "it would provide financial guarantees for some of the funds' holdings of SIVs." CEO Alfred West explains the rationale for voluntarily providing credit support, in the aftermath of a threatened downgrade of SIV Cheyne Finance, LLC paper. Held by several SEI funds, "managed for SEI by Columbia Management, the money-management arm of Bank of America Corp," the funds' rating could likewise be compromised. Click here to listen to the recorded November 12, 2007 presentation to SEI investors. 

A recent IMF presentation, entitled "Regional Economic Outlook - Europe" stresses the importance of improving "risk assessment models, market and liquidity risk management, due diligence, and transparency regarding the loan origination process and counterparty risk exposure."

Color me confused. Haven't many banks held themselves out to be leaders in the area of risk control? What about the fact that banks are highly regulated? Doesn't that contribute to good oversight? What is the role of Basel II, looming right around the corner and meant to reflect robust risk management activities on the part of banks in the U.S. and abroad?

For those banks with pension clients, what is the process in place to vet all recommended money market funds, including their own? Is the process conflict-free? Conversely, are pension funds directly (or through pension consultants) asking sufficient questions about the safety of recommended short-term capital pools?

As the mysteries unfold, don't be surprised what we learn about the importance of good fund selection and risk review process.

Note: Wikipedia defines a structured investment vehicle as "an evergreen credit arbitrage fund, similar to a CDO or Conduit. They are usually from around $1bn to $30bn in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV is formed to make profits from the difference between the short term borrowing rate and long term returns." Click here for more information.

If Fed Helps Banks with Valuations, Is There Independence?

According to a November 8, 2007 Bloomberg report, Federal Reserve Chairman Ben S. Bernanke says `"We are working with the banks, the ones who sponsor these off-balance-sheet instruments, to make sure that they are getting true valuations,'" Click here to read the full story.

A few things come to mind.

1. What form of "help" is offered?

2. How can federal regulators assist with orderly asset write-downs and then still be in a position to independently review the banks' process?

3. Will tough questions be asked about how banks, going forward, will attempt to avoid another sub-prime (or related) debacle? If there is a silver lining, let it be good lessons learned about modeling and risk controls.


Will Auditors Become the Next Dismal Scientists?

Since Thomas Malthus predicted the end of mankind as population growth surged, economists have been known as the dismal scientists. (Click here to check out U.S. and global person counts.)

According to "Auditors set for tough talks with clients" by Jennifer Hughes (Financial Times, November 5, 2007), valuation challenges may force accountants to wear the mantle of "life of the party NOT." Though a current focus is on how clients plan to report valuations at year-end, a la FAS 157, auditors must be concerned about ongoing general lack of good process by some reporting entities.

Clients' failure to thoroughly document, and implement, a (hopefully) robust valuation process puts auditors squarely in the litigation crosshairs if they are seen as doing less than a good job of oversight. Though a few years old, the AICPA published a summary of problem areas based on SEC investigations. Four out of five times, the auditor failed "to gather sufficient audit evidence," with countless cases involving "inadequate evidence in areas such as asset valuation, asset ownership and management representations." Click here to access "Top 10 Audit Deficiencies" by Mark S. Beasley, Joseph V. Carcello and Dana R. Hermanson (Journal of Accountancy, April 2001).

It was not too long ago that the U.S. SEC Division of Enforcement and the Office of the Chief Accountant alleged that a CPA "failed to adequately assess the substantial evidence produced by the audits" that there were material "overstatements of the value of convertible bonds and convertible preferred stock." Click here to read the overview.

In "Auditor liability and caps get a hearing in Washington," Financial Week reporter Nicholas Rummell (October 15, 2007) quotes the co-chair of a newly formed committee, Donald Nicolaisen, former chief accountant at the SEC, as saying that "now is the ideal time to look at auditor liability because there is no crisis." Yet the article states that "audit expenses for the largest accounting firms related to litigation and liability had risen to $1.3 billion in 2004, 14.2% of total revenue. In 1999, related expenses were about 7.7% of revenue." (By the way, life sure has changed in the last few weeks as market volatility seems the norm.)

This blog author's take on things is that there will be some "issues" going forward. The math is simple: Investor Losses = Investigation Into What Went Wrong = Blame. While auditors may not be the only ones asked tough questions about oversight, issues abound.

  • How much rigor should be applied by auditors in assessing the mark-to-market (model) process?
  • How do internal auditors treat a lack of independence for those reporting entities that create their own marks in lieu of hiring an outside third party?
  • How many auditors feel comfortable valuing complex derivative instruments?
  • Is statistical sampling of holdings in a large portfolio of "hard to value" instruments considered sufficient?

Stay tuned...


Pension Fiduciaries - Have You Asked Your Bankers About Their Risk Controls?

In a November 5, 2007 statement, Citi announced that current CEO Charles Prince will step down. Robert E. Rubin will become Chairman of the Board and a search for a new leader will begin immediately. In a related story, Wall Street Journal reporters Carrick Mollenkamp and David Reilly describe Citigroup's struggles to estimate trading losses, in large part due to the fact that internal quantitative models relied heavily on credit ratings assigned to securities that were used in structuring Collateralized Debt Obligations (CDOs). With recent downgrades (to arguably better reflect risk levels), the value of Citi's sub-prime holdings similarly sank. Credit fears dampened already limited trading interest, forcing a heavy reliance on a mark-to-model approach.

As this blog's author has stated many times before, model risk is real. Bad or inappropriately used models lead to imprecise outputs. Decisions based on poor information can only lead to trouble. According to "Why Citi Struggles to Tally Losses Swelling Write-Downs Show Just How Fallible Pricing Models Can Be" (Wall Street Journal, November 5, 2007), modelers projected future expected payments for then high-rated sub-prime backed CDOs on the basis of how similar credit rated corporate bonds were trading. By not recognizing that default experience for corporate versus sub-primed backed securities differed dramatically, Citi's rocket scientists painted too rosy a valuation picture.

In a related article ("Where Did the Buck Stop at Merrill? November 4, 2007), New York Times reporters Graham Bowley and Jenny Anderson describe oversight problems at Merrill Lynch. Following a $8.4 billion charge and the recent resignation of CEO O'Neal, questions have arisen about whether board members should be more aware of daily operations, especially those areas that are likely to present problems if things go awry. Quoting Meredith Whitney, CIBC World Markets financial analyst, the point is made that Merrill had no one with sub-prime experience to serve on any of the committees charged with risk oversight and auditing. Despite creating a post for Chief Risk Officer in early September 2007, other experts cited in the article decry the lack of board/oversight committee independence from senior management, at the same time that large trading books were "hard to value."

By extension, this notion of oversight applies to pension fiduciaries. As this blog's author has repeatedly emphasized, plan sponsors MUST do a thorough job of vetting service providers (including banks) with respect to their "red flag" controls. How many pension fiduciaries ask about the existence of a Chief Risk Officer (or lack thereof)? How much detail do pension fiduciaries demand to know about each bank's risk management function, certainly for key parts of trading operations? Do pension fiduciaries ask to speak to members of the valuation team and/or those responsible for collateral management? Have pension fiduciaries asked banks about their progress with respect to preparing for Basel II and related model requirements? (Click here to read the November 2, 2007 press release from the Federal Reserve Board which describes their approval of new risk-based capital rules.) The list of other "must know" queries is long but nevertheless essential to proper due diligence.

Will clever attorneys make a case for poor process if pension fiduciaries have allocated monies to any or all of the banks now making headlines, citing breach if they failed to dig deep about risk and valuation policies and procedures?

FAS 157 and FAS 159 - Day of Reckoning for Pension Investors?

In case you missed it a few weeks ago, the Financial Accounting Standards Board voted 4-3 in favor of implementing FAS 157 on time. Ignoring early adopters, FAS 157 takes effect as of November 15, 2007. A company reporting at year-end (or any time after mid November) will be obliged to consider FAS 157. Its companion, FAS 159, allows organizations to "choose to measure many financial instruments and certain other items at fair value."

While "employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits)" are excluded from the list of eligible items that can be measured at fair value, plan sponsors are nevertheless impacted by both FAS 157 and FAS 159. 

  • If an employer issues stocks or bonds or transacts in other eligible assets and liabilities, FAS 157 and 159 will apply and could, at the enterprise level, indirectly impact pension plan economics.
  • If a plan invests in a wide variety of stocks and bonds issued by other reporting entities, fiduciaries will need to fully understand the gap between economic risk and the accounting representation.
  • In selecting external money managers, defined benefit and defined contribution plan fiduciaries alike will need to add FAS 157 and FAS 159 questions to their RFPs. Focus on  valuation model selection and testing, choice of inputs and appropriate "level" of three possible categories are a few of the many items to vet.

How FAS 157 relates to existing standards is not known with certainty at this time though FAS 133 accounting for derivative instruments is one affected area. While FAS 133 does not directly apply to a pension plan that trades derivative instruments, as investor, that plan must be savvy enough to access how issuer risk is impacted by new rules.  Consider a hypothetical scenario.

A defined benefit pension plan (Pension Plan Y) hires Bank X as a value-oriented equity portfolio manager. Bank X is a significant user of derivatives and has existing derivative instrument contracts with five different counterparties such a Bank Z, Corporation A and so on. Under FAS 157, Bank X must reflect counterparty risk in assessing fair value. Conceivably, this could result in a FAS 157 fair value for any or all of the five positions held by Bank X that is different enough from the fair value of the "hedged item." The result would be a nullification of favorable hedge accounting treatment for Bank X and reported post FAS 157 earnings that are more volatile. How does Pension Plan Y respond? Do they stop doing work with Bank X because their financial statements make them a higher risk? 

Reporting entities and investors alike are going to have to roll up their shirt sleeves and get to work. It doesn't take a rocket scientist to see the obvious. An incomplete understanding of FAS 157 and 159 lends itself to bad decision-making on the part of plan sponsors. 

Here we go...

Editor's Note: There are many ways to determine FAS 133 hedge effectiveness. If you want copies of selected articles on the topic, click here to send an email. Please include your name and company.) Click here to visit the FASB website to learn more about FAS 157 and 159.

You Say Potato - I Say Potahtoe - Valuation Terms Differ

As plan sponsors ready themselves for new valuation rules, it's critical to understand that "FASB Speak" is not always the same language as that used by traditional business appraisers. Consider the term "fair value."

According to FAS 157, "The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)." Click here to read a summary of Statement 157.

In contrast, the Model Business Corporation Act 3rd edition (copyrighted 2003 by the American Bar Foundation), defines "fair value" to mean "the value of the corporation’s shares determined:
(i) immediately before the effectuation of the corporate action to which the shareholder objects;
(ii) using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and (iii) without discounting for lack of marketability or minority." Dr. Shannon Pratt (in his book entitled The Lawyer's Business Valuation Handbook) describes "fair value" as a statutory standard of value applied in dissenting shareholder cases but influenced by the actual state venue. He goes on to say that "fair value" is seldom mistaken for "fair market value" in appraisal land.

According to the International Glossary of Business Valuation Terms  (2001),  fair market value is "the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts." Click here to access the full glossary.

What's the moral of the story? When people banty about valuation terms, ask exactly what they mean.

Should Pensions Care About Valuation Fraud?

According to "Bonds' Pricing Is Questioned In Email Trail, Former Trader at RBC Alleges Mismarking Of Plain-Vanilla Issues " (October 26, 2007) Wall Street Journal reporter Susan Pulliam describes alleged fraud at one of the large Canadian banks. Whether government and corporate bonds were incorrectly valued to hide losses remains to be seen. However, if true, this is serious stuff.

Pension fiduciaries should be regularly asking external managers about their trading checks and balances. However, in light of recent negative headlines, one wonders (a) whether sufficiently tough questions are being asked (b) who is doing the investigation and (c) whether risk management and valuation best practices are more myth than reality at some organizations.

ERISA and state pension laws make it clear that fiduciaries have a solemn obligation to properly select and review external money mangers. Are breach of duty complaints likely to ensue for those plan sponsors who have selected "troubled" money managers and cannot provide evidence of a disciplined and comprehensive review of their risk management and valuation policies? 

Our forthcoming November 6, 2007 webinar will look at trading controls and the selection and review of external money monagers. Click here for more information.

The Abracadabra of Valuation - Pension Fiduciaries Beware

Wall Street Journal reporters Susan Pulliam, Randall Smith and Michael Siconolfi fascinate with some interesting statistics about "hard-to-value" assets. In "U.S. Investors Face An Age of Murky Pricing Values of Securities, Tougher to Pin Down; Discord at Dillon Read" (October 12, 2007), they suggest that dollar volumes of securities that don't readily trade now likely outweigh those that do. Their comment that "money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles" leaves one gasping for air. Adding to their assertion that some managers cannot sell at the level quoted by their brokers (quelle surprise!), I've heard through the grapevine that some banks and brokers are no longer willing to quote at all.

So where does this leave pension fiduciaries? The news is not good. If you are a plan auditor, treasurer, trustee and/or member of the investment committee, trying to (a) evaluate current portfolio performance (b) assess external asset managers (c) make changes in the strategic asset allocation mix and/or (d) undertake a risk management program, valuation numbers are paramount. If you are in the dark about what drives asset valuation in terms of identified risk drivers (and their behavior) or know little about how your fund manager addresses pricing, model validation, hedging effectiveness, trading limits and so on, look out. You are smack dab in the middle of the danger zone.

Moreover, if you are relying on a third party intermediary, ask if (a) they play the role of fiduciary and (b) the extent to which they vet managers' valuation policies and procedures. In addition, don't count on your fellow investment committee members to do the heavy lifting. Attorneys confirm my common sense conclusion. "Investing in something you don't understand is a no-no." If only one person on the committee understands the nature of a particular asset class or manager, that's cold comfort in the event of a lawsuit wherein fingers will point to EVERYONE who signed the allocation ok.

Regarding models, they are only as good as the underlying assumptions and how well they map back to reality. Who is testing the models used by your asset managers? Who is verifying the quality of input data? How often are so-called hedges evaluated for economic efficacy? Who is responsible for monitoring the collateral posted by fund managers? Do you have a system that can provide early warning signs that a manager has strayed from his or her stated approach? What needs to be added to your valuation policy (if one exists)? How are you measuring leverage and are your asset managers measuring leverage the same way?

The list goes on...

Valuation is arguably magic if it's arbitrary and capricious. There is an entire industry of valuation professionals at the ready, supported by a large and growing body of knowledge.

Poof or protect? How are your assets doing? 

Click here to read one of many articles about model risk.



Dr. Susan M. Mangiero to Lead Valuation Masterclass

Pension Governance, LLC is proud to be a media sponsor of the Asset Allocation Summit Australia 2008. This blog's author is personally delighted to lead the master class about valuation. Entitled "Global best practices in hedge fund valuation and risk management ," the class will examine topics such as biggest risks for hedge funds in valuation, what makes for an effective valuation process and difficulties in valuing private equity holdings and complex derivatives.

Click here for more details.

See you "down under."

Pension Governance is a Proud Co-Sponsor of Workshop on Hedge Fund Valuation

Introduction to Hedge Fund Valuations
October 31, 2007 --- Loews Philadelphia Hotel, Philadelphia, PA

Program Focus:
At a time when the global hedge fund market exceeds $2 trillion and regulators are seeking ways to force more transparency, understanding valuation fundamentals is critical. This course is a unique offering that combines information about hedge fund industry structure with core valuation concepts. The course will examine the overall structure of a hedge fund, including standard partnership terms, revenue structure, liquidity restrictions, and impact of hedge fund strategy on value of hedge fund business itself. Special issues such as side pockets and high water marks will be discussed, along with a description of regulatory initiatives with respect to hedge fund operations.

What You Will Learn:
This four-hour course will enable attendees to:

Understand competing industry valuation standards and best practices

Understand basic structure of hedge funds and fund of funds

Differentiate between valuation of hedge fund and hedge fund portfolio

Understand basic regulation relating to hedge funds

Learn about various investment strategies and how they impact valuation
Understand impact of FAS 157 and AU 332 as relates to hedge funds

Who Should Attend:
Hedge fund general counsel, valuation practitioners, auditors, regulators, and institutional investors such as pension funds

Susan M. Mangiero, Ph.D., AIFA, AVA, CFA, FRM, president and CEO of Pension Governance, LLC, has over 20 years of experience in capital markets, global treasury, asset-liability management, portfolio management, financial risk control, and valuation. She has worked on three trading desks, in the areas of foreign exchange, fixed income, futures, and options. Dr. Mangiero is regularly invited to speak about valuation, risk, and governance with an emphasis on applications to pensions and hedge funds. She has addressed groups that include the U.S. Department of Labor, Chicago Board of Trade, New York State Department of Insurance, Merrill Lynch, Association of Public Pension Fund Auditors, Association of Forensic Economics, New England Public Employee Retirement Systems Forum, Global Association of Risk Professionals, American Society of Appraisers, the Wall Street Transcript, Strategy Institute, Connecticut State Department of Banking, Canadian Investment Review (keynote), Strategic Research Institute, Incisive Media (publisher of Hedge Funds Review) and the Connecticut Society of Certified Public Accountants. Her book, Risk Management for Pensions, Endowments, and Foundations (John Wiley & Sons, 2005), looks at risk management and valuation issues, with an emphasis on fiduciary responsibility and best practices.

Continue Reading...

Pension Risk and Hedge Fund Cherry Picking

An October 9, 2007 Wall Street Journal article describes new academic research that suggests foul play in hedge fund orchards everywhere. In "Pricing Tactics Of Hedge Funds Under Spotlight: Some Managers Select Favorable Valuations To Lift Performance," reporters David Reilly and Gregory Zuckerman cite empirical evidence that hedge fund managers may cherry pick prices of "hard to value" instruments as a way to pretty up performance.

The issue of valuing instruments for which no ready market exists is a challenge indeed. At a time when pension funds are allocating billions of dollars to hedge funds, private equity and venture capital pools, fiduciaries risk serious fallout if they fail to establish solid ground rules regarding valuation. There are any number of "must have" elements that comprise effective policies and procedures. Ignore them and plan sponsors lose a precious opportunity to detect possible trouble before things get out of hand.

Now is not the time to take shortcuts when it comes to valuing "hard to value" instruments or conducting proper oversight of portfolio managers who trade relatively illiquid stocks, bonds, derivatives and hybrids.

If you are interested in reading other posts about valuation, click on any of the links provided below. In addition, feel free to email us if you want to read some of our many articles on the topics of risk management and valuation.

Valuation Problems Are Going to Cost Plan Sponsors Big Time

Model Risk - Great Unknown for Pension Plans

Valuation Awakening - Does the Emperor Have Clothes?

Tulip Craze Redux and What Models Mean to Pensions

Survey Shows that Pensions Worry About Risk Management and Valuation

Pensions and Hedge Funds and Private Equity - Assessing Risks

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

Side Pockets and Valuation

Courts Want Evidence of Valuation Expertise

Private Equity, Mutual Funds and Valuation

Do You Really Know the Value of Your Portfolio?

Pension Funds Still Embrace Alternatives

In reading "Alternative investments still hot with pension fund managers" (Andrew Osterland, Financial Week, September 27, 2007), several things caught this blogger's eye. Summarizing a recent Citigroup Investment Research Survey of U.S. and European funds, the article states that "almost 90% of pension fund managers allocate assets to private equity investments vs. 50% to hedge funds." It was somewhat surprising then to read that "over 80% of managers expressed concern over the lack of marking-to-market of hedge fund investments."

Does that mean that pension investors are less concerned about the valuation of private equity positions? That seems odd. While true that many hedge funds actively trade (and therefore tend to have a shorter holding period than private equity managers), we've fielded valuation calls from more than a few defined benefit plan auditors and investment committees. Concern about how to fair value any position for which no ready market exists - hedge fund or otherwise - ranks high on their "watch out" list.  

Though some believe that accounting rule changes are the primary reason for concern, the Private Equity Industry Guidelines Group reports the following:

FASB Statement No. 157 did not change GAAP, it includes "provisions which required subtle changes to the guidelines which could be deemed significant! Fair Value was required for PE investments prior to Statement 157. Statement No. 157 clarified the definition, usage and disclosures necessary when using Fair Value and in certain circumstances changes historic practice in the private equity industry as further outlined below." (Source: 2007 Updated Private Equity Valuation Guidelines Frequently Asked Questions)

With more than $1.0 trillion expected to flow into alternatives by 2010 (as per survey results), understanding hedge fund and private equity valuation is critical.

Private Pools of Capital - Pensions Help to Craft Policy

According to a September 25, 2007 press release for the President's Working Group on Financial Markets ("PWG"), pension funds are playing an active role in setting policy. Following on the heels of guidelines released in February 2007, one committee, headed by Eric Mindich, CEO of Eton Park Capital Management, seeks to provide the asset management perspective. A second committee, led by Russell Read, Chief Investment Officer of the California Public Employees Retirement System, will represent institutional investors such as pensions, endowments and foundations. Click here to read yesterday's press release.

Drawing on the "Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital," drafted earlier this year, committee members will consider fiduciary duties. Not surprisingly, decision-makers are asked to consider the adequacy of disclosure, risk and valuation policies. Excerpted text follows.

  • 5.1 Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.
  • 5.2 Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.
  • 5.3 Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems.
  • 5.4 Fiduciaries that determine to invest in a private pool of capital should ensure that the size of their investment is consistent with their investment objectives and the principle of portfolio diversification.

The guidelines merit more than a cursory review. One sentence in particular struck a chord. Citing the importance of news, institutional investors are urged to obtain and analyze data that is both frequent and "with sufficient detail that creditors, counterparties, and investors stay informed of strategies, the amount of risk being taken by the pool, and any material changes." As readers of this blog know, seeing is believing. More than a few asset managers may be unwilling to unlock the keys to the information gateway, citing economic hardship if forced to provide full disclosure. Just a few days ago, the SEC announced penalties for an asset manager who failed to file Form 13F, evidencing their exercise of "investment discretion over $100 million or more." (Note: There is no universal agreement that 13F filings permit "sufficient" information transparency. At least one court case asks whether an asset manager should be forced to file without recompense for the "taking" of added-value that results from "superior" analysis.)

Additionally, access to greater amounts of information does not necessarily beget better information. Even if available data is Goldilocks perfect ("just right"), what happens when pension investors are unable to process what has been received?

It will be informative to see what the two committees create in terms of operationalizing these fine, but arguably broad, guidelines.

Valuation Problems Are Going To Cost Plan Sponsors Big Time

This blog's author recently had the pleasure of addressing an audience of hedge fund compliance officers and auditors about valuation issues - a topic near and dear to my heart. As an accredited appraiser, a certified financial risk manager and someone who has worked with models and trades, I am fully aware (and in fact often tout) the inextricable relationship between risk analysis and valuation. Simply put, effective financial risk management does not occur in a vacuum but rather depends on reliable valuation numbers. GIGO (Garbage In, Garbage Out). If a fund manager relies on faulty information, the inevitable result is flawed process, including (but not limited to) inaccurate hedge size (if hedging occurs), imprecise performance reports, possible asset allocation or portfolio re-balancing mistakes, trading limit utilization problems and so on. 

From the investors' perspective, the trickle down effect can be costly. Any "issues" at the asset manager level directly impact fees paid by pension funds, their own asset allocation decisions, not to mention cash flow and funding status breach as possible forms of "valuation fall-out." Valuation is the proverbial four-letter word in investment risk management. Cause for consternation, valuation issues are often complex and demand rigor with respect to policy creation, implementation and review.

Being somewhat impolitic, yet wanting to convey an important message to an important audience of hedge fund professionals, I cited chapter and verse about valuation pitfalls from a pension fiduciary's perspective. Including the need to get private placement memorandums that address what and how the fund manager intends to assess the portfolio on a regular basis, I explained the rationale for use of an independent third party to either render opinions of value, or at the very least, conduct a valuation process check. Even when a hedge fund does not exceed the twenty-five percent ERISA money limit (pursuant to the Pension Protection Act of 2006), best practices abound for both the fund manager and the pension investors alike. Interviewing traders, along with the asset manager's Chief Risk Officer, about valuation policies and procedures is another good idea. If a fund has no functional risk manager, ask why. Interestingly, one person responded to my comments by declaring success at drafting sufficiently obtuse documents that would likely keep investor accusations at bay.

In today's Wall Street Journal, reporter Eleanor Laise tells readers that it's not just hedge funds caught in the valuation cross-hairs. Mutual funds have their own issues. For example, when a security is not frequently traded, multiple methods might generate disparate "fair value" estimates. Quotation quality runs the gamut from the use of stale prices to "accommodation quotes" offered by "friendly brokers." Time-of-day selection is another conundrum, especially in the case of non-U.S. securities or instruments such as highly customized derivatives. Laise adds that "valuation policies can vary substantially from fund to fund." In some situations, an independent outside firm provides prices. Elsewhere, internal models or broker-dealer quotes are used. (See "Funds Struggle with Pricing Pitfalls," Wall Street Journal, September 17, 2007.)

As I've written (and presented) many times before, plan sponsors who sit silently by, without grilling asset managers about their valuation policies and procedures, are asking for trouble. Pension fiduciaries have a duty to oversee external fund manager performance as relates to the stated risk tolerance and return goals. This includes a weighty discussion about price quotes, marking to market (or model) and provider quality. (Not being an attorney, plan sponsors should seek counsel for a precise assessment of their responsibilities.)

With new accounting rules on their way and a variety of significant valuation unknowns, subprime loan-related losses may look like a walk in the park. What we don't know can hurt!

Editor's Note:

Pension Governance, LLC has partnered with the National Association of Certified Valuation Analysts to develop a technical workshop on hedge fund valuation. Click here for a course description. Other programs are in the works. Click here to read more about our June 28, 2007 webinar about hedge fund valuation. (The recording and program materials are available for a modest fee.) If you want additional information about valuation training for your board, risk analysis or process checks, click here to drop us a line.




Model Risk - Great Unknown for Pension Plans

In "How Street Rode The Risk Ledge And Fell Over," Wall Street Journal reporter Justin Lahart writes that "many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become." Warnings about model error or "model risk" are not new. In "Model Risk and Valuation" (Valuation Strategies - March/April 2003), Dr. Susan M. Mangiero, CFA and Accredited Valuation Analyst, suggests possible red flags, adding that the consequences of a poor, inaccurate or incomplete model (or problems with data) can be dire. She adds that what constitutes a "good" model is likewise important to assess. This is sometimes made more difficult when inputs themselves must be modeled. For example, in the case of derivatives related to credit risk or mortgage loans (dominating headlines of late), estimating variables such as prepayment or recovery rates is an important precursor to any valuation of the derivative instrument itself. Email us if you would like articles about model risk and valuation.

Public Pension Plans and Hedge Funds

Washington Post reporter Tomoeh Murakami Tse writes about the growing number of public pensions with current monies allocated to hedge funds or thinking about making an investment. She quotes Larry Swartz, executive director of the Fairfax County pension funds' board of directors as focused on many factors. "It's about developing a smoother return stream and managing the level of volatility in the retirement system year to year."

In stark contrast, Masachusetts Secretary of State William F. Galvin counters that "There's an inconsistency between the concept behind hedge funds, which is high-risk, high-return, and the concept behind pension funds, which is little risk, guaranteed return."

So who is right? Do hedge funds offer a way to reduce risk or do they instead add risk to a portfolio?

Without knowing more about a particular hedge fund's strategy and quality of  risk controls, it would be hard for anyone to make a blanket statement, one way or the other. What is important is process. Yours truly, Susan M. Mangiero, President of Pension Governance, an independent research and training company, is quoted as saying that survey results suggest that pension funds are too easy on hedge fund managers. "A pension fund manager really needs to ask some tough questions about how the hedge fund is valuing these assets." Importantly, it's not just valuation but a host of other factors that fall into the "must know" category before monies should be committed. See "Public Pension Systems Betting on Hedge Funds" by Tomoeh Murakami Tse , Washington Post, July 24, 2007.)

Valuation Awakening - Does the Emperor Have Clothes?

A mystery is unfolding. How can securities receive robust credit ratings and then turn out to have questionable value? Isn't there supposed to be continued oversight vis-a-vis an issuer's ability to pay? In "Moody's CFO sued over bond ratings; Firm gave too high ratings to sub-prime bonds," Business Times Singapore reports on a class action complaint by a private investor. Alleging that the CFO "failed to disclose that Moody's assigned 'excessively' high ratings to bonds that were backed by sub-prime mortgages," traders are now betting that additional suits against other rating agencies will follow. While a complaint in no way attaches guilt to the defendant, it will be interesting to learn more about the sub-prime bond ratings process if these cases proceed. (Some organizations post information on the website.)

Reuters reporter Neil Shah discusses some pitfalls when complex securities are "marked to model," including unrealistic assumptions that can skew results. "The worry is that well-heeled hedge funds, Wall Street proprietary trading desks and ratings agencies may be too optimistic when analyzing or valuing exotic mortgage investments. As a consequence, future drops in market prices may be more severe and possibly trigger panic selling by sophisticated investors." (Click here to read "Can Wall Street be trusted to value risky CDOs?" July 16, 2007)

As investors wait for the other shoe to drop, readers are reminded that process is everything. Unless a plan sponsor is prepared to ask tough questions about how an asset manager values the portfolio and components thereof, it may be a redux of "The Emperor Has No Clothes." Worse yet, individual fiduciaries could be exposed to allegations of breach for failure to effect proper due diligence." As an Accredited Valuation Analyst, my appraiser colleagues would no doubt concur with me. Valuation is a specialty and not to be taken lightly. As markets tank ("worst fall in nearly five months" on July 24) plan sponsors may find themselves in an uncomfortable double whammy position - plunging prices of traded equities and difficulty in unwinding "hard to value" instruments. (See "Markets tumble as credit concerns spread" by Michael Mackenzie and Saskia Scholtes, Financial Times, July 24, 2007)

Though written in 2004, "Asset Valuation: Not a Trivial Pursuit" by Dr. Susan M. Mangiero is still worth a read. Click here to download the article. (You can sign up for a free 14-day trial subscription and access the article for no charge.) Drop us an email if you want to know more about our training in the areas of risk and valuation for trustees, board members and investment committees. All inquiries will be kept private.

Two Hedge Funds Report Assets Are Nearly Gone


Wall Street Journal journalists Kate Kelly, Serena Ng and Michael Hudson report that two once-large hedge funds are barely worth the paper that documents their existence. According to a letter to investors, parent Bear Stearns has already committed $1.6 billion in a "collateralized repo line to the High-Grade Fund" but cautions that prices are dropping fast. At the heart of the matter is the challenge to "place values on assets tied to subprime home loans" that are not actively bought and sold. (See "Subprime Uncertainty Fans Out - Bear's Hedge Funds Are Basically Worthless; More Bond Fire Sales," Wall Street Journal, July 18, 2007.) 

As an accredited appraiser, I'm here to say that there is an entire industry of valuation professionals who eat, live and breathe process, standards and methodologies. In fact, following the U.S. savings and loan debacle in the early 1980's and the 1989 enactment of the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA"), Congress essentially sanctioned the work of several entities - Appraiser Qualifications Board and the Appraisal Standards Board. For more information about the Appraisal Foundation and its history, click here.

So the hullabaloo about valuation problems (likely the tip of the iceberg) is extremely important but ignores a critical point.

In general (and not necessarily germane to this particular pair of hedge funds), a failure of institutional investors to oversee who renders value numbers, how, and on what basis, opens the door to "anything goes." Independent assessments of models and processes are arguably more important than ever before. If plan sponsors feel uncomfortable with the rigors of valuation and risk management, hire experts to help. Make sure that they know what they are doing. Ask whether they have specialized credentials and experience.

Why is valuation so important? Numbers drive nearly EVERYTHING financial,  from performance reporting to risk management to determination of fees and asset allocation decisions. GIGO - Garbage in, garbage out - could be very hard to explain as an acceptable basis for good decision-making.

If you are interested in reading a June 4, 2007 interview I gave to Securities Industry News about hedge fund valuation, click here.

SEC Announces Investigation of Hedge Funds' Valuation Methodologies reporters, Karey Wutkowski and John Poirier, relay the SEC's intention to review valuation methods used by hedge funds.  Testifying before the House Financial Services Committee on June 26, Chairman Christopher Cox said that "We are going to further review, using the SEC staff, the valuation and other issues that managers for these funds have." Apparently, his message to the press, after the hearing, was serious, citing "concern that hedge funds and the investment banks that manage them are not marking assets to their proper value," something that "is of interest to the SEC's examinations and enforcement departments." Click here to read more.

So what does this portend for the plan sponsors knee deep in "hard-to-value" hedge funds? In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!

In some circumstances, the use of an external consultant may provide little refuge, especially if a plan sponsor is unable to demonstrate that the consultant has a good command of valuation principles as applied to hedge funds. Having just co-led a workshop about hedge fund valuation, I was appalled to hear a colleague describe the "not my job" mentality of some service providers who act as pass-throughs for valuation numbers. That begs the question - If the consultant, administrator, prime broker or custodian are accepting traders' marks with no review (however formal), who exactly is overseeing the valuation activity at a particular hedge fund or fund of funds? Moreover, how independent are numbers that are generated by traders whose bonus is almost always tied to reported performance? (We'll talk about valuation standards and best practices in later posts.)

Stormy days ahead?

If you'd like our insight or want to learn more about the work we do in this area (before the fact, during the investment process or after trouble begins), email us. All inquiries are kept confidential. Also note that we'll be devoting seventy-five (75) minutes to the topic of hedge fund valuation from noon to 1:15 p.m. EST on June 28. Click here for more information.

Tulip Craze Redux and What Models Mean to Pensions

Since the mid 1600's, tulips have come to symbolize economic bubbles. Excess demand for the floral beauties led Dutchmen to pay a hefty price, resulting in the tulip mania of the early 17th century.

One wonders if a June 24 article by New York Times reporter Gretchen Morgenson hadn't been inspired by this tale of yore. Entitled "When Models Misbehave," this prize-winning business columnist describes the challenges of assessing securities that trade in relatively illiquid markets. In the absence of ready buyers and sellers, traders mark to model, making assumptions about the future behavior of inputs such as interest rates. Unfortunately, problems may arise if the underlying assumptions make no sense. Consider the notion that past is prologue. Referring to the sub-prime debacle currently plaguing several large financial institutions, Morgenson describes 2006 and 2007 lending practices as overly generous and likely to tighten. Correctly recognizing that future supply-demand conditions for credit might change leads to an altogether different model outcome.

Lack of independence or "the fantasy that a firm's principals prefer" is another concern. Blind acceptance of model-generated outputs as gospel could mean a subsequent, and arguably tainted, outlay of serious money to other trades.

Morgenson has a good point.

It's easy to be lulled into false security with computer-generated numbers. Unfortunately, bad values beget bad economics. A computational flaw, unstable or inappropriate model and/or low-integrity data could end up costing investors millions of dollars. Trading decisions based on garbage are expensive mistakes.

Good model-building is a start. Validating, testing, revising and testing anew should follow. Heady stuff but anything else might be considered remiss. Importantly, it's up to investors to query asset managers about what's inside the black box.

Anecdotally, I'm not sure there is enough of this rigorous oversight happening right now. As an accredited appraiser, I'm disturbed by the laxity of investigation about valuation and the related process of risk management.

With new accounting rules on their way, we'll talk much more about models and model risk in future posts. In the meantime, click here if you'd like us to send you information about valuation and modeling.

Large Endowment Loses Auditor Over Valuation Issues

According to the Daily Texan, the University of Texas Investment Management Company will soon have to rely on its internal audit staff. Chairman of the University System's Audit, Compliance and Management Review Committee, Regent Robert Estrada "reported to the board that Ernst & Young was uncomfortable with pricing the investment company's private equity and hedge fund investments. Regent Robert Rowling added that the firm also had issues with the time gap between UTIMCO's quarterly reports." Click here to read the article.

In a related piece, this blogger was interviewed about the topic of hedge fund valuation in Securities Industry News. Part of a June 4, 2007 special report entitled "Critical Issues for Hedge Funds," the topic of how, why and when hedge funds get valuation help (or don't as the case may be) arose. As an accredited appraiser, I know from firsthand experience that many people in hedge fund land do not acknowledge the presence of the traditional business valuation community. That's not necessarily good since the latter group has long ago acknowledged the regulatory prohibition against a formulaic approach and the need for specialized valuation training. Judges are none too happy and are tossing expert opinions out of their courtroom if they fail to reflect established valuation concepts and practices.

When asked why valuation is so important in this industry, I said the following:

<<  Valuation numbers drive nearly every financial decision. Hedge fund managers need to know how to rebalance their portfolios, adjust risk management positions and report numbers to investors upon which they earn their fees. Valuation becomes especially important in the case of illiquid investments like private equity, distressed securities, emerging-market securities and complex derivatives. It is also an issue as more hedge funds go public. How else will you come up with a net asset value for the initial public offering, without a formal assessment? Additionally, institutional investors are on the hook to understand how hedge funds value their holdings. The last thing pension fund, foundation or endowment fiduciaries want is a blowup that could have been prevented with a thorough vetting of the managers' valuation process. That includes assurance from the hedge fund managers that numbers are being provided by an independent third party. >> (To read "The State of Valuation", go to A subscription is required but you can register for a trial.)

If you would like a copy of some of the articles I've written about hedge fund, derivative instrument and asset valuation, click here to send an email.

Survey Shows That Pensions Worry About Risk Management and Valuation

In his May 16 testimony to Congress, Mr. Douglas Lowenstein, head of the Private Equity Council, extolled the virtues of non-public investments. With over $110 billion invested in private equity by twenty large public pension funds, Lowenstein cites relatively higher historical returns that have helped plan sponsors pay the bills. Click here to read his testimony.

A few months earlier, a survey conducted by the State Street Bank describes escalating interest in hedge funds. At the same time, half of respondents expressed "a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices," adding that "they find it difficult to gain a portfolio-wide view of risk, and that aggregating risk statistics provided by all hedge funds in their portfolio was problematic. The same number also agreed that obtaining an accurate valuation of hedge fund holdings can be problematic." Click here to read the executive summary of the survey.

As with any investment, there is no "perfect" choice. Selection depends on a wide variety of factors.( A discussion about optimal asset allocation and security/fund selection is outside the scope of this blog post.) However, a few points are in order.

1. Risk management and valuation concerns are not created equal. They vary across type of asset and fund. Private equity funds tend to trade less frequently than hedge funds. Even within an asset class (assuming you agree that hedge funds constitute a separate asset class), the risk-return tradeoff varies by strategy, management and much more. For example, the use of derivatives by a market neutral hedge fund can differ dramatically from that of a macro oriented fund.

2. The use of a side pocket may reduce the need for frequent valuations. However, institutional investors need to understand if a side pocket is to be used, what will go inside the side pocket and the impact on reported performance as a result of its use.

3. Knowing that a manager employs derivatives is not enough. Understanding instrument and strategy choice is likewise important (though still not sufficient).

4. Valuation numbers provided by traders or anyone else who stands to benefit by reporting high numbers should be discarded and replaced with those provided by an independent party.

If you are interested in knowing about other red flags, email us in confidence.

Pensions and Hedge Funds and Private Equity - Assessing Risks

In case you missed it, here is the link to a video of my appearance on CNBC's Morning Call.  While I concede that it's impossible to have an in-depth conversation in only a few minutes, several things are worth mentioning as a result of the May 17 chat with host Mr. Mark Haines.

1. Not all institutional investors have a large staff to vet different investment ideas. Moreover, large does not always mean better. Witness Fannie Mae and Amaranth Advisors. "Thorough" is the watch word.

2. If considering a hedge fund, ask if the fund has a functional risk manager who monitors, tests and reviews policies for financial and operational trouble spots. Does that person have independence and authority to effect meaningful change?

3. I believe the other speaker in this segment said that private equity avoids having to deal with the daily volatility of being invested in public equities. Caution - The absence of a ready trading market does not necessarily mean that there is less risk. Some could easily assert the opposite. Private equity deals, because they are private, entail valuation challenges, difficulty in liquidating ownership interests and so on.

4. The use of correlation (a measure of linear association) to gauge diversification benefits depends on having good data for all relevant time periods. If using an inappropriately long calendar period (example: last ten years), output may reflect a smoothing out effect which therefore underestimates "true" volatility.

5. There is much more to say on the topics of risk management and valuation!

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

At a time when pension funds explore new ways to buoy funding, billions of dollars are being allocated to hedge funds and fund of funds. Either direct or part of a portable alpha strategy, alternative investments offer potential benefits but often bring new challenges in the form of multi-tiered fees, valuation, leverage, transparency, short-selling, illiquidity and operational risk. Add to the mix the mandates of the Pension Protection Act of 2006 and one thing is clear. Pension fiduciaries are on the hook to demonstrate a solid understanding of the structural and financial characteristics of hedge funds and fund of funds and what could potentially cause problems if left unchecked.

To help pension decision-makers better understand this important area, Pension Governance, LLC has created the Hedge Fund ToolboxSM – a series of six webinars that focus on hedge fund economics, operations and legal considerations. Webinars are scheduled as follows:

•Hedge Fund Fees, Performance and Transparency (June 14, 2007)
•Hedge Fund Documentation, Background Checks, Enforcement and Litigation (June 19, 2007)
•Role of Consultants and Financial Advisors in Selecting Hedge Funds (June 26, 2007)
•Hedge Fund Valuation, Use of Side Pockets and New Accounting Rules (June 28, 2007)
•Hedge Fund Leverage, Use of Derivatives and Risk Management (July 10, 2007)
•Hedge Fund Operational Risk (July 12, 2007)

Register to attend the entire series or individual webinars. If you miss an event, recordings will be available for a modest fee for non-subscribers. Webinars are free to all Pension Governance subscribers. For more information, go to

About Pension Governance, LLC:
Pension Governance, LLC ( is an independent research and analysis company that focuses on benefit plan related investment risk, corporate strategy, valuation and accounting issues, with the fiduciary perspective in mind. Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village (, ( and the National Association of Certified Valuation Analysts ( as media sponsors.

Pension Governance, LLC
Susan M. Mangiero, 203-261-5519

Pension Governance, LLC Launches New Website Devoted to Pension Risk Issues

Pension Governance, LLC is proud to announce the launch of a new website for pension investment fiduciaries. In what is believed to be a unique online information portal devoted to pension investment risk and valuation issues, and reflecting original content from practitioners, combines independent analysis and research with commentary about urgent issues affecting both defined contribution and defined benefit plans.

At a time when pension finance dominates headlines around the world, investment committee members, treasurers, CFOs and trustees are confronted with a slew of new challenges and a need to “connect the pension governance dots.”

The primary goal is to empower investment fiduciaries with objective educational information about relevant issues before they commit millions of dollars and countless hours to a particular strategy. Dr. Susan M. Mangiero, president of Pension Governance, LLC and author of Risk Management for Pensions, Endowments and Foundations, adds, “We want to create a meaningful conversation about pressing and oft-complex investment and risk issues that are not going to go away any time soon. We have put together a top-notch group of contributing editors from a variety of disciplines, including law, insurance, treasury, alternative investments and corporate governance. Our strategic partners join us in our efforts to promote investment fiduciary education and best practices.”

In addition to the Knowledge Center Library, includes interesting features such as Pension Chat (interviews with industry leaders), Courthouse Corner and Fiduciary Focus. Soon to come is the Pension Parade of Horribles, a source of information about bad practices and lessons learned.

Subscribers can read annotated online articles from a variety of news sources, access research team members via Ask Professor Pension, download original content from expert practitioners, receive Pension Risk AlertSM and attend webinars for no additional fee. A forthcoming webinar is a June 4 discussion about 401(k) plan governance in the aftermath of the Pension Protection Act of 2006. Another webinar, part of the Hedge Fund Toolbox - a series of discussions from the pension fiduciary perspective - is a May 15 discussion about fees, documentation and key person background checks. Many other webinars about a variety of pension topics such as valuation, liability-driven investing and performance analytics are in the works and will be announced shortly.

Web designer Dawn Barson, co-founder of think creative group, llc, describes the care taken to build an infrastructure that permits Pension Governance editors maximum flexibility. “Knowing how much the editors want to keep the site fresh, we worked hard to build a robust administrative console so that new features can be added all the time.” Additional programming is already underway, with many more functions being designed to help investment fiduciaries access information and analysis quickly, easily and in a cost-effective manner.

With over thirty years of experience in the pension industry, Dan Carter, Pension Governance Vice President of Business Development, describes a sea change in the challenges that confront fiduciaries. “There is so much to know in this field and getting it from independent sources is critical as never before.” Mangiero concurs, “There is no shortage of content. We’ll be adding to the site all the time. People should check back often for updates.”

Visitors can sign up for a free two-week trial subscription by going to and are encouraged to submit requests and comments to

Pension Valuation Tower of Babel

In my June 22, 2006 post entitled "Will the Real Pension Deficit Please Stand Up?", I made the case that measurement ambiguity is dangerous. It prevents anyone from addressing a financial funding problem in any meaningful way. While ERISA plan metrics have often been the focus, it turns out that municipal plan analysis may be similarly difficult to interpret. New York Times journalists Mary Williams Walsh and Michael Cooper report that the use of multiple valuation methods can result in completely different assessments. (See "On Tracking of Pensions, No Consensus", August 27, 2006.) Their interviews with several rating agency professionals suggest concern and the need to supplement reported numbers with additional metrics.

Actuarial methods are called into question as well, especially if they result in overly optimistic investment return projections and artificially smoothed expenses over time. Though clarification would be a welcome relief, the reporters write that "The Governmental Accounting Standards Board, which sets the rules, is in the initial stages of reviewing the 12-year-old standard governments use when reporting pension values. Any changes are likely to take years."

In contrast, note what an anonymous blog reader has to say (with some minor edits).

The NYT article talks about valuing the pension liability using the appropriate municipal bond yield. Because this rate is lower than the current GASB-mandated rate, the liability balloons.

But municipal bond yields are low because they are tax exempt. I'd make the case for the same-risk corporate bond yield. (If NYC has Aa credit, use the Aa corporate bond yield.) This approach would reflect the risk of the pension liability, but not the tax shield. Since pension distributions are subject to taxation, the tax-exempt municipal yield is inappropriate from the pensioner's perspective.

Some might argue that public pension obligations are close to guaranteed since municipalities can raise taxes to pay bills. This suggests they should be valued at a risk free rate. If so, I'd argue that it should be a Treasury rate, not a Aaa muni rate.

As an Accredited Valuation Analyst, I think it's safe to say that reasonable people can disagree about assumptions as long as each appraiser employs logic and can defend, and document, the basis of his or her assumptions. Competing methodologies are a different story altogether when they produce outrageously divergent outcomes that are hard to support.

Perhaps this is the beginning of a new specialist career - pension valuation translator.

Side Pockets and Valuation

What's inside your side pocket? The answer may shock you. That's the gist of a recent article about investments that are tucked away, not to see the light of day until the positions are sold or marked down in anticipation of bad news. In "Street Sleuth: 'Side-Pocket' Accounts of Hedge Funds Studied" Wall Street Journal, August 4, 2006, reporters Gregory Zuckerman and Scott Patterson write that funds have been known to place large chunks of their portfolio in side pockets. Any investor seeking to withdraw money may find it difficult, sometimes facing "limits on their ability to withdraw their money, terms that are put in place so a fund can avoid being forced to sell investments at a sizable loss if a number of investors suddenly want their money back."

They cite Securities and Exchange Commissioner Roel Campos who addressed side pockets as part of his remarks before the SIA Hedge Funds & Alternative Investments Conference on June 14, 2006.

Hedge funds may hide poor-performing assets in side pocket accounts to exclude such assets from the fund's valuation for purposes of calculating performance fees. Some hedge funds require leaving some of the investment in side pockets as a condition for redemption, even though the condition was not disclosed in the investment agreement. On the larger scale, there is the potential for excessive leverage, the concentration of positions, the dependence of valuations upon complex proprietary models, and operational risks for settlement and clearance systems. There is also the risk that hedge funds will all exit at the same time - as purportedly occurred in the 1997/8 Asia Financial Crisis. Performance fee structures give hedge funds an incentive to engage in risky strategies that may not be fully disclosed, and some advisers may not have sufficient risk management processes in place.

Complicating things is the fact that a hedge fund can have multiple side pockets. For a fund of funds manager, the situation could be daunting if he or she allocates money to a large number of funds, each with multiple side pockets.

Supporters of side pockets argue that valuing investments under less than ideal conditions is worse than putting them aside for awhile. They advocate the use of side pockets so that investments they describe as carefully selected have a chance to grow.

Nevertheless, there are things one can do. Even when formal valuations are not performed by an independent appraiser, the use of a qualitative risk driver matrix offers a relatively low-cost form of discipline to get investors thinking about scenarios that might spell trouble. The idea is to both identify factors that could depress value and think about the likelihood of occurrence. For example, the value of equity issued by a closely-held airline company that does not hedge will no doubt drop as oil prices rise. (This author is surprised by the number of investors who have not taken this rather simple step in assessing the risk elements of their portfolio.)

More and more pundits describe a blurring of the lines between hedge funds (some of them anyhow) and private equity funds. The Mid-Atlantic Hedge Fund Association is devoting an entire meeting to this topic on October 12. Founding member and chairman of the board of this educational organization, Dechert attorney Brian Vargo describes the three-hour program as a lively discussion that is sure to include valuation as one of several challenges associated with the trend towards convergence.

In case you missed it, the author wrote about the importance of getting independent opinions of value or having an outsider review the valuation process already in place on June 18, 2006. Click here to read the post.

Courts Want Evidence of Valuation Expertise

Judges continue to expel experts (and their reports) when they are unable to demonstrate relevant credentials and experience. In a July 2006 case involving the fair market value assessment of private company equity, the U.S. Tax Court wrote: "We are not obligated to pay any regard to an expert opinion that lacks credibility" and criticized the report for not adhering to the Uniform Standards of Professional Practice, otherwise known as USPAP.

Within the last few weeks, the IRS released valuation guidelines, a product of the Valuation Policy Council. "The VPC was established in 2001 to assist IRS leadership in setting direction for valuation policy that cuts across functional lines, and in identifying process improvements to improve compliance and better utilize resources." (Click here for a copy of the new guidelines and here for a credential comparison chart.)

As pension funds increase their exposure to private company stock, the valuation issues are profound. The last thing pension fiduciaries should want is to pay someone to render an opinion of value and have the court toss it out for lack of substance. Ditto for regulatory enforcement and arbitration proceedings.

Private Equity, Mutual Funds and Valuation

Wall Street Journal reporter, Eleanor Laise recently wrote that an increasing number of mutual funds are "venturing into the risky world of private-equity investments", "because of the prospects for higher returns." While SEC rules limit assets to no more than fifteen percent in illiquid holdings, Ms. Laise describes potential problems. Higher legal expenses for more complex deals, difficulty of unwinding a position and valuing private investments are far from trivial challenges. She cites one SEC investigation of a mutual fund that allegedly undervalued its private company positions to give the impression that it had not breached the fifteen percent limit. "The SEC also has charged funds with inflating the value of illiquid investments. Mutual-fund managers have an incentive to overestimate the value of these holdings because they collect fees that are calculated as a percentage of total assets in the fund." (See "Mutual Funds Delve Into Private Equity" by Eleanor Laise, Wall Street Journal, August 2, 2006.)

Applying a version of the transitive property from mathematics, the implication is clear. Some pension funds have increasing exposure to private equity investments that do not trade in a ready market.

1. Pension funds allocate money to mutual funds.

2. Mutual funds buy private equity.

3. Pension funds are exposed to private equity as an asset class. (This is in addition to any direct allocation by pension funds to private equity.)

The message is clear. For those pension funds investing more money in private equity (indirectly or directly), the valuation issues are real and cannot be overlooked.

Ode to Valuation

According to Oscar Wilde, a cynic is "a man who knows the price of everything and the value of nothing." In today's world, that could be a label that some pension fiduciaries end up wearing with regret. At a time when pension funds are allocating more and more money to alternative investments, assessing their value and understanding why (and how) the value is likely to change is paramount.

Could hedge fund regulation help to shed light on valuation practices? We may never know.

Just a few weeks ago, the D.C. Circuit Court of Appeals vacated a rule that required hedge fund managers to register, pursuant to the Investment Advisors Act of 1940. Wall Street Journal reporter Kara Scannell describes that, in the aftermath, "10 managers have filed papers to withdraw from registration." Whether this is good or bad depends on a host of factors. However, critics are likely to cite registration shyness as a step backward with respect to better understanding how hedge funds value their positions. While some funds report net asset values on a daily basis, others don't because they trade instruments for which there is no ready market or trading occurs infrequently.

As written before, this creates its own set of problems. (See the June 18, 2006 posting about hedge fund valuation.)

This blog's author, an Accredited Valuation Analyst, CFA charterholder and certified Financial Risk Manager, writes about the topic of hedge fund valuation, and the fiduciary implications, in two new articles.

Write to if you would like a copy of either or both articles:

1. "Hedge Fund Valuation: What Pension Fiduciaries Need to Know" (Journal of Compensation and Benefits, July/August 2006)

2. "a growing necessity for hedge fund valuation" (, June 29-July 5, 2006).

Incidentally, any concerns about transparency and valuation can rightfully be said to apply to private equity and venture capital funds as well. Future blog postings will look at these other types of alternatives.

Do You Really Know the Value of Your Portfolio?

Proper asset valuation is a cornerstone of the investment management process. Without good numbers, it is virtually impossible to make meaningful decisions about asset allocation, portfolio re-balancing, risk control, and manager evaluation. The challenge is especially relevant as endowment, foundation and pension fiduciaries commit billions of dollars to hard-to-value instruments at the same time that regulators are asking tough questions about methodology and process.

Anyone with fiduciary responsibilities needs to have a solid grasp of valuation fundamentals AND understand what happens in the absence of good numbers. The consequences are dire.

Duties extend to assessing external money managers on the basis of their respective valuation processes. (If you get a blank stare, worry.)

1. Do they use independent appraisers or do traders provide their own marks at the same time that they are compensated for reported performance?

2. What valuation models are used?

3. Are they recognized as standard models?

4. Are the models tested?

5. Where does the model input data come from?

6. What systems are used to value individual positions and portfolios?

7. Is model risk well understood and analyzed on a periodic basis?

The list goes on. If a plan sponsor is uncomfortable with evaluating a manager's policies and procedures, hire someone to help. Oversight is a core responsibility and cannot be outsourced away.

There is a lot to say about this subject. I'll be speaking about valuation as part of the (a) Asset Allocation & Risk Management Strategies for Institutional Investors (AARMS) conference in Boston on May 18 (b) National Association of Certified Valuation Analysts (NACVA) annual conference on June 2 and (c) Hedge Funds 101 & 102 conference for FRA, LLC in New York on June 23.

If you are interested in presentations and/or articles on the topic of valuation and model risk, contact me . I'd like to know what keeps you up at night with respect to everything valuation.

Without doubt, there is increasing emphasis on the topic of valuation with respect to both process and outcome.

Valuation is in the news!

"Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources." (Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, U.S. Securities and Exchange Commission)

"According to a survey conducted by the Alternative Investment Management Association (AIMA) in Q4 2004, 20% of the assets held by hedge funds are hard-to-value securities. But many of these hard to value assets are concentrated within specific strategies such as distressed debt, emerging markets and mortgage backed-securities. Investors in a non diversified hedge fund may therefore have up to 100% exposure to hard-to-value securities. A combination of assets with poor market liquidity, leveraged structures and their non-stable correlation with other related assets mean valuations can exhibit considerable volatility within a short period of time." (Hedge Funds: Are their returns plausible? Speech by Dan Waters, Sector Leader Asset Management, Financial Services Authority - UK, March 16, 2006)

"The more unusual the instrument or the greater the degree to which the asset payoffs are determined by a tiny fraction of the economic states the harder is the instrument to value and assess the risk." (The Growth of Derivative Securities speech by Chester S. Spatt, Chief Economist and Director of the Office of Economic Analysis, U.S. Securities and Exchange Commission, December 8, 2005)

"Diligence, prudence and caution should be applied when valuing private companies, and in particular when considering the valuation write-ups of early-stage companies, in the absence of market-based financing events." (Industry Group Releases Clarification Valuation Guidelines Endorsed By ILPA press release, October 2004) - Note: ILPA = Institutional Limited Partners Association

"Preliminary results from a survey on the pricing of hedge fund portfolio assets suggest that considerably more than one-third of managers mark hard-to-price securities in equity and fixed-income portfolios according to their own models, rather than using dealer's prices." (Model-Driven Pricing Common for Illiquid Securities,, February 3, 2004)

"Investment Adviser Defrauded Hedge Funds, SEC Suit Alleges" (Derivatives Litigation Reporter, January 15, 2001)

"Ambiguity clouds valuation methods" (Financial Times, February 25, 2002)