CHAPTER 4 Best Practices in Hedge Fund Valuation. Recent news reports on hedge fund valuation problems have drawn increased attention to the issue of risk tolerance and the role it plays in an investment strategy. | 4 Best Practices in Hedge Fund Valuation Recent news reports on hedge fund valuation problems have drawn increased attention to the issue of risk tolerance and the role it plays in an investment strategy. Valuation issues figure prominently in the Securities and Exchange Commission s recent staff report on hedge funds and in news accounts such as the high-profile departure of a top fund manager at a leading hedge fund group. They also come into play in the market-timing scandals of the mutual fund world since mutual fund valuations created the opportunity for market timers in the first place. Hedge fund investors should heed the results of Capco s recent study on the root causes of hedge fund failures which identified operational risk factors that together seem to account for approximately half of catastrophic cases. Red flags to watch for include misappropriation of funds and fraud misrepresentation unauthorized trading or trading outside of guidelines and resource infrastructure insufficiencies. Issues related to valuation the determination of fair market value for all of the positions that make up a fund underlie many of these operational risk factors. Most of the instances of fraud and misrepresentation involved some form of deception regarding the value of assets held by the fund and many of the resource infrastructure problems we studied eventually man- Stuart Feffer PhD and Christopher Kundro 53 54 HEDGES ON HEDGE FUNDS ifested themselves through some form of inability to accurately price or risk the fund s book. While valuation issues were not specifically identified in our original study as a major category of operational risk on its own various aspects of the valuation problem have played either a primary or a contributing role in more than a third 35 percent of cases of failures that we studied. This information suggests that the industry is not yet taking the steps needed to address problems in the valuation process. In fact we believe that issues .
