Value in Esoteric Funds

Dermot S. L. Butler tackles some of the common misconceptions about
the role of the fund administrator in the valuation of more esoteric funds.

The following article, which was written by Dermot S L Butler, Chairman of Custom House,
was originally published in the April 1998 edition of International Investment

Key Points

• Illiquid emerging markets present valuation problems.
• Independent valuations of assets advisable.
• Recognised conventions for valuing unlisted securities should be followed.

The public perception of a fund administrator's two most important tasks are the calculation of NAV and the distribution of that information to shareholders. The reputation of an administrator can be made or broken, depending upon how quickly, efficiently and consistently it can complete those tasks.

Unfortunately, it is not always so simple with the more esoteric alternative investments or hedge funds, where the valuation of the underlying assets can prove somewhat problematic.

Delays in verifying a valuation will inevitably lead to delays in the publication of the NAV, which in turn leads to an unhappy investor.

An administrator's ability to provide a good service is largely dependent upon their access to critical information - the raw materials of the valuation process. For example, funds which probably cause the most valuation problems for administrators are fund of funds, as the administrator cannot calculate the NAV of his fund until then receive the NAV of the underlying fund.

Accurate Information

Yet it is not simply a matter of obtaining the information in a timely fashion. It is also important that the administrator can verify that information is accurate. An administrator will be concerned that prices used for the fund valuation are fair and reasonable, and that the valuation procedures comply with the prospectus.

Furthermore, administrators should obtain independent valuations of assets where necessary although this wi11 apply where the assets are valued on the basis of electronic data feeds from recognised markets and exchanges.

In today's market, where we have seen an extraordinary growth in alternative investment products, that growth has been matched by an increasing range of asset classes - the valuation of which is often less than straightforward.

These include, but are not limited to, emerging markets, private equity, distress securities and venture capital funds, and a wide range of funds that invest solely, or partially, in complex derivative instruments.

Emerging Markets Funds

Emerging markets funds, which invest in equities quoted on the stock exchanges of various emerging markets, should be relatively simple to value, provided the administrator has access to relevant stock exchange price feeds.

It must be recognised that many of these stock exchanges are highly inefficient and illiquid. If we accept that a fair valuation is the mid-price between the bid and offer at close of business on valuation day, then the valuation of the fund should present no problem.

To take the following example of a genuine Russian quoted share: is US$17 a reasonable valuation for a share that is quoted at US$11 bid and US$23 offered? Everyone is a winner, except existing shareholders, because new subscribers buy too cheaply and redeemers are paid too much.

There are several recognized conventions for valuing unlisted securities within closed-funds and the selection of valuation method will often be dictated by the character of underlying investments. For example, investments into the shares of mature unlisted companies, with an earnings history, may be valued - either on the basis of current year, or historic earnings - using a multiple reflecting the sector P/E ratios.

The British Venture Capital Association guidelines suggest a 25% discount be applied when using P/E multiples of quoted companies to value unlisted companies.

Real Transactions

For venture capital and development companies which do not yet have an earning stream, a conventional valuation would be on a cost/latest transaction basis. This is where the valuation is based on the original purchase cost, adjusted to reflect any subsequent actual third-party transactions in the shares, which are of material value.

The advantage of this method is that the prices are based on 'real' transactions as opposed to 'theoretical' valuations. This is the most conservative method, and it can result in a dramatic increase in asset values in the event of a sale at a substantially higher level than the original cost price of the investment. Similar problems occur with other illiquid assets, such as quoted shares in which trading is restricted, if the fund has bought shares through a placing with a restriction on selling for 12 months.

The shares are publicly quoted shares with a visible market price - however, when valuing those shares, the administrator obviously cannot assume a value which equates to the market price, as they cannot be sold at that price on the day of the valuation. Should the value therefore include a discount to reflect the illiquidity? If so, how much?

This is a 'policy' question. What is extremely important in this area is that the prospectus must clearly and explicitly describe the chosen valuation method and the associated 'risks'. In fact, many of these pricing problems can be handled by full and complete disclosure in the prospectus, providing the administrator complies with the chosen valuation methods shown therein.