Last week two separate reports from U.S. Treasury Department committees identified valuation as key to the survival of the hedge fund industry—which now manages over $2 trillion in assets.  “Valuation is ultimately at the core of any investment,” says Principles and Best Practices for Hedge Fund Investors (from the Investors’ Committee to the President’s Working Group on Financial Markets [PWG]):

The increasing complexity and diversity of hedge fund portfolios and the increasing allocation to complex investments has resulted in a significant increase in efforts to formulate tools and processes for accurately valuing them….Auditors and institutional investors are striving currently to improve valuation techniques in the context of hedge funds increasingly investing in less liquid assets and harder to value assets.

Likewise, the Best Practices for the Hedge Fund Industry (from the Asset Managers’ Committee to the PWG) has “raised the bar” by advocating the adoption of “robust valuation procedures,” including those that would segregate responsibilities between portfolio managers and those responsible for valuations.

But can these assets be valued?  The hedge fund industry’s call for self-regulation and disclosure is “an act of desperation,” says a new posting by Peter Schwartz at Pension Risk Matters.  The funds want to avoid government oversight and regain public trust, he contends, by resolving the problem of valuation.  “There is a palpable sense…that all would be well if we only knew how to value structured securities and derivatives.”  But we don’t, he says.  “The credit rating agencies don't.  The banks don't.  The hedge funds don't.  Institutional investors don't.”   Absent rigorous valuation data, methods, and models, he says, “there is no floor to the risk that financial institutions face when they toy with structured securities and derivatives.”

Susan Mangiero, publisher of Pension Risk Matters, disagrees.  While self-regulation and market discipline would be ideal, “I'd like to think that calls for reform are positive reactions to problems rather than ‘desperate’ pre-emptive strikes against statutory mandates,” she says, in a recent posting (April 17, 2008).  Mangiero believes that analysts can, under most circumstances, value complex securities with an appropriate “toolbox,” including: 1) reasonable assumptions; 2) appropriate and tested models; 3) understandable and available data; 4) identification of relevant risk factors that drive value; 5) methodology that reflects relevant economic considerations; 6) disciplined, systematic processes; and 7) common sense.  “Ultimately, value equals price when a willing (and hopefully informed) buyer and seller agree on terms,” Mangiero says.  “Until then, should we surrender to what some deem as villainous fair value accounting rules or roll up our shirtsleeves and get to work, acknowledging that a calculated ‘value’ may differ from an eventual price?”

To hear more from Mangiero, tune into her live teleconference with Rob Slee and Aswath Damodaran on “Measuring Risk,” presented from the upcoming NYSSCPA Business Valuation conference Monday, May 19, 2008.  For more information, click here.