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Global Hedge Fund Valuation and Risk Management Survey

Summary ResultsInsights into current industry practices*

Global Hedge Fund Valuation and Risk Management Survey PricewaterhouseCoopers ii SUMMARY RESULTS PricewaterhouseCoopers

BackgroundAs hedge funds continue to become more institutionalized, managers are facing significant challenges on a variety of fronts, including rapid growth of assets, greater regulatory scrutiny, and increased demands from investors. In this environment, forward-thinking hedge fund managers are bolstering their controls around valuation and building infrastructure to support risk management. At the same time, managers must be cognizant to implement these changes in ways that not only safeguard their firm’s reputation but also maintain operational efficiency. Thus, firms are adopting different strategies in tailoring their risk management programs to achieve a good balance between fostering growth and ensuring proper control over investment and operational risks.

During September and October of 2004, PricewaterhouseCoopers conducted its second hedge fund survey focused on valuation and risk management issues impacting hedge fund managers. We posed questions that covered broad risk-related topics, including governance, valuation, investment practices and operational risk management practices. The survey questionnaire was designed to gather detailed information on specific policies, procedures, reporting, tools and organizational structures used by leading hedge fund firms. The findings provide insights into current industry practices and innovations as well as data to enable participants to benchmark their own initiatives to improve controls and operational efficiency.

On the following pages, we provide a high-level summary of the survey data and some trends in near-term risk management priorities for hedge fund managers based on the survey results.

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Global Hedge Fund Valuation and Risk Management Survey PricewaterhouseCoopers 2 SUMMARY RESULTS

Highlights and Conclusions✦ Enhanced risk management practices are clearly a priority for hedge fund managers. In particular,

all firms surveyed indicated that they dedicate significant time and resources to valuation issues.

However, despite increased expectations from regulators and investors, there are still large

differences in the transparency and documentation of valuation policies and procedures, especially

for non-listed and less liquid products.

✦ Survey participants also confirmed the importance of maintaining strong controls over valuation,

reconciliations and market risk. However, the data reveals a wide range in the size and

organization of resources used to support these functions and to maintain segregation of duties.

✦ Similarly, the firms in the survey population are at different stages in developing their basic risk

infrastructure consisting of compliance, internal audit, risk management and IT/data management.

✦ The survey confirmed that the governance structures of hedge funds have not changed

significantly despite the forces of change that have impacted public companies and registered

investment companies.

Profile of Survey Participants68 firms based in the U.S., Europe, Asia, and Canada participated in the survey.

✦ The participating firms reported total assets under management in excess of $225 billion.

✦ The size of each firm’s assets under management ranged from $50 million to over $10 billion.

✦ 88% of the participants are stand-alone management firms; the remaining are part of larger

financial institutions.

✦ The majority of survey participants are registered as investment advisors; 28% are registered as

commodity pool operators.

✦ Most firms describe themselves as multi-strategy with an average of 4.5 investment strategies

employed per firm. Sixteen firms described themselves as single strategy.

✦ The number of employees per firm ranged from less than 10 to more than 500, with an average

number of 9 serving as portfolio managers.

Risk Management Priorities and Oversight Given the widespread discussion about the risk management “function” in the hedge fund industry and the role of the

independent risk manager, we asked participants to evaluate their risk management priorities and how they align their

professional staff to meet those objectives. The objectives at the top of the priority list were not surprising:

✦ Control the volatility of returns within each strategy;

✦ Manage and mitigate operational risks (transaction processing);

✦ Enforce strict compliance (regulatory reporting and personal trading); and

✦ Provide oversight for the valuation process.

Unlike larger, more diversified financial institutions, the survey confirmed that certain risk management practices,

including counterparty risk measurement and formalized approval of new instruments, appear to be lower priorities for

hedge fund managers.

PricewaterhouseCoopers Global Hedge Fund Valuation and Risk Management Survey 3SUMMARY RESULTS

There was a complete absence of consensus regarding the accountability for risk management (see Figure 1).

We received eight different responses to the question, “Who has the primary responsibility for risk management

in our organization?”.

The only option not selected was

the General Counsel. There was

also a profound split regarding the

presence of a risk management

committee – yes (31%), thinking

about it (30%), and not considering

it (39%), which demonstrates the

diversity of views and approaches to

risk management.

Given this fragmented picture

regarding the risk management

function, it was not surprising that

the independent risk manager was

cited only occasionally in the survey

results. Approximately a third (31%)

of respondents currently have an

independent risk manager and more than half (52%) state that they have no plans to create the position in the near-

term. We found that the presence of a risk manager was more correlated to the size of the firm than to the mix of

investment strategies. For example, firms with assets under management exceeding $5 billion were more likely to

have a risk manager. Lastly, backgrounds of the existing risk managers varied, although a clear majority have trading

and/or quantitative experience.

Valuation Policies and ProceduresThe survey results confirmed a broad range of practices employed by the participants in the valuation of positions

and independent price verification. However, despite the looming regulatory impact, only about half of the group

(56%) said that they maintain “detailed” valuation procedures. A much smaller proportion (37%) indicated that they

have instituted a formalized pricing committee and nearly half have no plans to establish one (48%).

On the topic of valuation practices, we made a careful distinction in the survey questions between determining,

reviewing and approving fair values (at the portfolio level as well as at the asset class level). We asked respondents to

identify specific individuals/departments with primary responsibility for each phase of the valuation process (Figure 2).

Primary Responsibility for Risk Management

No single Individual 16%

Senior Portfolio Manager(s)

16%

Chief Compliance Officer

5%Chief

Financial Officer 13%

Chief Operating Officer

6%

Independent Risk Manager

17%

Board of Directors

3%

General Partner(s) 24%

General Counsel 0%

FIGURE 1

Source: PricewaterhouseCoopers


Third party administrators were frequently cited for determining portfolio fair values; whereas, the back office is primarily

responsible for reviewing and approving fair values. Nonetheless, we still found that the front office ultimately approves

the valuations in 20% of the firms surveyed. Other responses included the general partner, the board of directors and

the prime broker.

A substantial section of the

survey probed procedures for

obtaining and validating market

prices and other input values. We

asked participants to complete

a matrix consisting of 19

product types across securities,

loans, structured products and

derivatives, and assumed that the

three predominant sources were

pricing services, prime brokers

and quotations provided by other

brokers/counterparties. The pattern

of “primary” and “secondary”

sources per product type contained

few surprises. However, especially

for less liquid products, the data revealed variations in the use of last trade, bid or mid-market quotes.

We posed several additional questions on definitions and procedures for pricing less liquid positions since the risks

of valuation subjectivity or disputes are more pronounced. The results present an overall impression of diligence,

although a third of the respondents stated that the process does not identify stale prices and more than half stated

that they do not perform “acid” testing to compare a recent transaction price to the prior valuation price. In addition,

in cases where dealers are an important source of price quotes, more than half (54%) stated that they do not

distinguish between dealers who are trading counterparties and those with whom they do not trade.

Organization for Independent Controls and Risk ManagementA top-level review of the survey

data across all the categories of

governance, organization, risk

management, valuation, controls

and IT is remarkably consistent

with the self-assessment distilled in

Figure 3. For example, virtually all

survey participants responded that

they take care to devote sufficient

human and technical resources

to the fundamental controls over

valuation and key reconciliations.

However, the self-assessment on

methodologies and tools for risk

measurement and capital allocation

is less positive.

Segregation of Fair Value ResponsibilitiesFIGURE 2

Other

Responsibility not formally assigned

Pricing Committee/ Group

Third Party Administrator

Back Office

Middle Office/ Risk Management

Front Office

Approving

Reviewing

Determining17%

10%

20%

35%

8%

8% 2%12%

7%

2%, 2%, 2%

13%

12% 12%

39% 31%

10%20%

18% 20%


Self-Assessment of Fund Performance in Key Risk Areas

FIGURE 3

0 20 40 60 80 100

Risk Identification

Risk Management

Valuation

Controls

Risk Aggregation

Capital allocation

People deployment for risk management,

including price verification

Risk technology Quite weak

Neither/Nor

Quite Strong

Very Strong

11% 41% 33% 3%

25% 45% 16% 2%

25% 45% 16%

20% 42% 23%

42% 44% 5%

64% 20% 6%

28% 52% 11%

34% 48% 6%

2%



We then divided the survey population into three groups based on assets under management, and the organizational

profiles appeared in more stable patterns (Figure 4).

In addition to the roles outlined in

Figure 4, we found that the internal

audit function was not prevalent and

was generally found only at the hedge

funds sponsored by large financial

services companies and certain of

the largest independent hedge fund

managers.

Operational Risk ManagementIn our survey, operational risk management refers to the controls and back-up facilities necessary to ensure

accurate, efficient transaction processing, reconciliations and document management. Virtually all respondents stated

that reconciliation processes are rigorous and documented, although the nature and extent of this documentation

varies significantly. Some of these processes are automated, although the degree of automation varies. The survey

results indicated that disaster recovery procedures have been formalized and tested at 53% of the respondents’ firms,

which is much lower than we would have expected.

About 70% of respondents outsource some or all of their back/middle-office functions to an independent third

party fund administrator or custodian (among large firms, this percentage drops to 59%). However, we noted that

more than two-thirds of respondents reported that their prime brokers/custodians and third party administrators

do not have a SAS 70 report or that they were unaware of the existence of a SAS 70 report. As the industry

continues to become more institutionalized, we believe that SAS 70’s reports may become more prevalent, and

we have already seen indications of this trend. While 80% of respondents stated that they monitored the same

back/middle office functions performed by these third parties, this suggests that 20% of respondents are not

mitigating the risk of error due to outsourced functions.

Disclosure to Regulators and InvestorsGiven the frequent discussion in the industry regarding investor and/or regulator demands for increased “transparency”

from hedge fund managers, we asked participants for their assessment of the current environment on reporting and

disclosure. Among the questions we asked were the following:

FIGURE 4

Position Established Very Large>$5 bn

Large$5bn<>$1bn

Medium<$1bn

All%

Compliance Officer 83% 71% 44% 65%

In-house Counsel 78 56 22 49

Independent Risk Manager

37 44 12 31

Head of IT 45 41 32 40



Regulators comprise an important

stakeholder group for hedge fund

managers and are very focused on

valuation issues, as are investors.

However, the results indicated that

few participants expect pressure

for more frequent independent

valuations.

We also asked several questions

at a detailed level regarding

current methods and format for

performance analysis, both for in-

house use and investor reporting. The data varied according to the primary strategies of the manager, although it is

noteworthy that over half of the respondents (54%) perform this analysis on an in-house application. In addition, risk

measures do not appear to be fully integrated into the assessment of portfolio manager performance; only half (50%)

of portfolio managers are measured on a risk-adjusted basis.

What Are the Priorities Going Forward?At the conclusion of the survey, we asked each participant to tell us their “biggest” priority for next year. For the most

part, responses came in four categories:

✦ Improve returns on both an absolute and risk-adjusted basis;

✦ Expand product range and investment strategies;

✦ Improve controls and compliance procedures; and

✦ Strengthen back office and increase automation.

The hedge fund universe continues to be one of the most dynamic sectors in the financial services industry. At the

same time, as hedge funds continue to become more institutionalized, hedge fund managers will need to adapt to

new requirements emanating from investors, regulators and tax authorities.

Our survey data suggests that more firms are implementing robust tools and processes to manage operational

risks and minimize errors in valuation in light of these forces of change. However, managers are implementing these

controls in a variety of ways. We believe that there is no single right way to implement systems for valuation and risk

management, and we are committed to monitoring the continual developments in this industry. The degree to which

there will be a more standardized approach to risk management as the hedge fund industry matures remains unclear.

Also, given the institutionalization and regulatory scrutiny facing the industry, the question remains as to whether

hedge fund firms, which are individualistic by their nature, will continue to take diverse approaches based upon

philosophical differences and the unique nature of investment strategies.

Overview of PricewaterhouseCoopers’ Hedge Fund PracticeAs a recognized leader serving both traditional and alternative investment management strategies,

PricewaterhouseCoopers is committed to helping our clients determine what successful firms will need to do in

order to stay at the forefront in an increasingly competitive and dynamic industry.

We are setting the pace in providing “best practice” and benchmarking information to the leaders in the private

investment funds industry through our seminars, special studies, and thought leadership initiatives. ✦

FIGURE 5

Do you feel increasing pressure to have independent valuations performed more frequently?

Yes 22% No 78%

FIGURE 6

Do you feel increasing pressure from your investors to disclose additional information?

Yes 52% No 48%



Survey Advisory Committee

Mark Casella Greg EckertNew York San Francisco1 646 471 2500 1 415 498 [email protected] [email protected]

Eric Gronningsater Graham PhillipsNew York London1 646 471 5493 44 20 7213 [email protected] [email protected]

Kevin Barry Marie-Anne Kong Yao FahNew York Hong Kong1 646 471 4711 85 2 2289 [email protected] [email protected]


PricewaterhouseCooopers (www.pwc.com) is the world’s largest professional services organization. Drawing on the knowledge and skills of more than 120,000 people in 130 countries, we help our clients solve complex business problems and measurably enhance their ability to build value, manage risk and improve performance in an internet-enabled world.

PricewaterhouseCoopers has exercised professional care and diligence in the collection, processing and reporting of the information in this report. However, the data used is from third party sources, and PricewaterhouseCoopers has not independently verified, validated or audited the data. PricewaterhouseCoopers makes no representations or warranties with respect to the accuracy of the information contained in this report. PricwaterhouseCoopers will not disclose the name of any respondent without their prior approval, and under no circumstances will PricewaterhouseCoopers disclose individual entity data. No part of this publication may be reproduced without prior written consent of PricewaterhouseCoopers.

For further details or additional copies, please contact Pat Mears at PricewaterhouseCoopers on 1 646 471 5309 or e-mail at [email protected]

NY-PD-05-0532/500166 © 2004 PricewaterhouseCoopers. All rights reseved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP.

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