Global Hedge Fund

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<ul><li> 1. Global Hedge Fund Valuation and Risk Management Survey Summary Results Insights into current industry practices* </li></ul> <p> 2. ii SUMMARY RESULTS Global Hedge Fund Valuation and Risk Management Survey PricewaterhouseCoopersPricewaterhouseCoopers 3. Background As 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 firms 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. PricewaterhouseCoopers 4. 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 Participants 68 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 firms 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.2 SUMMARY RESULTSGlobal Hedge Fund Valuation and Risk Management SurveyPricewaterhouseCoopers 5. 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 FIGURE 1 the General Counsel. There wasPrimary Responsibility for Risk Management also a profound split regarding the presence of a risk management No single Individual16% General Partner(s) committee yes (31%), thinking 24% about it (30%), and not considering it (39%), which demonstrates the Senior PortfolioManager(s) Board of diversity of views and approaches to16% Directors risk management. 3% General Counsel 0% Independent Given this fragmented pictureRisk Manager regarding the risk management Chief17% Compliance Officer function, it was not surprising that5% Chief Chief the independent risk manager was Financial Officer Operating Officer cited only occasionally in the survey 13%6% Source: PricewaterhouseCoopersresults. 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 Procedures The 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). PricewaterhouseCoopers Global Hedge Fund Valuation and Risk Management Survey SUMMARY RESULTS 3 6. 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.FIGURE 2A substantial section of theSegregation of Fair Value Responsibilitiessurvey probed procedures for Front Office 17% 18%20% Determiningobtaining and validating market Reviewingprices and other input values. WeMiddle Office/ 10% 20%10%Approving Risk Managementasked participants to complete Back Office 20% 39% 31%a matrix consisting of 19product types across securities,Third PartyAdministrator 35% 12% 12%loans, structured products and Pricing Committee/ derivatives, and assumed that the Group 8% 7% 13%three predominant sources were Responsibility not formally assigned2%, 2%, 2%pricing services, prime brokersand quotations provided by other Other 8% 2%12%brokers/counterparties. The pattern Source: PricewaterhouseCoopersof primary and secondarysources per product type containedfew 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 Management A top-level review of the surveyFIGURE 3 data across all the categories of Self-Assessment of Fund Performance in Key Risk Areas governance, organization, risk management, valuation, controls Risk technology 11% 41% 33% 3% Quite weakPeople deployment Neither/Nor and IT is remarkably consistentfor risk management, 25%45% 16%2%with the self-assessment distilled inQuite Strong including price verification Capital allocation25%45% 16%2%Very StrongFigure 3. For example, virtually all survey participants responded that Risk Aggregation 20%42%23% they take care to devote sufficientControls 42%44%5%human and technical resources Valuation 64%20%6% to the fundamental controls over valuation and key reconciliations.Risk Management28%52% 11% However, the self-assessment onRisk Identification 34% 48% 6% methodologies and tools for risk 0 2040 6080100measurement and capital allocation Source: PricewaterhouseCoopers is less positive.4SUMMARY RESULTS Global Hedge Fund Valuation and Risk Management SurveyPricewaterhouseCoopers 7. 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 Figure 4, we found that the internal audit function was not prevalent and Position EstablishedVery LargeLarge Medium All was generally found only at the hedge&gt;$5 bn $5bn$1bn</p>