Among the various conflicts of interest that arise in the hedge fund management business, valuation of portfolio assets may be first among equals. The specific conflict is this: portfolio managers often play a fundamental role in the valuation of portfolio assets and, at the same time, the compensation of portfolio managers is often tied directly to the valuation of such assets. Therefore, portfolio managers often have an incentive to assign greater values to portfolio assets. The higher the valuation, the higher the compensation
. As a general rule, greater difficulty in valuing portfolio assets leads to a more acute valuation conflict. For a manager that trades exclusively public equity, the valuation conflict would be muted because the value of portfolio assets can be ascertained relatively easily from objective third-party sources. (Though as the Galleon episode taught, public equity managers have their own issues. See “Is the ‘Mosaic Theory’ a Viable Defense to Insider Trading Charges Against Hedge Fund Managers Post-Galleon?
,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).) However, for a manager that trades harder-to-value assets – derivatives, distressed debt, certain real estate and other “hard” assets, etc. – the valuation conflict looms larger. For assets of uncertain value, a manager can strike its mark within a range of plausible values. Inasmuch as portfolio managers participate in valuation of such assets and are compensated based on valuation, an actual or apparent conflict exists. The most obvious way to resolve this conflict would be to remove portfolio managers from the valuation process altogether. However, the problem with this solution is that, in general, the more difficult to value the asset, the more important the role of portfolio management staff in the valuation process. As a practical matter, if a smart portfolio manager has spent six months or a year analyzing a complex asset, it is unlikely that a valuation firm or administrator will have greater insight into the value of that asset. Yes, that portfolio manager’s compensation may be tied directly to the value of the asset. But, realistically, nobody will know the asset better than the portfolio manager. (This is one of the reasons why hedge fund managers are increasingly “shadowing” functions performed by their administrators. See “When and How Should Hedge Fund Managers Shadow Functions Performed by Their Fund Administrators?
,” Hedge Fund Law Report, Vol. 5, No. 10 (Mar. 8, 2012).) So, how can hedge fund managers deploy the unique expertise of investment professionals to arrive at accurate valuations while at the same time mitigating the incentive those professionals have two shade valuations up? For a growing number of hedge fund managers, the answer to this question is: organize and operate a valuation committee. But that answer raises as many questions as it resolves. For example: What exactly is a valuation committee? Who should be on it? What should it do? When should it meet? And so on. This article addresses these and related questions. In the course of doing so, this article provides hedge fund managers with a basic framework for thinking about whether and how to constitute a valuation committee, how to structure the operations of such a committee and mistakes to avoid in organizing and operating committees.