Often thought to be a source of comfort, we’ve found that an independent hedge fund valuation consultant can actually be a red flag. A third-party valuation is only needed when observable market pricing isn’t available, so right off the bat it signals that the fund is dealing with some off-the-run investments that require additional scrutiny. In my experience, frauds and shady actors will often hire rubber-stamp artists masquerading as valuation agents as a way to give investors a false sense of security with their questionable marks.
Story time. I was doing due diligence on a promising looking niche credit fund for an endowment client when I realized that the marks were blatantly off. One position constituted over 15% of the portfolio (a huge problem by itself) and it was fraught with a high degree of default risk. The fund was marking it as a par position, but even rudimentary analysis of the case showed it was a 50/50 binary outcome at best. (Note: If you can guess the fund I’m talking about I will mail you a prize.)
When I first looked at the fund, it was comforting to see that there was an independent valuation professional providing some adult supervision despite the illiquidity of the positions. We called the valuation consultant to see if we were missing something with our analysis.
What we found was that the valuator was getting paid handsomely to be completely useless.
I had never heard of the valuator before so I asked how many clients they had. The answer I received was a classically vague “fewer than 15”. I was uninspired. Technically I have “fewer than 15” ears, but I decided to continue listening anyway in the hope that something credible would come out of the conversation.
Next I asked: “What information comes from the fund versus what information is independently sourced by you (the agent)”? A: “We read news articles and publications but all the numerical information comes from the fund.”
This answer fascinated me. I had no idea what reading publications had to do with assigning a valuation number to a position, but I pressed forward, more for a kind of dark entertainment value at that point: “Has there ever been a disagreement on valuation between the fund and you?” A: “No”.
I asked if the agent verified the information coming from the fund. A: “to the extent possible.”
When a conversation starts to feel like a Congressional hearing it is clear that nothing useful will come of it. The valuation agent would have valued this risky case at a trillion dollars if the fund asked them to, and I suppose it makes some sort of sense in the most pathetic, unscrupulous way possible. The agent is a small group of people that can collect a fee for literally pushing the “calculate” button on the numbers that the fund provides once a month. They disclaim the results up the wazoo, so it’s less likely that the regulators will target them if (or when) everything comes crashing down.
In this way it is not very different than the “independent’ ratings that S&P & Moody’s provided that fueled the sub-prime crisis. The relationship between issuer and ‘independent’ valuator is a conflict of interest by definition.
Key due-diligence questions. All of the above being said, I don’t want to cast the entire valuation industry into the landfill. I’m sure some independent valuators are legitimate or at least quasi-legitimate. To separate the mud from the mire, here are some key due-diligence questions to ask:
- Does the valuation agent perform any other services for the fund other than valuation?
- What inputs are provided by the fund as part of the valuation process?
- What inputs are sourced independently?
- Who has final say over the valuation of a position if there is a disagreement?
- Has there ever been a disagreement between the valuator and the fund over the valuation of a position?
- How many clients do you have?
- What percentage of your revenue does the fund constitute? (The idea here is that the more clients an agent has, the more they have to lose if their reputation gets shattered by having an Enron-like situation take place under their purview)
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