CONSULTATION REPORT

PRINCIPLES FOR THE VALUATION OF

HEDGE FUND PORTFOLIOS

TECHNICAL COMMITTEE
OF THE
INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS

MARCH 2007

This paper is for public consultation purposes only. It has not been approved for
any other purpose by the IOSCO Technical Committee or any of its members.

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How to Submit Comments

Comments may be submitted by one of three methods at the latest on 21 June 2007. To
help us process and review your comments more efficiently, please use only one method.

1. E-mail

• Send comments to Ms. Pamela Vulpes: Pamela@iosco.org

• The subject line of your message should indicate “Principles for the Valuation of
Hedge Fund Portfolios”.
• Please do not submit attachments as HTML, GIF, TIFF, PIF, or EXE files.

OR

2. Fax

Send a fax to the attention of Ms. Pamela Vulpes, using the following fax number:
34 (91) 555 93 68.

OR

3. Post

Send your comment letter to:

Ms. Pamela Vulpes

IOSCO General Secretariat
C/ Oquendo 12
28006 Madrid
Spain

Your letter should indicate prominently that it is a public comment on “Principles for the
Valuation of Hedge Fund Portfolios”.

Important: All comments will be made publicly available, unless anonymity is

specifically requested. Comments will be converted to PDF format and then posted on the
IOSCO-website. Personal identifying information will not be edited from submissions.

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 Table of Contents

I. Executive Summary

II. Introduction

III. Drivers of IOSCO’s focus on hedge fund portfolio valuation

A. The increasing importance of hedge funds to global capital markets

B. The complexity of some hedge fund portfolio strategies and their

underlying instruments

C. Central role of financial instrument valuations to hedge funds

D. Conflicts of interest can exacerbate valuation difficulties

E. Examples of how the jurisdiction of organization of a hedge fund causes

differences in hedge fund structures

IV. Scope of application of the principles

V. The Nine Principles

1. Comprehensive, documented policies and procedures should be established for

the valuation of financial instruments held or employed by a hedge fund.

2. The policies should identify the methodologies that will be used for valuing all of
the financial instruments held or employed by the hedge fund.

3. The financial instruments held or employed by hedge funds should be consistently

valued according to the policies and procedures.

4. The policies and procedures should be reviewed periodically to seek to ensure

their continued appropriateness.

5. The Governing Body should seek to ensure that an appropriately high level of
independence is brought to bear in the application of the policies and procedures
and whenever they are reviewed

6. The policies should seek to ensure that an appropriate level of independent review
is undertaken of the individual values that are generated by the policies and
procedures and in particular of any valuation that is influenced by the Manager.

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7. A hedge fund’s policies and procedures should describe the process for handling
and documenting price overrides, including the review of price overrides by an
Independent Party.

8. The Governing Body should conduct initial and periodic due diligence on third
parties that are appointed to perform valuation services.

9. The arrangements in place for the valuation of the hedge fund’s investment
portfolio should be transparent to investors.

VI. Conclusion and Request for Comment

Appendix A. Contributors

Appendix B. Bibliography

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I. Executive Summary

This paper is focused on principles for valuing the investment portfolios of hedge
funds and the challenges that arise when valuing illiquid or complex financial
instruments. The principles are designed to mitigate the structural and operational
conflicts of interest that may arise between the interests of the hedge fund manager and
the interests of the hedge fund. Hedge funds may use significant leverage in their
investment strategies, the impact of which increases the importance of establishing
appropriate valuations of a hedge fund's financial instruments.

While preparing this paper IOSCO has worked closely with a group of industry
experts to gain practical insight from experienced hedge fund investors, hedge fund
managers and firms that provide professional services to hedge funds. We are publishing
this paper to solicit public comments.

The chief aim of the principles is to seek to ensure that the hedge fund’s financial
instruments are appropriately valued and, in particular, that these values are not distorted
to the disadvantage of fund investors. This paper identifies the implementation of
comprehensive policies and procedures for valuation of hedge fund portfolios as a central
principle. It recommends general principles that should guide the governing body and its
manager in developing and implementing such policies and procedures. The paper also
emphasizes that these policies and procedures should be consistently applied. In
addition, it stresses the goals of independent oversight in the establishment and
application of the policies and procedures in order to mitigate the conflicts of interests
that managers face. IOSCO believes that investors will ultimately benefit if hedge funds
follow these principles.

Investors need to be vigilant with respect to any hedge fund that does not exhibit
these principles throughout all aspects of its valuation process. Investors should satisfy
themselves that the management and governance culture promotes the application of the
principles to the extent practicable. While the adoption and compliance with these
principles should benefit investors, the measures themselves will not reduce the need for
investors to conduct appropriate initial and on going due diligence with respect to their
interests in hedge funds.

The principles apply to all hedge fund structures, but IOSCO recognizes that
hedge funds are varied in their size, structures and operations. The governing body of
each hedge fund should take into consideration the nature of the fund's structure and
operations when seeking to apply the principles.

The goal of the principles is to promote, among other things, the consistent
application of a set of valuation policies and procedures in the valuation of a hedge fund
portfolio, and independence in, and transparency of, this valuation process. The
principles are applicable across a wide range of jurisdictions as well as a number of
different hedge fund and service provider structures and in all cases are relevant to the
interests of investors.

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II. Introduction

The IOSCO Technical Committee Standing Committee on Investment

Management (SC5) drafted this paper pursuant to a mandate from the IOSCO Technical
Committee.1 This mandate to SC5 generally requests that it examine the policies and
procedures2 employed by hedge funds in the valuation of their portfolios and, working
closely with industry representatives, develop a single, global set of principles relating to
the valuation of the financial instruments employed or held by hedge funds when
implementing their strategies. Accordingly, SC5 and representatives from the European
and United States hedge fund industry collaborated to produce this paper, which presents
a set of principles for valuing the portfolios of hedge funds. In addition, the IOSCO
Technical Committee Standing Committee on the Regulation of Market Intermediaries
(SC3) was consulted in the production of this paper.

The chief aim of the principles is to seek to ensure that the hedge fund’s financial
instruments are appropriately valued and, in particular, that these values are not distorted
to the disadvantage of fund investors.3 This paper identifies the implementation of
comprehensive policies and procedures for valuation of hedge fund portfolios as a central
principle. It recommends general principles that should guide the 'Governing Body'4 and
its manager (the “Manager”) in developing and implementing such policies and
procedures. The paper also emphasizes that these policies and procedures should be
consistently applied. In addition, it stresses the goals of independent oversight in the
establishment and application of the policies and procedures in order to mitigate the
conflicts of interests that Managers face. IOSCO believes that investors will ultimately
benefit if hedge funds follow these principles.

It is important to understand that this document is not intended to be an academic

review of the relevant literature, a treatise on financial instrument valuation
methodologies or an analysis of the application of accounting or auditing principles to the
valuation of hedge fund portfolios. Instead, the approach has been to create a document

1In its meeting on 7 February 2006, the IOSCO Technical Committee approved the mandate
proposed by SC5 regarding hedge fund portfolio valuation.

2 'Policies' refer to the high level valuation policies and 'procedures' refers to the pricing
procedures which outline the detailed processes by which prices are obtained for valuing the
financial instruments of an investment portfolio.

3 IOSCO recognizes the diversity and complexity of the financial instruments that hedge
funds hold or employ in pursuing their investment strategies. IOSCO utilizes the term
'financial instrument' (instead of 'asset') to focus the paper and principles on the valuation of,
among other things, assets, liabilities, conditional obligations, contracts for differences,
financial contracts and hedges.

4 The Governing Body may also be known as the “Board of Directors” or the “General
Partner,” depending on the jurisdiction of the hedge fund. See section III.E. for further
explanation.

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that builds upon the very substantial analytical and practical work that has been done in
this area by industry associations, academics and market participants.5

This statement of principles is intended to be a practical tool that can be used by

Managers, Governing Bodies, and others involved in the valuation process. In addition,
the principles may be of use to institutional and sophisticated individual investors and
their representatives.

5 See the extensive Bibliography, which SC5 has drawn upon in its work.

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III. Drivers of IOSCO’s Focus on Hedge Fund Portfolio Valuation

A. The increasing importance of hedge funds to global capital markets

The wider context of this work and an important part of the impetus for this paper
is the growth of hedge funds over the past decade, the number of which has grown six
fold over this time period. With investor capital currently in the order of $1.5 trillion, and
the use of leverage applied to that capital when making investments, hedge funds play an
increasingly important role in global capital markets. Hedge funds provide substantial
liquidity in all asset classes throughout the world.

They are, moreover, important sources of investment diversification for

institutional and sophisticated individual investors, and a source of continuous product
change and innovation, potentially enhancing the liquidity and resiliency of financial
systems worldwide.

B. The complexity of certain hedge fund portfolio strategies and their

underlying instruments

The growing influence and importance of hedge funds in global financial markets
brings with it challenges and risks. Important among these is the difficulty in valuing
complex, illiquid financial instruments. The valuation of certain hedge fund portfolios is
inherently difficult because of the nature of the investment strategies that many funds
pursue and the financial instruments that underlie them. In some instances, reliable
market information about precise values for certain types of financial instruments is not
readily available (e.g., distressed securities and over-the-counter structured notes). These
types of instruments can be difficult to value for a variety of reasons, including lack of a
liquid market, the use of valuation models that rely on imperfect data and/or are
dependent on the occurrence of a future event (the probability of which may be difficult
to estimate).

It is worth noting that the valuation of complex, illiquid financial instruments is

by no means an issue unique to hedge funds. Counterparties dealing with hedge funds
and persons investing in private equity and other investment vehicles exposed to complex
or illiquid instruments, among others, will face similar valuation challenges. But the
confluence of structural and other risks around valuations in hedge funds has led IOSCO
to focus this work on hedge funds.

C. Central role of financial instrument valuations to hedge funds.

The valuation of the financial instruments employed or held by hedge funds is

critical to hedge fund investors and potential investors because it affects, among other
things, hedge fund net asset value (“NAV”), financial reporting, performance reporting
and presentations, fees paid to hedge fund service providers (e.g., the Manager),
collateral requirements and risk profiles.

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 In particular, hedge fund investors, which may include registered collective
investment schemes ("CIS") in some IOSCO member jurisdictions (e.g., registered funds
of hedge funds), purchase and redeem fund shares based on the valuations of the funds’
financial instruments. These same investors make decisions to remain invested in the
fund, purchase or sell shares in the fund or re-weight their exposures to other asset classes
/ fund managers based, in part, on the fund’s performance. A hedge fund calculates that
performance based upon changes in its NAV which are driven primarily by changes in
the value of its portfolio. In addition, the Manager often charges the fund an advisory fee
and/or a performance fee based, respectively, on the amount of assets under management
and the capital appreciation of the fund’s NAV.

D. Conflicts of interest can exacerbate valuation difficulties

In addition to the inherent difficulties in valuing certain complex and illiquid

financial instruments that are held or employed by certain hedge funds, the structure and
operation of hedge funds can exacerbate these difficulties because of serious attendant
conflicts of interest. In particular, potential conflicts of interest arise for a Manager that
takes an active role in the valuation process. Managers play key roles in hedge fund
operations, including in helping to value the funds' investment portfolios.

In many cases involving complex or illiquid financial instruments that are hard to
value, the Manager may in practice be the most reliable or indeed the only source of
information about pricing for a particular financial instrument. Further, the Manager may
design and implement the policies and procedures relating to valuation of the fund's
investment portfolio. Although the Governing Body of the hedge fund will be ultimately
responsible for the policies and procedures relating to the valuation of the investment
portfolio, in practice the Manager will exercise a great deal of day-to-day control and
influence over the process.6

Potential conflicts of interest arise, however, for a Manager who takes an active
role in the valuation process. For example the Manager very often receives an advisory
and/or performance fee that is based on the value of fund’s portfolio. In addition, the
Manager has a significant interest in the ongoing success of the fund and the
understandable desire to optimize performance and hence the flow of investment
attracted to the fund and/or retained within it. A period of performance that does not meet
investor expectations could negatively impact the perceived desirability of the fund and
the view taken of it by its investors. The Manager may have both the incentive and the
ability to influence the valuation of the financial instruments in the portfolio in ways that
do not reflect their value.

These conflicts of interests and structural concerns are magnified when the hedge
fund invests in difficult-to-value instruments. Other instruments, such as liquid exchange-

6 In some jurisdictions, as discussed below, the Governing Body may be the Manager.

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traded instruments, or instruments for which valuation inputs are readily observable and
verifiable, present less room for manipulation because the resulting values can easily be
verified through sources that are independent of the Manager (e.g., through a securities
exchange).7 In addition to the conflicts arising from the Manager’s role, the common use
by hedge funds of significant leverage can exacerbate the impact of valuation errors.

Whatever the cause of valuation misstatements, either deliberate or accidental,

improper valuations of hedge fund financial instruments may cause harm to investors, for
instance, as they acquire and dispose of interests in the fund. The conflicts of interest,
outlined above, may affect the proper valuations of the financial instruments of hedge
funds and have prompted IOSCO to explore issues relating to valuation. SC5 is well
positioned to examine issues relating to how hedge funds conduct business vis-à-vis their
investors, given its broad representation from countries in which hedge fund managers
are active.

E. Examples of How the Jurisdiction of Organization of a Hedge Fund

Causes Differences in Hedge Fund Structures

Hedge fund structures vary significantly depending on the laws of the jurisdiction
in which they are organized. Despite the differences, conflicts of interest are inherent in
hedge funds in connection with the valuation of the financial instruments that hedge
funds hold or employ. In particular, conflicts of interest exist between the interests of the
Manager and the interests of the hedge fund and its investors. Examples of the structures
of hedge funds in different jurisdictions illustrate the inherent conflicts of interest that can
arise. As explained below, the identity of the Governing Body will vary depending on
the jurisdiction in which the hedge fund is established.

Ultimate accountability for the proper valuations of a hedge fund’s investment

portfolio rests with the Governing Body of the hedge fund. The identity of the Governing
Body will vary depending on the jurisdiction in which the hedge fund is established. For
example, Managers that are themselves organized and operating in one jurisdiction (e.g.,
the United Kingdom or the United States) often organize hedge funds in another
‘offshore’ jurisdiction (e.g., the Cayman Islands). The laws of the offshore jurisdiction
typically require a hedge fund organized there to have a board of directors that is
independent of the Manager. That board of directors is, however, typically selected by
the Manager. While the board of directors has the responsibility, under the law of the
jurisdiction in which it was organized, to serve as the Governing Body of such a hedge
fund, the Manager may in practice exercise day-to-day control over the hedge fund.

7 The paper does not address certain issues faced by hedge funds that relate indirectly to

portfolio valuation, including but not limited to, timely disclosure of the fund’s NAV,
valuation of the hedge fund portfolio as a whole (as opposed to valuation of particular
financial instruments), valuation of investments in other funds held by a fund of hedge
funds, and compliance with applicable accounting principles. It was determined that these
issues were beyond the scope of the paper and could possibly be addressed in later papers.

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 In other jurisdictions, the hedge fund Manager may serve as the Governing Body
of a hedge fund. For example, many Managers have organized hedge funds under the
laws of a particular state of the United States, typically as a limited partnership or a
limited liability company. Often the Manager (which may have been organized in the
United States or another jurisdiction) or an entity affiliated or associated with the
Manager will serve as the general partner for the limited partnership or the managing
member for the limited liability company. The general partner or managing member also
may direct the investment decisions of the hedge fund or hire third-parties to conduct, or
assist with, the management of the hedge fund’s portfolio. Under applicable US state
law, the general partner of a limited partnership and the managing member of a limited
liability company generally have the responsibility to serve as the Governing Body of a
hedge fund. Therefore, the Manager may itself act as the Governing Body of the fund
because the Manager serves as its general partner or managing member.

Other than the company and limited partnership structures mentioned above,
some offshore hedge funds may be structured in the form of unit trusts. Trustees of
hedge funds are usually appointed to hold and safeguard the fund’s assets and have duties
to act in good faith for the benefit of unit holders and must administer the hedge funds in
accordance with the terms, conditions and powers stated in trust deeds and implied by
law. While technically or legally the Manager may be appointed by the trustee to
manage the funds pursuant to the trust deed, in practice, it is not uncommon that the
trustee is selected by the Manager. The Manager may be empowered under the trust deed
to remove the trustee without unit holders’ consent. Furthermore, in the absence of any
legal or regulatory requirement on the independence of the trustee, the trustee and the
Manager may belong to the same financial group. The Managers may control the
operations of the hedge funds, despite the fact that the trustees are serving as the
Governing Body of the hedge funds to oversee the activities of the Managers.

In some jurisdictions (e.g., France, Germany, Ireland, Spain, Switzerland), a

hedge fund may be organized and operated within the jurisdiction and it is also subject to
registration and regulation under the laws of that jurisdiction (e.g., the laws require the
hedge fund to engage a depositary to hold and safeguard the fund’s portfolio). Those
laws typically impose a governance system on hedge funds that is similar or identical to
the governance systems of regulated CIS. The Governing Body of such a hedge fund
generally would be the board of directors of the asset management company of the hedge
fund. Some of the functions of the Governing Body can also be performed by the
depositary of the hedge fund.

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IV. Scope of Application of the Principles

The principles apply to all hedge fund structures, but IOSCO recognizes that
hedge funds are varied in their size, structures and operations. The Governing Body of
each hedge fund should take into consideration the nature of the fund's structure and
operations when seeking to apply the principles.

The challenges of valuing complex and illiquid instruments arise in many hedge
funds, wherever located, and however structured. Moreover, conflicts of interest of one
type or another arise in the case of all hedge funds, wherever located and however
structured. The principles set forth in this paper are designed to assist hedge funds in
valuing their portfolios so as to reduce the structural and operational conflicts of interest
that may arise and help ensure that valuations are robust and appropriate.

In implementing and operating the principles, IOSCO considers that it is helpful

for Governing Bodies, Managers and those involved in valuation to keep in mind the
important underlying concept of independence. Independence in the valuation of the
financial instruments that are held and employed by hedge funds may be evidenced in a
number of ways, as outlined in the discussion below.

Listed below in italics are nine principles for valuing the financial instruments
that are held or employed by hedge funds. Each principle is followed by explanatory
text.

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V. The Nine Principles

1. Comprehensive, documented policies and procedures should be established for

the valuation of financial instruments held or employed by a hedge fund.

The Governing Body should ensure that written policies and procedures are
established which seek to ensure integrity in the valuation process. In practice, the
Manager may be heavily involved in formulating the policies and procedures on behalf of
the Governing Body. The documented policies and procedures will generally set out the
obligations, roles and responsibilities of the various parties and personnel who are
involved in the valuation process. Given that hedge funds have varied structures and
investment strategies, it is important that appropriate policies and procedures are adopted
in each case.

In establishing policies and procedures, the following non-exhaustive list of

points should be addressed: (i) the competence and independence of personnel who are
responsible for valuing the financial instruments, (ii) the specific investment strategies of
the hedge fund and the financial instruments in the investment portfolio, (iii) the controls
over the selection of valuation inputs, sources and methodologies, (iv) the escalation
procedures for resolving differences in values for financial instruments, (v) the valuation
adjustments (if any) related to the size and liquidity of positions, as appropriate, and (vi)
the appropriate time for closing the books for valuation purposes.

2. The policies should identify the methodologies that will be used for valuing all of
the financial instruments held or employed by the hedge fund.

The policies should set out the methodology to be used for each financial
instrument, which include inputs, models and the selection criteria for pricing and market
data sources. It should specify a framework applicable to both current and, where
practicable, future instrument types in which the hedge fund anticipates investing. For
example, the policies should consider what constitutes an acceptable input,
acknowledging that prices should, whenever possible and appropriate, be obtained from
independent sources. As another example, the policies should address cut-off times when
securities are traded in multiple time zones. In any case, there should be a validation
procedure which governs how a single source or non-independent source may be
justified.

The selection of a methodology to value a particular class of financial instruments

directly affects the resulting pricing of an instrument. In selecting the methodology to
value a financial instrument, account should be taken of the sensitivity of varying
methodologies and how specific strategies may determine the relative value of the
financial instruments in the portfolio. The selection process for a particular methodology
should include an assessment of the different relevant methodologies that are available by
appropriately qualified and experienced parties.

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 If a model is used to value a financial instrument, the model and the variable
inputs should be explained and justified in the valuation policy and procedures.
Underlying data and assumptions used in model-based valuations, in addition to the
rationale for using them, should be appropriately documented (preferably
contemporaneously) to facilitate later review. The policy should specify how the model
and its inputs will be checked for appropriateness.

The policies and procedures should address how the valuation of financial
instruments will be undertaken in case an instrument falls outside of the scope of the
existing valuation policy. For instance, the person that values a newly purchased
financial instrument by a hedge fund should document his or her reasons for using a
particular valuation method. In addition, an independent party (as defined below) could
provide an ex-post review of the valuation method concurrent with the amendment of the
existing policies to account for the ‘new’ financial instruments.

3. The financial instruments held or employed by hedge funds should be consistently

valued according to the policies and procedures.

The persons who value the financial instruments should apply the policies and
procedures and the designated methodologies consistently. The Governing Body and the
Manager should make sure that consistent application of the policies occurs. The policies
and procedures should outline a mechanism which enables the monitoring of whether the
party or person who has responsibility for valuing financial instruments is following the
policies and procedures. The principle of consistency requires that the policies and
procedures, and the designated methodologies, should generally be:

• applied to all financial instruments within a fund that share similar economic
characteristics;
• applied across all hedge funds that have the same Manager, taking time zone and
trading strategies into account; and
• applied over time unless circumstances arise that suggest that the policy requires
updating; in particular, valuation sources and rules should remain consistent over
time.

4. The policies and procedures should be reviewed periodically to seek to ensure

their continued appropriateness.

The desirability of consistent application over time of the policies and procedures
should be balanced with a periodic review of, and appropriate changes to, the policies and
procedures. The Governing Body and/or the Manager should review the appropriateness
of the policies and procedures in light of the nature of the fund’s investment strategies.
The policies should allow for a review and change of methodologies periodically and
after any event that calls into question the validity or utility of the policies and procedures
(e.g., when market events call into question whether a particular pricing methodology
continues to be appropriate). This recognizes that hedge funds operate within a dynamic
environment in which the trading parameters, strategies and products change over time.

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The policies should outline how a change to the valuation policy, including a
methodology, can be effected and in what circumstances this is appropriate.
Recommendations for changes to the policies should be made to the Governing Body
which should review and approve any changes.

The policies and procedures should be reviewed prior to the fund’s engagement
with a new investment strategy or financial instrument to determine whether the existing
policies and procedures sufficiently address the new types of strategies or investments.

5. The Governing Body should seek to ensure that an appropriately high level of
independence is brought to bear in the application of the policies and procedures
and whenever they are reviewed.

Independence should be embedded into the processes adopted for valuation and
within any party appointed to undertake valuation responsibilities. The Governing Body
should ensure that the parties involved in the valuation process have an appropriate level
of experience, competence and that an appropriate degree of independence exists within
the valuation process (as explained in greater detail below)8

The effectiveness of the valuation process is correlated with the level of the
involved parties’ experience and understanding of the valuation of the financial
instruments in which the hedge fund invests, and the investment strategies adopted. It is
therefore important that the Governing Body manage the trade off between achieving the
benefit of independence yet ensuring appropriate experience and competence is present in
the parties involved and is brought to bear in the valuation process.

Independence may be achieved by using inter alia (i) third-party pricing services,
(ii) independent reporting lines within the Manager, and/or (iii) a valuation committee.

In particular, one or more of the following approaches, in no particular order of

preference, will increase independence in hedge fund valuation:

a. Third-party pricing services. The appointment of a qualified,

independent third party to be involved in the valuation process for the financial

8 The Governing Body may not be independent of the Manager, in the case of hedge funds
that are organized in certain jurisdictions, such as the United States. The Governing Body
nevertheless has fiduciary responsibilities to the hedge fund and should seek to increase
independence in the valuation process, to the extent practicable. In addition, non-
independent entities of the hedge fund (e.g., the Manager) may be involved in providing
valuations for the hedge fund.

15
 instruments of a hedge fund can help to mitigate conflicts of interest in valuation.
The Governing Body could engage a party (e.g., Administrator or Valuation
Agent) that would provide an appropriate degree of independence and mitigate the
influence of the Manager in valuation. The involvement of external parties could
balance the influence of the Manager and its personnel. The role of the third party
may vary from involvement in the approval and review of the policies and
procedures, and/or in the determination of particular valuations.

b. Independent Reporting Lines within the Manager. If the structure of

the hedge fund, or the nature of its investment strategies, demands it (e.g., in the
absence of readily available prices/inputs from independent sources), the Manager
may be actively involved in the valuation of the fund’s financial instruments.
Reporting lines should be established within the Manager to ensure that the
persons who are responsible for making investment decisions (often referred to as
front-office personnel) will be accountable to unrelated Manager personnel for the
valuations that the front-office personnel provide. The person(s) within the
Manager that oversees the front-office personnel in this instance brings a degree
of independence for purposes of valuation.

c. Valuation Committee. The Governing Body could oversee the

establishment of a valuation committee to review the valuation policy and
procedures and/or oversee the application of those policies and procedures on a
regular basis. Such a committee should be comprised of persons who have the
authority and experience to provide meaningful oversight of the valuation process.
The members of the valuation committee should be determined by their
knowledge of the degree and nature of controls that are required by the Governing
Body and the hedge fund’s range of financial instruments and investment
strategies.

The independence of a valuation committee can be strengthened by the

appointment of persons who are not connected to the Manager to represent the
interests of investors (such as a member of the Governing Body, in the case of
offshore hedge funds of a U.K. Manager). The committee may choose to consult
with external experts to help with assessing the reasonableness of valuations of
financial instruments that are difficult to value.

In addressing the need for greater independence in valuation for a particular hedge
fund, the Governing Body should consider the relationship of the parties involved in
valuation with other parties involved in the fund’s operations (e.g., the relationship
between the Manager and any Valuation Agent, or the relationship between the personnel
of a Manager who are responsible for valuation and the front-office personnel who make
the investment decisions), the investment strategy of the fund, the extent of readily
available independent prices/inputs for the investment portfolio and the relevant
experience of the party.

Depending on the particular facts and circumstances (relating to the independence

of the relationship between the Manager and its controlling persons), the board of
directors, general partner, valuation committee or third-party Valuation Agent may be
termed an ‘independent party’ for the purposes of valuation. In the case of hedge funds
that rely on independent reporting lines within a Manager to achieve greater
16
independence in valuation, the person(s) within the Manager that oversees the
front-office personnel in the valuation process could be viewed as an independent party
for the purposes of valuation.

6. The policies should seek to ensure that an appropriate level of independent review
is undertaken of the individual values that are generated by the policies and
procedures and, in particular, of any valuation that is influenced by the Manager.

There should be a review process for individual values generated by the policies
and procedures to ensure their appropriateness. Some specific cases in which the risk of
inappropriate pricing may be greater include:

• prices only available from a single counterparty or broker source;

• illiquidity of exchange prices (e.g., listed derivative products, small
cap stocks);
• valuations influenced by the Manager;
• valuations influenced by parties related to the Manager; and
• valuations influenced by other entities that may have a financial interest in
the fund's performance.

It is recognized that the experience and expertise to value complex and illiquid
instruments in an appropriate manner may rest with a limited number of individuals. In
these situations it may be more difficult or not possible to find an independent pricing
service or source with sufficient expertise to provide pricing for such financial
instruments. For example, the counterparty of a derivative contract is often utilized as the
primary (or only) pricing provider for the instrument. Sourcing prices from such a
provider may, however, present a conflict of interest for the price provider, as the price it
furnishes may be influenced by its expectation of trading the instrument with the client or
in the market place. The furnished price could lead to an overstated or understated price
because the counterparty may hold either a position which is in the same or opposite
direction to that of the hedge fund.

The policies and procedures should include sufficient controls to ensure that an
appropriate degree of objectivity is brought to bear in considering values that are obtained
from external sources, such as counterparties and potential counterparties. That
objectivity may be achieved through involvement of the independent party. Effective
practice would involve sufficient and appropriate checks on the reasonableness of such
values and reviewing material exceptions (that is, material deviations from values that
have been previously provided). Such checks could include, for example:

• verifying prices by a comparison amongst counterparty-sourced pricings

and over time;
• examination and documentation of exceptions;
• validating prices by comparison of realized prices against recent carrying
values;
• consideration of the reputation, consistency and quality of the pricing
source;

17
 • a comparison with prices generated by a third party (e.g. comparison of
prices generated by a Manager versus those generated by a valuation
agent);
• highlighting and researching any differences that appear unusual and/or
that vary by valuation threshold established for the type of financial
instrument;
• testing for stale prices or implied parameters (e.g., spreads, volatilities);
• a comparison against the prices of any related financial instruments and /
or their hedges; and
• review of the inputs used in model based pricing.

The selection of external pricing/input sources or providers by the Manager

should be reviewed by the independent party. The role of the independent party is to
bring objectivity to the pricing process, to promote greater transparency of pricing
sources where the source is non-independent, arbitrate and resolve disputes on the
determination of an appropriate price and to balance any undue influence of the Manager.
The Manager often has the greatest insight when making comparisons among potential
pricing sources and therefore may be instrumental in proposing a pricing source for the
financial instruments. An independent party should be informed, in a timely manner, of
the reasons for selecting any pricing source and/or input over any other and ensure that all
methodologies, including sources and/or inputs, or changes thereto, are selected with
impartiality and on merit alone. The Manager should contemporaneously document the
rationale for selecting any pricing source and/or input.

7. A hedge fund’s policies and procedures should describe the process for handling
and documenting price overrides, including the review of price overrides by an
Independent Party.

A price override (or deviation) is the rejection of a value for a financial instrument
that was determined according to the policies and procedures of the hedge fund. In
certain exceptional circumstances, the value of a financial instrument determined in
accordance with the fund’s policies and procedures may not be appropriate. The
Manager, Valuation Agent or other party involved in the pricing process may therefore
propose an override to that value and use another.

In all cases, the procedures for price overrides should encompass a requirement
for reporting to, and an appropriate level of review by, the independent party as soon as
practicable. The detail of, and reasons for, each override should be documented
contemporaneously with the override including any evidence supporting the case for the
proposed override. A price override should not be used until the review has taken place.
Such a report, prepared regularly, could be one of the mechanisms by which the
independent party satisfies itself that consistent application of the policies and procedures
is taking place.

Where overrides have occurred, any other financial instruments in the fund that
are related to the overridden instrument should be reviewed to assess whether any
additional adjustments are also required. The repeated use of overrides for a particular
financial instrument should trigger, under the policies, a review of the policy and/or
procedures.

18
8. The Governing Body should conduct initial and periodic due diligence on third
parties that are appointed to perform valuation services.

The Governing Body typically appoints third parties to perform valuation services
for the hedge fund. Such third parties could include, among others, a Manager, an
administrator or valuation agent. When the Governing Body decides to appoint a
third-party, suitable due diligence should be conducted to determine that the service
provider has and maintains appropriate systems and controls and a sufficient complement
of personnel with an appropriate level of knowledge, experience and training
commensurate with the hedge fund’s valuation needs. The Governing Body should
consider applying, where appropriate, Principles 1 and 2 from section III of IOSCO
'Principles on outsourcing'.9

9. The arrangements in place for the valuation of the hedge fund’s investment
portfolio should be transparent to investors.

Relevant information that should be made available to investors upon request

includes, but is not necessarily limited to:

• The valuation policies of a hedge fund and material changes to the policies
(accompanied by, as appropriate, an explanation and quantification of the effect of
such a change);

• A description of the roles, skills and experience of all of the parties that are
involved in the valuation of the financial instruments of the hedge fund;

• A description of the extent to which valuations have been provided by or

influenced by the Manager;

• A description of any material conflicts of interest associated with the parties who
are valuing the fund’s financial instruments;

• The hedge fund’s responses to investor questionnaires or any other requests for
information about valuation issues; and

• Information about the nature and degree of any contracted pricing services.

9"Principles on outsourcing of financial services for market intermediaries".

www.iosco.org/library/pubdocs/pdf/IOSCOPD187.pdf
19
VI. Conclusion and Request for Comment

The goal of the principles is to promote, among other things, the consistent
application of a set of valuation policies and procedures in the valuation of a hedge fund
portfolio, and independence in, and transparency of, this valuation process. The
principles are applicable across a wide range of jurisdictions as well as a number of
different hedge fund and service provider structures and in all cases are relevant to the
interests of investors.

Investors need to be vigilant with respect to any hedge fund that does not exhibit
these principles throughout all aspects of its valuation process. Investors should satisfy
themselves that the management and governance culture promotes the application of the
principles to the extent practicable. While the adoption and compliance with these
principles should benefit investors, the measures themselves will not reduce the need for
investors to conduct appropriate initial and ongoing due diligence with respect to their
interests in hedge funds.

IOSCO seeks comments from the public, including investors and Managers,
governing bodies, hedge fund counterparties and service providers on all aspects of this
paper. IOSCO specifically seeks comments by 21 June 2007 on:

1. What is your opinion of each of the principles?

2. Has IOSCO correctly identified the challenges inherent in the valuation of

hedge fund financial instruments?

3. Has IOSCO correctly addressed those challenges?

4. In what ways could the principles be amended to further benefit investors in

hedge funds?

5. Are there material obstacles to the implementation of the principles within

hedge funds?

6. Are there additional principles that would benefit hedge fund investors?

7. What, if any, additional specific measures should be incorporated within the

policies or procedures to enhance the principles?

SC5 will carefully consider all comments and will revise the paper as appropriate.
A final paper is expected to be published by IOSCO in the Autumn of 2007.

20
Appendix A. Contributors to the Report

IOSCO Technical Committee Standing Committee on

Investment Management (SC5)

Industry – Regulator Working Group

Chair
Dan Waters
Director
FSA

Segun Aganga Olwyn Alexander Tim Barker

Managing Director Partner Executive Vice President
Goldman Sachs International PricewaterhouseCoopers Markit Group Limited

Ronan Daly Frank Dornseifer Mark Everitt

President Investment Management Department Director of Risk Manage-
BISYS Hedge Fund Services Limited BaFin ment
Quellos Capital Manage-
ment, LP

Alison M. Fuller Marta Garcés Mike Greenstein

Assistant Chief Counsel Senior Economist Partner
SEC CNMV PricewaterhouseCoopers

David W. Grim Douglas Hull Alexa C. Lam

Branch Chief Capital Markets Sector Board Member &
SEC FSA Executive Director
SFC, Hong Kong

David K. A. Mordecai Martin Pabari Peter Rose

President Chief Financial Officer Co-Director of Research
Risk Economics Limited, Inc. CQS (UK) LLP Ivy Asset Management

Douglas Scheidt Dr. Christian Schindler Michael E. Singer

Associate Director and Chief Counsel International Affairs/Policy Co-President
SEC BaFin Ivy Asset Management

Thomas Smith Cyrille Stevant John L. Sullivan

Deputy Director Secretary of SC5 of IOSCO Senior Counsel
CFTC Senior Executive Officer SEC
AMF

Jorge Vergara
Senior Economist
CNMV

Alternates
William Douglas Simon Gregory Ken Marlin
Executive Director Head of EMEA & Asia compliance Chief Compliance Officer
Goldman Sachs International Ivy Asset Management Ivy Asset Management

Michael Nachmani Karen Tyrrell

Vice President Managing Director - Europe
Goldman Sachs, New York BISYS Hedge Fund Services Limited

21
Appendix B. Bibliography

Chronological order

Risk standards for institutional investment managers and institutional investors, Risk
Standards Working Group, RWSG (1996)
www.cmra.com/risk.pdf

Regulatory approaches to the valuation and pricing of collective investment schemes,

IOSCO, (May 1999)
www.iosco.org/library/pubdocs/pdf/IOSCOPD91.pdf

Delegation of functions, IOSCO (2000)

www.iosco.org/library/pubdocs/pdf/IOSCOPD113.pdf

Hedge Fund disclosure for institutional investors, International Association of Financial

Engineers, IAFE (July 2001)
www.iafe.org/upload/IRC%20Consensus%20Document%20July%2027,%202001.pdf

Enhancing public confidence in financial reporting, Group of Thirty, CMRA (2003).

www.group30.org/pubs.php?page=pubs2003.html

SEC roundtable discussions relating to hedge funds (May 2003)

http://www.sec.gov/spotlight/hedgefunds.htm

Valuation issues and operational risk in hedge funds, Capco, (Dec 2003)
www.capco.com/WorkArea/showcontent.aspx?id=2446

The management of hedge funds' operational risks, Jean-Rene Giraud, Edhec (April
2004)
www.edhecrisk.com/edito/RISKArticleEdito109663559892051438/attachments/Managin
g%20Operational%20Risks%20-%20Working%20Paper.pdf

Valuation concepts for investment companies and financial institutions and their
stakeholders, International Association of Financial Engineers, IAFE (June 2004)
www.iafe.org/upload/IAFEValuationConcepts0604.pdf

SEC v. Beacon Hill Asset Management LLC (June 2004)

www.sec.gov/litigation/complaints/comp18745.pdf
www.sec.gov/divisions/enforce/claims/beaconhillasset.htm

US private equity valuation guidelines, Private Equity Industry Guidelines Group,

PEIGG (Sep2004)
www.ilpa.info/PDF/PEIGG_PE_Valuation_Guidelines_September_04.pdf

Asset Manager Code of Professional conduct, CFA Centre for financial market integrity
(Nov 2004)
www.cfapubs.org/doi/pdf/10.2469/ccb.v2004.n4.4008

22
International private equity and venture capital valuation guidelines, (Jan 2005),
www.privateequityvaluation.com

"Principles on outsourcing of financial services for market intermediaries". IOSCO (Feb

2005)
www.iosco.org/library/pubdocs/pdf/IOSCOPD187.pdf

Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry, Alternative
Investment Management Association, (AIMA) (April 2005)
www.citco.com/funds/library/AIMAAsset.pdf

CFTC roundtable discussions relating to the commodity pool industry and operators
(April 2005)
http://www.mfainfo.org/images/PDF/CPO_Roundtable_Transcript.pdf

Discussion Paper 05/4, Hedge Funds: A discussion of risk and regulatory engagement,
FSA (June 2005)
www.fsa.gov.uk/pubs/discussion/dp05_04.pdf

Credit Derivatives: CDOs and Structured Credit Products, Satyajit Das, John Wiley &
Sons, (2005 3rd edition) ISBN 0470-821590, 850 pages

Mitigating hedge funds' operational risks, Benefits and limitations of managed account
platforms, EDHEC (June 2005)
www.edhec-risk.com/features/RISKReview.2005-12-
06.1517/attachments/Mitigating%20Hedge%20Funds%20Operational%20Risks.pdf

Toward greater financial stability: A private sector perspective, Counterparty Risk

Management Group II, "CRMPG II"(July 2005)
Valuations, Guiding Principle 33, pages 132-133
Section V: Complex financial products – Risk management, risk distribution and
transparency
Appendix D: Risk management challenges facing institutional fiduciaries
www.crmpolicygroup.org

Sound practice for hedge fund managers, Managed Funds Association, MFA (Aug 2005)
www.mfainfo.org

The international convergence of capital management and capital standards. BIS (Nov
2005)
Valuation of the trading book, paragraphs 684-701, valuation paragraph 778(ii) of Basel
II,
www.bis.org/publ/bcbs118.pdf

EDHEC European alternative diversification practices survey (Dec 2005)

www.edhec-risk.com/features/RISKArticle.2006-02-
20.5819/attachments/Edhec%20EADP%20Survey.pdf

Warren Buffett, Finance and financial products, pages 10-11, Berkshire Hathaway
Annual Report (Mar 2006)
23
www.berkshirehathaway.com/letters/2005ltr.pdf

Testimony of James Chanos to US Senate sub committee hearing on the hedge fund
industry, pages 14-18 Valuation; Performance reporting (May 2006)
http://banking.senate.gov/_files/ACF82BA.pdf

Fair value measurements, Financial Accounting Standards Board, FAS157 (Sept 2006)
www.fasb.org/st/
www.fasb.org/pdf/fas157.pdf

Alternative investments – audit considerations, AICPA practice aid

www.aicpa.org/download/members/div/auditstd/Alternative_Investments_Practice_Aid.p
df
Interpretation guidance, Auditing investments in securities where a readily determinable
fair value does not exist, AU Section 9332
www.aicpa.org/download/auditstd/announce/Audit_Interpretations_Auditing_Fair_Value
.pdf

The Regulatory Environment For Hedge Funds, A Survey And Comparison - Final
Report, Report of the Technical Committee of IOSCO (Nov 2006)
www.iosco.org/library/pubdocs/pdf/IOSCOPD226.pdf

Quantification of Hedge Fund Default Risk, EDHEC, (Jan 2007)

http://www.edhec-risk.com/features/RISKArticle.2007-01-24.1044?newsletter=yes

24