The calculation of the NAV is a core administrator task because it is the price at which investors buy and sell the shares or units of the fund. It is also the key determinant in reporting fund performance, calculating fees and producing financial reports. The accurate and timely calculation of the NAV, therefore, is vital. It should be noted that while there are multiple fund structures in existence, this section should be viewed in the context of two broad categories – unitised funds and limited partnerships. The mechanics of arriving at the overall net assets in both cases are broadly the same but the process of identifying individual investor valuations differ significantly.
A unitised fund strikes a NAV per share and issues units or shares to the investors. A limited partnership strikes an overall asset value and issues capital interests to the partners. A limited partnership is a form of partnership similar to a traditional partnership, except that it is required to have a general partner (which carries out the day to day management role) and the investors are limited partners.
There are five main steps in the calculation of NAV:
a. trade capture;
b. security valuation;
c. reconciliations;
d. expense calculation; and
e. holding current authorised signatory lists of investors.
a.) Trade Capture
There are two basic types of transactions that an administrator needs to process in the books and records – transactions reflecting investor activity and those reflecting trading activity. As most hedge funds only allow subscriptions and redemptions on a monthly or quarterly basis and tend to be aimed at high net worth or institutional investors, the investors’ activity tends to be less voluminous in comparison with other types of investment funds. Nevertheless, efficient communication is required between the investor dealing teams and the valuation teams to ensure that the valuation system is updated for all investor dealing. Most administrators will have an electronic link between the investor dealing system and the valuation system. In some administration companies, these two functions may be combined.
The level of portfolio trading activity varies between hedge funds, depending on the strategy the fund is pursuing. It is essential that the trading activity of the fund is properly reflected in the valuation systems of the administrator. Most hedge funds and prime brokers have the capability to communicate electronic trade files on a daily basis, detailing all the trades done. The method of communication will differ, depending on the technological sophistication of the manager, but should be electronic. Common methods include SWIFT, FTP or CSV/Excel files that are pushed to the administrator.
Once received, the administrator will process the transaction activity into the books and records. For many asset types, most administrators will have the capability to upload these trade details in an automated fashion. Some asset types, especially various exotic over the counter (“OTC” hereafter) instruments may require manual intervention. To ensure independence of record keeping the administrator should receive all trades from the investment manager and then reconcile all transactions with the relevant prime broker, counterparty or custodian.
b.) Security Valuation
There are two main aspects to the valuation process, price collection and price governance. Price collection covers the mechanical process of collecting prices from agreed sources at agreed times. Price governance covers the process by which the pricing policy, controls, responsibilities, disputes and issues are escalated and resolved. Accepted international sound practice provides for the establishment of a pricing committee and the creation of a pricing policy document. The price collection process should then be documented in the pricing policy document and should provide for pricing sources, cut off times etc., as well as for hierarchies, tolerances, escalation procedures and approvals and manual processing, where relevant.
In all cases, it is important to consider the independence of the pricing process. Wherever possible, but subject in all cases to the fund’s pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund. However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is documented, checked where a secondary source is available and reported to the pricing committee or board, periodically.
Particular consideration should be given to OTC or unquoted instruments, i.e., securities that are not quoted that may be highly illiquid and difficult to value accurately. Considerations include whether counterparty valuations are available and/or appropriate and whether the instruments can be valued by independent vendors. The pricing policy document will provide clarity on the relative priority of sources and tolerances between various sources available. It should also be noted that certain jurisdictions place greater reliance on a counterparty price and any specific jurisdictional requirements need to be reflected in the pricing policy. The pricing policy document should be approved by the board or governing body of the fund on a regular basis (annually or when altered).
It should be noted that while some HFAs have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility.
Particular attention should be given to the governance aspects of the AIMA Guide to Sound Practices for Hedge Fund Valuation, as the observance of their principles should avoid any misunderstanding or lack of clarity around pricing and responsibility. The Guide notes that the area of valuation has been topical and, in some cases, controversial. The role of the HFA has regularly been questioned and many investors and other industry participants have asked: “Is the HFA responsible for valuations?” The Guide notes (and agrees) that both the AIMA and IOSCO documents suggest that it is the governing body that is ultimately responsible for the valuation of assets. In most cases, this is a board of directors or a general partner. Typically, the board will set a pricing policy. The governing body and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.
c.) Reconciliations
In calculating a reliable NAV, a thorough and complete reconciliation of cash and trading positions to the prime broker and other brokers needs to be carried out, ideally, on a traded and settled basis (although a settled and traded reconciliation may not always be possible). All assets held by the fund should be reconciled between the administrator’s records and those of the relevant third parties; this will include assets or collateral held with prime brokers, futures brokers, CFD counterparties, OTC counterparties, custodians or any other group, with all material differences and breaks understood and documented prior to NAV determination. The reconciliations should encompass nominal holdings, value and transactions entered into during the period. The administrator should normally be able to show that the prime broker is reflecting the same trades, holding the same positions and valuing those positions in line with the administrator’s own records and that any break can be explained satisfactorily. Some administrators may offer a three-way reconciliation facility where the books of the administrator, prime broker and fund manager are reconciled periodically.
d.) Expense Calculation
The fund must accrue its expenses accurately and on a timely basis in order to strike an accurate NAV. All known variable and fixed fees including management; administration; custody; performance; audit fees; listing expenses; establishment costs; legal expenses and directors’ fees need to be accrued. Many funds and administrators will agree an expense budget or schedule in advance of fund launch to govern the accrual process. The annual budget should be agreed with the client at the start of each fiscal year. Of these expenses, potentially the most complex fee is the performance fee, which can be calculated using multiple different methods. Discussion of and examples of these methods can be found in appendix 3. It should be noted that some regulators require sight of the performance fee wording and a worked example in order to approve the fund.
e.) NAV Calculation and Reporting
The final step in calculating the NAV of the fund is to calculate the NAV per share of each class in issue. In order to do this, the administrator will typically do the following:
- a. calculate the allocation ratio for each class in issue (N.B., there are a number of different methods for determining allocation ratios. This document does not seek to prescribe any specific method but recommends clarity of approach, possible via the SLA);
- b. allocate the income, expenses, gains and losses for the fund based on the above allocation ratio;
- c.adjust for any share class specific items, such as any hedging gain/loss, new issue profits, differing management and performance fees;
- d.calculate the NAV per share;
- e.agree the NAV with the fund manager; and
In addition, there may be a set of variables which may require additional processing or consideration including:
a. multi class/multi currency processing and hedging, i.e., where classes of shares are issued in a currency other than the base currency. The fund manager may decide to hedge currency exposure. As mentioned above, there are multiple hedging methods and the Guide does not recommend one over another but recommends clarity, likely via the SLA.
- b. some fees may be deferred or reinvested and any such arrangement will require processing;
- c. some hedge funds may offer shares at a discount or premium, arising from fees or charges; and
- d. if the fund is subject to adverse or unusual market conditions, additional market or valuation provisions may be required.
Many hedge funds agree a process up front of launch where the NAV is subject to a review by the fund manager in advance of its release to investors. This review is generally an additional control which assists in ensuring that the records are reconciled with those of the fund manager. It is not intended to replace any control within the HFA and is not intended to absolve the administrator from agreed and documented contractual responsibility.