Global Hedge Fund

Valuation and Risk Management Survey

Summary Results
Insights into current industry practices*

ii

SUMMARY RESULTS

Global Hedge Fund Valuation and Risk Management Survey

PricewaterhouseCoopers PricewaterhouseCoopers

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

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.

SUMMARY RESULTS

Global Hedge Fund Valuation and Risk Management Survey

PricewaterhouseCoopers

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 the General Counsel. There was also a profound split regarding the presence of a risk management committee yes (31%), thinking about it (30%), and not considering it (39%), which demonstrates the diversity of views and approaches to risk management.

FIGURE 1

Primary Responsibility for Risk Management

No single Individual 16% General Partner(s) 24%

Senior Portfolio Manager(s) 16% General Counsel

Board of Directors 3%

Independent 0% Given this fragmented picture Risk Manager Chief 17% regarding the risk management Compliance Officer function, it was not surprising that 5% Chief Chief the independent risk manager was Financial Officer Operating Officer 13% 6% cited only occasionally in the survey Source: PricewaterhouseCoopers results. 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 nearterm. 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

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. A substantial section of the survey probed procedures for Determining obtaining and validating market 18% 20% Front Office 17% Reviewing prices and other input values. We Middle Office/ 10% Approving 20% 10% Risk Management asked participants to complete a matrix consisting of 19 20% 39% 31% Back Office product types across securities, Third Party 35% 12% 12% loans, structured products and Administrator derivatives, and assumed that the Pricing Committee/ Group 8% 7% 13% three predominant sources were Responsibility not 2%, 2%, 2% pricing services, prime brokers formally assigned and quotations provided by other Other 8% 2%12% brokers/counterparties. The pattern of primary and secondary Source: PricewaterhouseCoopers sources per product type contained few surprises. However, especially for less liquid products, the data revealed variations in the use of last trade, bid or mid-market quotes.
FIGURE 2

Segregation of Fair Value Responsibilities

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

FIGURE 3

Self-Assessment of Fund Performance in Key Risk Areas

Risk technology People deployment for risk management, including price verification Capital allocation Risk Aggregation Controls Valuation Risk Management Risk Identification
Source: PricewaterhouseCoopers

11% 25% 25% 20% 42%

41% 45% 45% 42%

33% 16% 16% 23% 44%

3% 2% 2%

Quite weak Neither/Nor Quite Strong Very Strong

5% 20% 6% 11% 6%

64% 28% 34% 52% 48%

20

40

60

80

100

A top-level review of the survey data across all the categories of governance, organization, risk management, valuation, controls and IT is remarkably consistent with the self-assessment distilled in Figure 3. For example, virtually all survey participants responded that they take care to devote sufficient human and technical resources to the fundamental controls over valuation and key reconciliations. However, the self-assessment on methodologies and tools for risk measurement and capital allocation is less positive.

SUMMARY RESULTS

Global Hedge Fund Valuation and Risk Management Survey

PricewaterhouseCoopers

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, we found that the internal audit function was not prevalent and was generally found only at the hedge funds sponsored by large financial services companies and certain of the largest independent hedge fund managers.

FIGURE 4 Position Established Compliance Ofcer In-house Counsel Independent Risk Manager Head of IT Very Large >$5 bn 83% 78 37 45 Large $5bn<>$1bn 71% 56 44 41 Medium <$1bn 44% 22 12 32 All % 65% 49 31 40

Operational Risk Management

Source: PricewaterhouseCoopers

In our survey, operational risk management refers to the controls and back-up facilities necessary to ensure accurate, efficient transaction processing, reconciliations and document management. Virtually all respondents stated that reconciliation processes are rigorous and documented, although the nature and extent of this documentation varies significantly. Some of these processes are automated, although the degree of automation varies. The survey results indicated that disaster recovery procedures have been formalized and tested at 53% of the respondents firms, which is much lower than we would have expected. About 70% of respondents outsource some or all of their back/middle-office functions to an independent third party fund administrator or custodian (among large firms, this percentage drops to 59%). However, we noted that more than two-thirds of respondents reported that their prime brokers/custodians and third party administrators do not have a SAS 70 report or that they were unaware of the existence of a SAS 70 report. As the industry continues to become more institutionalized, we believe that SAS 70s reports may become more prevalent, and we have already seen indications of this trend. While 80% of respondents stated that they monitored the same back/middle office functions performed by these third parties, this suggests that 20% of respondents are not mitigating the risk of error due to outsourced functions.

Disclosure to Regulators and Investors

Given the frequent discussion in the industry regarding investor and/or regulator demands for increased transparency from hedge fund managers, we asked participants for their assessment of the current environment on reporting and disclosure. Among the questions we asked were the following:

PricewaterhouseCoopers

Global Hedge Fund Valuation and Risk Management Survey

SUMMARY RESULTS

FIGURE 5

Do you feel increasing pressure to have independent valuations performed more frequently? Yes 22%
FIGURE 6

No 78%

Do you feel increasing pressure from your investors to disclose additional information? Yes 52% No 48%

Regulators comprise an important stakeholder group for hedge fund managers and are very focused on valuation issues, as are investors. However, the results indicated that few participants expect pressure for more frequent independent valuations.

We also asked several questions at a detailed level regarding Source: PricewaterhouseCoopers current methods and format for performance analysis, both for inhouse use and investor reporting. The data varied according to the primary strategies of the manager, although it is noteworthy that over half of the respondents (54%) perform this analysis on an in-house application. In addition, risk measures do not appear to be fully integrated into the assessment of portfolio manager performance; only half (50%) of portfolio managers are measured on a risk-adjusted basis.

What Are the Priorities Going Forward?

At the conclusion of the survey, we asked each participant to tell us their biggest priority for next year. For the most part, responses came in four categories: Improve returns on both an absolute and risk-adjusted basis; Expand product range and investment strategies; Improve controls and compliance procedures; and Strengthen back office and increase automation.

The hedge fund universe continues to be one of the most dynamic sectors in the financial services industry. At the same time, as hedge funds continue to become more institutionalized, hedge fund managers will need to adapt to new requirements emanating from investors, regulators and tax authorities. Our survey data suggests that more firms are implementing robust tools and processes to manage operational risks and minimize errors in valuation in light of these forces of change. However, managers are implementing these controls in a variety of ways. We believe that there is no single right way to implement systems for valuation and risk management, and we are committed to monitoring the continual developments in this industry. The degree to which there will be a more standardized approach to risk management as the hedge fund industry matures remains unclear. Also, given the institutionalization and regulatory scrutiny facing the industry, the question remains as to whether hedge fund firms, which are individualistic by their nature, will continue to take diverse approaches based upon philosophical differences and the unique nature of investment strategies.

Overview of PricewaterhouseCoopers Hedge Fund Practice

As a recognized leader serving both traditional and alternative investment management strategies, PricewaterhouseCoopers is committed to helping our clients determine what successful firms will need to do in order to stay at the forefront in an increasingly competitive and dynamic industry. We are setting the pace in providing best practice and benchmarking information to the leaders in the private investment funds industry through our seminars, special studies, and thought leadership initiatives.

SUMMARY RESULTS

Global Hedge Fund Valuation and Risk Management Survey

PricewaterhouseCoopers

Survey Advisory Committee

Mark Casella New York 1 646 471 2500 mark.j.casella@us.pwc.com Eric Gronningsater New York 1 646 471 5493 eric.gronningsater@us.pwc.com Kevin Barry New York 1 646 471 4711 kevin.b.barry@us.pwc.com Greg Eckert San Francisco 1 415 498 7443 gregory.eckert@us.pwc.com Graham Phillips London 44 20 7213 1719 graham.p.phillips@uk.pwc.com Marie-Anne Kong Yao Fah Hong Kong 85 2 2289 2707 marie-anne.kong@hk.pwc.com

PricewaterhouseCoopers

Global Hedge Fund Valuation and Risk Management Survey

SUMMARY RESULTS

PricewaterhouseCoopers

PricewaterhouseCooopers (www.pwc.com) is the worlds largest professional services organization. Drawing on the knowledge and skills of more than 120,000 people in 130 countries, we help our clients solve complex business problems and measurably enhance their ability to build value, manage risk and improve performance in an internetenabled world. PricewaterhouseCoopers has exercised professional care and diligence in the collection, processing and reporting of the information in this report. However, the data used is from third party sources, and PricewaterhouseCoopers has not independently verified, validated or audited the data. PricewaterhouseCoopers makes no representations or warranties with respect to the accuracy of the information contained in this report. PricwaterhouseCoopers will not disclose the name of any respondent without their prior approval, and under no circumstances will PricewaterhouseCoopers disclose individual entity data. No part of this publication may be reproduced without prior written consent of PricewaterhouseCoopers. For further details or additional copies, please contact Pat Mears at PricewaterhouseCoopers on 1 646 471 5309 or e-mail at patricia.b.mears@us.pwc.com NY-PD-05-0532/500166 2004 PricewaterhouseCoopers. All rights reseved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP.