03/18/2009

Funds of Funds Face New Markdown Rule

With the audit season just around the corner, new accounting rules are requiring funds of funds to consider secondary-market prices when valuing investments in hedge funds that have blocked or gated redemptions.

In the past, the auditor of a fund of funds could value an investment in an underlying hedge fund simply by pegging it to the net asset value, as confirmed by that fund's auditor. But under the Financial Accounting Standards Board's mark-to-market requirements, known as FAS 157, the NAV of an underlying fund will have to be discounted by a fund of funds if the hedge fund manager has invoked gate provisions or suspended redemptions, said Jeffrey Yager, a partner at accounting firm McGladrey & Pullen.

Now, the big question for fund-of-funds auditors is: How much of a discount?

Funds of funds and their auditors will get some guidance from the American Institute of Certified Public Accountants, which is preparing a "technical practice aid" to advise auditors. An early draft of the document says that when valuing funds that have been gated or closed to withdrawals, auditors must consider recent sales of the fund's shares on the secondary market.

Even when shares have sold at a steep discount, however, auditors aren't required to mark down a multi-manager vehicle's investment in that fund by the full discount, and can consider a range of other factors, including the reputation of the hedge fund manager.

Still, the new rule could cause problems for multi-manager funds. Fund-of-funds managers generally would prefer not to mark down the NAV of an underlying fund, especially if there's a chance the markdown later will be reversed. In that situation, a fund-of-funds investor that redeemed after a markdown but before a reversal could argue that it suffered more than its fair share of losses. Conversely, any new investor during that period would enjoy more than its fair share of gains.

The final version of the "technical practice aid" is due out in time for the fund-of-funds' 2008 auditing season, which begins around May. Funds of funds hold off on their year-end audits until the single-manager vehicles have completed theirs.

The accounting institute's guidelines aren't expected to provide objective formulas for valuing gated or locked-up fund shares, Yager said. Auditors will have significant discretion in weighing secondary-market prices against other factors that might support higher valuations. That's because it's often hard to determine whether a secondary-market sale reflects the overall market for a fund's shares or might have been skewed by a particularly distressed seller willing to accept a cut-rate price. More weight would be given to secondary-market transactions when there have been multiple sales with consistent pricing.

In addition to the secondary market, fund-of-funds auditors also can take into consideration a fund manager's pedigree, the performance of the fund over time and the severity of the fund's liquidity problems.

Under FAS 157, hedge funds were required to mark to market beginning Jan. 1, 2008. They don't have to consider secondary-market prices for their own funds' shares when calculating NAV, Yager said. Instead, the NAV of single-manager vehicles is based on the market value of the fund's holdings.

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