Valuation Disclosures are Paramount in President's Working Group Committee Report

April 23, 2008

On April 15, 2008, the Asset Managers' Committee (the "AMC"), an independent, private-sector committee of the President's Working Group on Financial Markets (the "PWG"), presented to the PWG its report entitled "Best Practices for the Hedge Fund Industry" (the "AMC Report").  The AMC Report is based on the PWG's ten fundamental principles, released in February of 2007, which took the position that market discipline, governed by institutional investors and managers of private investment funds, together with statutory limitations restricting access to private investment funds to wealthy investors, are sufficient means by which industry risks may be mitigated.

The AMC Report offers guidance to hedge fund managers in five main areas: (i) valuation; (ii) disclosure and investor protection; (iii) risk management; (iv) trading and business operations; and (v) compliance, conflicts and business practices.  The AMC Report recognizes that the extent to which its guidance will apply to any particular hedge fund manager will vary depending on the manager's size, strategies, products and other characteristics.

Key among the recommendations offered by the AMC Report is improved disclosure of hard-to-value assets, especially those for which no market price information is available.  In determining the value of any asset, hedge fund managers are faced with an inherent conflict of interest, since valuation has a direct impact on managers' compensation.  In order to minimize these risks, the AMC Report proposes that hedge fund managers segregate certain valuation functions and controls, including the creation of valuation committees to monitor compliance with valuation policies.  The AMC Report specifically recommends that hedge fund managers adopt "robust valuation procedures that call for a segregation of responsibilities, thorough written policies, oversight and other measures for the valuation of assets, including specific focus on hard-to-value assets."

U.S. generally accepted accounting principles ("GAAP") and recently adopted FAS 157, which becomes effective for fiscal years beginning after November 15, 2007, establish a hierarchy of assets tiered on the reliability of available pricing information.  Level 1 assets are those that have observable market prices; Level 2 assets are those that have some observable market price information other than quoted market prices; and Level 3 assets are those that have no observable market information.  FAS 157 will require the percentage of assets at each level to be reported on an annual basis, which will help investors determine how assets are allocated.  The AMC Report encourages fund managers to implement these new standards and then expand upon them -- by providing such information on at least a quarterly basis.  As noted above, the applicability of the guidance offered by the AMC Report will differ on a case-by-case basis.  For example, much of the guidance on valuation will not apply to managers that invest solely in easy-to-value Level 1 assets.

The AMC Report also calls for increased disclosure in other areas, including public company-type disclosures.  It suggests that, in addition to a private placement memorandum, managers provide investors with annual audited (GAAP-compliant) financial statements, periodic performance information, and other investor communications, as well as timely disclosure of significant events.

The AMC Report also provides guidance in risk management.  It recommends the adoption of "a comprehensive framework to measure, monitor, and manage risk consistent with the intended risk profile."  According to the AMC Report, managers should: (i) identify risks to the portfolio; (ii) measure the principal categories of risk (such as liquidity risk, leverage, market risk, counterparty credit risk, and operational risk); (iii) adopt policies and procedures that establish monitoring and measurement criteria; (iv) maintain a regular and rigorous process of risk monitoring; and (v) retain knowledgeable personnel to measure and monitor risk.  Trading practices and business operations are other topics addressed in the AMC Report, emphasizing that managers must continuously assess the effectiveness of their operational and internal controls.

The last area discussed in the AMC Report is compliance, conflicts and business practices.  In order to maintain a commitment to the highest standards of integrity and professionalism, the AMC Report recommends that managers have (i) a written code of ethics; (ii) a written compliance manual, including a process for handling conflicts of interest and a robust training program to educate personnel regarding the manager's policies; and (iii) a compliance function that includes a Chief Compliance Officer, appropriate discipline and sanctions, and an annual review of the compliance framework.

The AMC is composed of representatives from a diverse group of hedge fund managers representing many different investment strategies.  All of the AMC Report authors, hedge fund managers whose firms collectively have more than $140 billion in assets under management, have voluntarily agreed to implement the practices outlined in the AMC Report.

Also on April 15, 2008, the Investors' Committee (the "IC"), another independent, private-sector committee of the PWG, released its report, entitled "Principles and Best Practices for Hedge Fund Investors" (the "IC Report"), which offers guidelines for investors and their fiduciaries for use in determining whether a hedge fund investment is appropriate.  It recommends that investors and their fiduciaries adopt the AMC best practices as a guide to conducting due diligence reviews of hedge funds.

The PWG was formed by Ronald Reagan following the 1987 stock market crash to give recommendations for legislative and private sector solutions for "enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation's financial markets and maintaining investor confidence."  It is composed of the Secretary of the Treasury and the chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.

The AMC Report and the IC Report are available at http://www.amaicmte.org/.

For more information about this e-Alert, please contact Anthony L. Perricone, Chair, Fund Services Group (212.398.5290 or aperricone@sonnenschein.com), or your regular Sonnenschein attorney.

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