We recently spoke with a senior manager working for the New York office of one of the Big 4 accounting firms. He casually mentioned what appears to be the latest addition to the accountant's lexicon: NAV Divergence.
Under this concept, a hedge fund prepares its NAV under one set of accounting (or more accurately valuation) standards. This is used to cut the "trading NAV", which will be the price used for subscriptions, redemptions and, of course, the payment of the manager's management and incentive fees.
The slight snag is that this "trading NAV" won't be the same as the NAV reported in the financial statements, prepared under US GAAP.
There is actually a long standing precedent for this practice: hedge funds reporting under International Financial Reporting Standards (IFRS) are required to price long securities at the bid and short securities at the ask, to reflect the prices the fund would actually receive in a sale (or equally pay to cover a short.) Some hedge funds disagree with this policy (despite the fact that it seems to be a very appropriate valuation method), and disclose in their offering documents that they will price securities at the mid or at the last sale.
In these circumstances, the financial statements are prepared under IFRS, but a footnote disclosure identifies the difference between the financial statement NAV and the trading NAV.
It now seems that this concept has crossed the Atlantic and may quickly become an issue for US hedge fund investors - or more widely investors in hedge funds which report under US GAAP.
How could this arise? Under the new FAS 157 accounting standard, hedge funds must value their assets at fair value, being the exit price in a situation other than a forced or distressed sale. What happens, however, if a hedge fund disagrees with FAS 157 and determines, for example, that it would be inappropriate to calculate the "fair value" of illiquid side pocket investments and hence decides to hold them at cost for "trading NAV" purposes.
As another example, what happens if a hedge fund holds a large block of a thinly traded small or micro cap stock and wants to take a blockage discount? This is explicitly disallowed by FAS 157: perhaps the hedge fund, however, could specify in its offering materials that it can make use of blockage discounts and hence calculates the 'trading NAV" on that basis.
To us, this seems to be a double edged sword. In some instances, GAAP may well be wrong - the example of blockage discounts is an excellent example. There is a very good argument that a fund should take some discount from open market prices when it holds many days (or months) of trading volume in what is nonetheless an exchange traded equity. The problem, however, is how to calculate that discount: how can investors compare one fund which takes a 5% discount to another which takes a 25% discount in pretty much similar situations. NAV Divergence allows individual funds essentially to set their own accounting policies, each of which must be analyzed and then monitored by investors.
The side pocket example also gives rise to problems. It may make sense for the underlying fund not to value its side pockets - but what about a fund of fund that holds a position in that manager? The fund of funds must record its investments at fair value if it is to calculate an accurate NAV for its own investors: holding valuable side pocket investments at cost will understate the fund of fund's own NAV. We can see all kinds of thorny issues here.
The biggest problem, though, comes when GAAP may well be right, but the hedge fund nonetheless wishes to use an alternate method of valuation. In recent times, plenty of funds may have disagreed with broker quotes or other pricing information available for toxic CDO, CBO and other structured paper. What happens if the fund is able to disregard this information and use its own "fair valuation" model for purposes of the trading NAV?
At the moment, one of the biggest protections against enduring misvaluation of complex securities is that, at least once a year, the fund must provide pricing evidence sufficient to convince the auditors that the financial statements are presented in accordance with GAAP and are, within the range of materiality, true and fair. (This is not to say, mind you, that we are in any way convinced that the auditors have any specific expertise in pricing: the average 23 year old sent out by the Big 4 to audit multi strategy funds is not exactly an expert in pricing complex securities.)
This issue aside, "NAV Divergence" seems to us to be a very slippery slope. If auditors allow different NAV's for side pockets and blockage discounts, the same logic could very well allow funds to use "alternate" valuation methods for hard to value securities. Under this process, a fund could concoct, with impunity, its own pricing policy entirely separate from the GAAP process which underpins the financial statements.
We are not saying that GAAP is always right. However, investors have a right for a level playing field and GAAP, at the moment at least, is the best option we have.
It goes without saying that investors should not accept funds who use NAV Divergence to revalue their books at prices higher than that permitted under GAAP. It also goes without saying that the auditors should not sign off on accounts prepared on this basis as it makes a mockery of the entire audit process.
Let's hope both the investor and auditor community can head this one off at the pass.
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