How much is that security worth? Valuation issues and recommendations for hedge fund advisers post‐registration

Every month, many hedge fund managers grapple with a fundamental conflict of interest. The conflict arises when a fund manager, whose compensation is based on fund performance, is charged with determining the value of the complex or illiquid securities in his portfolio. These securities often do not receive reliable market quotes, and may be difficult to value. Accordingly, a fund manager may be tempted to misprice the hard‐to‐price names in his account in order to bolster fund performance, and increase his own compensation. The situation is somewhat analogous to a chief financial officer calculating his corporation’s profits, all the while knowing that his calculations will affect his bonus. Change, however, is on the horizon. On December 2, 2004, the United States Securities and Exchange Commission (“SEC” or “Commission)” amended the Investment Advisers Act of 1940 (“Advisers Act)” to require certain hedge fund advisers to register with the Commission (the “Rule)”. Under the Rule, registered hedge fund advisers will be required to make their books available to SEC examiners by February 1, 2006, and, in turn, subject their valuation methods and policies to regulatory scrutiny.