Risk Without Reward

And will the auditors identify themselves, please....

It is not a new issue for due diligence practitioners to grapple with the challenges of getting the auditors to confirm that they are, in fact, actually the auditor of a hedge fund.

The issue for the audit firms is, surprise surprise, liability.  The auditors are desperate to navigate around the concept of privity, which basically states that only the parties to a contract have rights and obligations - and can then sue if things turn south.

As such, the auditors sign an engagement letter and contract with the fund as a distinct, individual legal entity.  There is no direct contract with the shareholders, collective or individual.

The legal problem arises if an audit firm confirms their relationship with an individual investor - especially (gasp!) if that investor is conducting pre investment due diligence and is not yet actually a shareholder of the fund (we will discuss this issue on the assumption that we are looking at an offshore fund structured as a corporation).  Any direct communication with the investor could, it is argued, create a contractual relationship which could then be enforced through a court of law.

As such, what should be a basic, utterly reasonable due diligence step - to confirm a key service provider relationship - can turn out to be slightly more painful than root canal surgery.

In fairness, most auditors outside the Big 4 are eminently reasonable - you can call the partner and get an immediate, verbal confirmation that the auditor has been engaged.  Job done in 2 minutes - excellent - and our ongoing appreciation for each audit firm that does adopt this approach.

However, the fun starts with the Big 4.  Most auditors will allow investors to confirm with the auditor that that they are, in fact, the auditor in question - upon signature of a quite laughable disclaimer letter under which the investor signs away all rights and obligations. 

However, the auditors have yet to agree a standard process and procedures differ by firm, and then by office within each firm.  We recently encountered a situation where a specific office of a Big 4 auditor will only provide a letter to the fund's board of directors (who are, needless to say, members of the Cayman "usual suspect" group serving on hundreds of individual boards - as an aside, our new rule is that if a director cannot, from memory, name all the entities they are a director of...then they are not fit to be a director).

This letter is then to be furnished to investors by the manager.  However, it goes without saying that, unless investors contact the auditor, they cannot confirm that the letter given to them by the manager is genuine!  It is patently ridiculous for an audit firm to expect investors to rely on this type of confirmation especially as (we hope!) an auditor would not rely on a PB statement or other confirmation given to them by the manager during the GAAP audit.  Yet investors are meant to be happy with this type of confirmation when they are about to invest tens of millions of dollars into a hedge fund?

However, there is an even bigger issue at play.  Even if an investor can get some form of confirmation that the audit relationship is genuine, the auditors will not send a copy of the financial statements direct to the investor because of privity.  In most instances, the accounts come from the manager; if the accounts come from the administrator, admins are, in turn, not stepping up to enforce a policy that the financial statements should be given to them by the auditor, not the manager - some do, some don't.  Even with the the audit confirmation, therefore, it is still not guaranteed that an investor is looking at a set of genuine accounts.

Clearly, this situation is unacceptable and, if the industry is going to evolve and institutionalize, we need to find a workaround.  To that point, we'd like to be a little contrarian and think out of the box.

We recently heard a leading audit partner make the comment that it was surprising and probably unfair that hedge fund investors seem to apply a different standard of care to a hedge fund audit, and certainly have different expectations, than they do when dealing with a public company.  This is certainly true - if I hold 100 GE shares, I do not phone up GE's auditor to confirm that the set of accounts I received through the mail are genuine.

However, this perspective goes, in our view, to what is really the heart of the problem.  A hedge fund is not a public company, it is not subject to meaningful regulatory oversight, it does not have deep pockets and it does not offer itself to hundreds of thousands of individual shareholders.  Instead, a hedge fund is a very small, private entity designed to pool significant assets from a very small number of investors.  Very, very few funds have more than a couple of hundred investor relationships - many have less than a couple of dozen.

An audit of that hedge fund is, therefore, disproportionately important to each of those investors as compared to an investor in a Fortune 500 public company.  Given the lack of transparency in a pooled hedge fund vehicle, the audit is a key tool to provide confidence that assets actually exist (the audit should have a full confirmation process).  The audit also gives some confidence over asset valuation given the auditor's testing (but certainly not independent repricing) of the manager's marks.  As such, it is entirely reasonable - and should be entirely expected by hedge fund auditors - that they are playing a different role, and have different functions, than if they are working on the audit of Pfizer.

If you have elected to invest via a managed account and have created your own managed account platform, you get round all of these issues.  The investor creates a fund entity to hold the assets, managed by a third party hedge fund manager; the investor appoints the directors of that entity (or may serve him / herself) and the investor - not the manager - appoints the auditor.  In this case, the auditor is now clearly working for you and the investor has direct confidence as to the identity of the auditor and the fact that the final financial statements are genuine.

Looking at the current challenge of working with auditors through a commingled hedge fund, this has to be a very material advantage for a managed account structure.

However, let's be really heretical.  Do investors in a hedge fund actually need an audit?  Or, to be more accurate, do they actually need a GAAP audit? 

Would investors not be better with some form of agreed upon procedures engagement which results in the preparation of financial statements presented in accordance with GAAP, but whereby the audit work is conducted in accordance with an AUP engagement letter?  In that way, investors (and potential investors) could sign to confirm the adequacy of procedures and thereafter get financial information direct from the auditor.  The twist here, of course, is that the auditor is now working for the investor, changing the nature of the relationship.

A heretical idea, we agree.  But not as heritical as a state pension plan losing $100 million when it turns out that a hedge fund gave them a fake set of accounts....and Deloitte / PwC / EY / KPMG refused to confirm that they were the auditor of the fund.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

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High Frequency Trading

The Canadian National Post newspaper has just run an article on high frequency trading, which has made its way north of the border in spectacular style.  According to the Post, the Toronto Stock Exchange (the TSX) was the venue for some 99.5% of trades in the largest 60 Canadian quoted companies one year ago: in a mere twelve months, this percentage has fallen to just 69%.  The winners are new, so called "alternative exchanges", which appear to be favoured by high frequency traders.

Such a shift in trading patterns is pretty dramatic by any measure.  When thinking about this, we certainly agree that any trading strategy which increases exchange volumes can be good - more volume can increase price transparency, make it easier to fill orders (especially smaller orders from retail investors), and reduce bid ask spreads.  

On the other hand, you have to take a step back and ask how high frequency traders make their money.  Exactly why is it that these traders need a computer data centre of the size usually reserved for manned space missions?  Exactly what informational, mathematical or regulatory advantage are these traders exploiting to make money as they place orders for millions of shares a day, in and out of names many times during each trading session?    

The SEC has already focused on the practice of "flash orders" whereby certain investors could access information about order flow a half second ahead of other market participants.  At first glance, you have to ask what possible difference a half second could make - until you realize that a half second is a very long time when you have Google levels of computing power.  Dark liquidity pools and other off exchange trading also seems to be an area of current regulatory focus (see a recent Bloomberg article for a summary of these developments.)

The National Post quotes Joe Saluzzi of Themis Trading, who comments: "What these guys are about is speed, and they are getting access to quotations before the general public…so, in essence, they are re-engineering the quotes by jumping between you and the seller". He continues: "most investors don't even realize they are losing money, because their pockets are getting picked without them even knowing it.  The price you paid may have been inflated during the day, because they are taking advantage of the order flow and you don't even know it."

To be clear, our comments are as an interested observer rather than an informed opponent (or proponent) of high frequency trading.  As above, volume and liquidity have many powerful advantages, and perhaps high frequency orders are the "wave of the future".

On the other hand, we do hold our hand up as professional skeptics.  The fact that a small group of trading entities with Fortune 500 style IT budgets can make a very profitable business out of high frequency trading raises our common sense antennae.  The reason, of course, is that there is no retail investor who could deploy the same trading technique - a Dell desktop simply won't cut it.  High frequency traders therefore have an advantage which is unavailable to the "average" investor.  

It's always good to bear in mind that much of investing is a zero sum game - someone makes money, with the unavoidable implication that someone else has lost it.  The skeptic in us, therefore, is reminded that it isn't always a great idea to bet too heavily on strategies which allow a small group of investment insiders to make money at the expense of the little guy. 

That, of course, was the lesson of mutual fund timing.

Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator's role in relation to security valuation.  We will, of course, return to this topic - but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today's administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments.  (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from "comparable" securities (essentially mark to model, albeit with mainstream models); and Level III, everything else).

This leaves investors with a challenge - if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument.  It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments - assuming the administrator has washed their hands of the problem - are third party pricing agents and auditor agreed upon procedures, or "AUP".  We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client.  The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work. 

Our first comment is, unfortunately, an Emporer Has No Clothes observation.  The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund's pricing on a quarterly basis.  This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags.  Firstly, many AUP only test a sample of prices, not the whole portfolio.  Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a "sample" basis???)

The bigger problem, however, is the type of testing completed by the auditor.  In way, way too many cases, the auditor tests security prices back to the manager's own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors.  If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low?  Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager's own pricing file, how does the auditor know that those pieces of paper are genuine?  As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis.  A full, GAAP audit review is, of course, performed at year end - this does include independent pricing (although - investor fyi - auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud.  In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point.  Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance?  Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?  

To this point, the actual audit standard applicable to AUP is available here.  The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner's report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular.  Per the standard, a client requests an auditor to complete AUP to assist "specified parties" to "evaluate subject matter or an assertion".  In our case, the assertion would be "are hard to value securities valued correctly at quarter end."

However, the specified party is usually the manager itself, making the client and specified party the same person.  The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place!  However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are "sufficient for their needs".  So, even if the investor believes that the AUP are not "sufficient for their needs" - which is hardly a long stretch - the investor has to sign that the procedures are sufficient if they are to even see the auditor's work.  With this magic piece of paper, the auditor has met its requirements and can sleep easy.  Meanwhile, the auditor will send a bill to - guess who - the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Kroll Fraud Report

Kroll publishes an annual fraud report - we commented on the prior year edition here, and the new document is available from Kroll's website.  Data was prepared in conjunction with the Economist Intelligence Unit.

As always, this is an interesting read, and we particularly agreed with the comments provided in the introduction:

"Fraud, corruption, and all that go with it may not have precipitated recession, but they certainly made its impact all the more painful. Losses, prosecutions, litigation, bankruptcies, were all sparked or exacerbated by the actions of groups or individuals in the years before; actions that went undetected and unpunished until too late.

The conventional wisdom is that fraud goes up in a recession. That isn’t necessarily true, as our survey shows. What goes up is the discovery of fraud, not always the same thing. Just like legitimate businesses, fraudsters are threatened by loss of income or the financial weakness of their businesses; Ponzi schemes are especially vulnerable. But other fraudulent areas – management conflict of interest, corruption, employee theft – also come to light when business conditions sour.

The data we have collected this year clearly highlights the industry hardest hit by fraud and wrongdoing: financial services. Over half of the respondents in this sector reported that the global financial crisis had increased levels of fraud at their companies – the highest figure for any industry.

Nearly 90 percent of firms reported being victims of some kind of fraud in the last three years. This sector also had the second highest proportion suffering from each of internal financial fraud and management self-dealing.

Unfortunately, though, over one in five financial services companies saw their internal controls weakened through cost cutting. It is understandable that in today’s climate, they should seek economies. But these will be false economies over the longer term if they lead to the resurgence of the same issues that so deeply damaged the industry in 2008-9.

“Tighter controls” will not be a popular rallying cry in Wall Street, the City or Nariman Point. The associated costs can be hard to bear in difficult times – but the cost of non-compliance can be harsher."

Exactly.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

A salary survey...from the real world

Back in January 2009, we published a post entitled "The Bonus Debate: Investment Banker or Heart Surgeon".  Our target was the compensation structure of the investment banking industry - and pretty much the same applies in the world of hedge funds.

As we said at the time:

"It is not hard to agree that one of the primary causes of the global economy's rollercoaster ride from excess to catastrophe has been compensation.  We have commented before on the many inconsistencies of hedge fund compensation and the fundamental weaknesses of the "2 and 20" structure.  Indeed, Castle Hall's White Paper, "Hedge Fund Investing in a New World", discussed these issues in October 2008.

Another compensation issue is, of course, the pay structure in the world of Wall Street's investment banks. According to Bloomberg today, "Wall Street bonuses may go the way of the dodo" and, yesterday, President Obama was widely reported as saying that the $18 billion bonus pool Wall Street paid itself at the end of 2008 was "shameful".

And yes, Wall Street's bonuses are shameful.  Particularly, they are asymmetric: you get paid on the way up but have no obligation to pay anything back on the way down.  It's like a balloon blowing contest where the person who blows the biggest balloon gets paid the most, but doesn't have to repay anything if it bursts a moment later.

What is really shameful - and what really is the root problem here - is the finance industry's sense of entitlement.  Progressively, it would seem that those working at the top of the finance "system", including many investment bankers and hedge fund managers, have developed their own value system, and their own, ever more inflated baseline for "normal" compensation.  Never has the gap between the psychology of Wall Street and Main Street been so wide.  

Hedge fund investment professionals, just like investment bankers, need to remember that $500,000 a year - let alone $5 million - is not a threshold level of "acceptable" compensation.  It is also the case that the compensation you make in your best year is not your baseline minimum for what you expect to get next time - a bonus may well be a highly generous recognition of being fortuitously in the right place at the right time."

Against this background, we have been amused to read about Mr. Andrew Hall, the Phibro commodity trader who has a contractually bomb proof potential $100 million pay packet.  Yet, on CNN this evening, there is a list of "top paying jobs": per CNN - "what other great careers from CNN Money's and payscale.com's list of Best Jobs in America offer great paychecks?"

The list is as follows:

1. Anesthesiologist: Median Salary $292,000, Best Salary $408,000

2. Physician/Obstetrician/Gynecologist: Median Salary $222,000, Best Salary $338,000

3. Psychiatrist: Median Salary, $177,000, Best Salary $279,000

4. Nurse Anesthetist: Median Salary,  $157,000, Best Salary $214,000

5. Sales Director: Median Salary, $140,000, Best Salary $239,000

6. Actuary: Median Salary, $129,000, Best Salary $257,000

7. Finance Director: Median Salary, $121,000, Best Salary $214,000

8. Software Architect: Median Salary, $117,000, Best Salary $166,000

9: Attorney / Lawyer: Median Salary, $115,000, Best Salary $262,000

10: Insurance Broker: Median Salary, $114,000, Best Salary $273,000

To put all this in perspective, if you were a stellar commodity trader with compensation of $100 million per year, you would earn the annual salary of the median anesthesiologist in roughly 5.5 hours.  So, arrive at work at 8:30 on January 1, you're done by 2pm.

As we said earlier this year, never has the gap between Main Street and Wall Street (or in this case a nice farmhouse in Connecticut) been so wide.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Rethinking Fund Administration 1.5

In one of our last posts, we began a series of comments discussing the current state of the hedge fund administration industry, with a particular focus on valuation.  We promised that our next post would address some solutions to the "valuation dilemma", and we will return to this topic shortly.

However, we were interested to read the new version of the AIMA Guide to Sound Practices for Hedge Fund Administrators, published in September (available here).  This includes, as would be expected, commentary as to the role and responsibilities of the administrator regarding valuation.  

Before we go to our second post on solutions, we thought that it would be useful to make some comments on the AIMA paper - which holds itself out as the central benchmark of administrator "sound practice" - as an addendum to our prior post.  We hence have some comments on rethinking hedge fund administration 1.5.

The point we would like to make is to compare what AIMA now say in 2009, with what they used to say in the first version of the administrator sound practices guide, which was published back in September 2004. 

In Section 3.2, Security Pricing, the "Old Guide" stated:

Security pricing is a high-risk area for administrators, managers and prime brokers. It requires high quality data feeds, automated price validation systems and highly experienced staff. The risk of applying the wrong prices to a fund is ever present and extreme care is required to avoid this and any consequent reputational damage to the manager, administrator and prime broker.

It is also vitally important to consider the independence of the pricing process. Wherever possible, the administrator must independently price the assets of the fund. This is essential to preserve the actual and perceived independence of the NAV process and to protect the manager from accusations of bias. If the pricing environment of the fund is not rigorous, then the investors could be exposed to the risk of incorrect pricing.

However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is agreed with the administrator and the auditor before the fund is launched and that there is some way for both of them to check the pricing of the instruments during the life of the fund. The administrator should be able to assess the “reasonableness” of the manager’s and/or product issuer’s price.

We would completely agree that it is "vitally important to consider the independence of the pricing process".  Moreover, even for the hardest to value securities, AIMA's 2004 guidance states that the administrator (and auditor) must find "some way for them both to check the pricing of instruments during the life of the fund."

When getting to the very hardest to price securities, the Old Guide states:

In some cases, the administrator may be required to rely on prices determined by the manager, using its own pricing model for some specific complex derivatives instrument, for example. Although this is not desirable, there may be no alternative. In such cases, the administrator should:

1. ensure that the valuation procedure whereby the administrator is obliged to value the fund’s portfolio on prices based on the manager’s pricing model or formula is fully disclosed in the offering documents and the administration agreement;

2. ensure that the manager discloses both to the administrator and the fund’s auditor how the pricing model works and permits the auditor to carry out spot checks from time to time, to verify correct application of the pricing model; and

3. if possible, install the pricing model on its own system so that it can check the prices provided by the manager.

Armed with their own sources and the counterparty’s valuation, the administrator should be in a position to value the OTC position competently.

These provisions, therefore, provide specific guidance to the administrator when looking at OTC trades and, overall, create a "do as much as you possibly can" mindset.  The guide continues:

Security pricing is a highly skilled area, requiring highly trained and knowledgeable staff. It should not be done by “part-timers” nor should there be duplication of effort. Ideally, each security should be priced once for all funds holding that security at that time. Control of this function is one of the central obligations of the administrator, who should be employing common pricing procedures across all of the funds it administers.

This again suggests that there is a clear responsibility for the administrator to both disclose any manager pricing and, moreover, do all that is possible to derive independent valuations.  We particularly like the comment that "control of the [pricing] function is one of the central obligations of the administrator."  Moreover, the Old Guide makes it clear that this work should be supported by suitably skilled resources within the admin's organization.

Well, what a difference five years makes.  These are the key comments on valuation from the New Guide:

In all cases, it is important to consider the independence of the pricing process. Wherever possible, but subject in all cases to the fund’s pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund. However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is documented, checked where a secondary source is available and reported to the pricing committee or board, periodically.

OK.  So now it is "important", not "vitally important" to consider the independence of the pricing process.  There is also a big difference between "wherever possible, the Administrator must independently price the assets of the fund" (which means that the administrator's prices would be used in the NAV) and "wherever possible, but subject in all cases to the fund's pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund."  Note also that we are now in a world where there "will", rather than "may" be occasions where valuations can only be made by the manager.  We continue:

The pricing policy document should be approved by the board or governing body of the fund on a regular basis (annually or when altered).

It should be noted that while some HFAs have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility.

Particular attention should be given to the governance aspects of the AIMA Guide to Sound Practices for Hedge Fund Valuation, as the observance of their principles should avoid any misunderstanding or lack of clarity around pricing and responsibility.

The Guide notes that the area of valuation has been topical and, in some cases, controversial. The role of the HFA has regularly been questioned and many investors and other industry participants have asked: “Is the HFA responsible for valuations?”

The Guide notes (and agrees) that both the AIMA and IOSCO documents suggest that it is the governing body that is ultimately responsible for the valuation of assets. In most cases, this is a board of directors or a general partner. Typically, the board will set a pricing policy.

The main thrust of the new document, therefore, is to revert attention to the pricing policy (and how many funds actually have one which really is detailed and comprehensive?) and place the administrator in a secondary, reactive role.  The guidance is much more vague, and there is certainly not the same emphasis on the "essential" need for administrators to "independently" value assets.   Moreover, there is now room for "many" administrators not to be "capable" and "expert" in the calculation of recommended prices for individual securities.  

Our biggest comment though, is one we have made before.  It remains utterly, utterly and utterly ridiculous to suggest that a Board of Directors comprised of two gentleman in the Cayman Islands with corporate secretarial backgrounds, who serve on the boards of hundreds of other hedge funds, can be "ultimately responsible for the valuation of assets" and "set a pricing policy".  For investors who allocate tens of millions - or hundreds of millions - of dollars to individual hedge funds, this comment can best be described as disingenious fallacy.  In fact, it is an insult to the intelligence of everyone concerned.

We would also point out that investors can pay the administrator millions of dollars per year for their services on some larger funds, while the average Cayman director gets $5-10,000 per fund.  That would seem to place some framework around who has the better knowledge and who is better placed to get involved. 

Perhaps the best comment, however, is the final "sound practice" guideline.

The governing body and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.

AIMA, therefore, leaves us in exactly the same place as our own experience of current administration servicing.  While some administrators do complete thorough and robust servicing, including detailed pricing, many do not.  The message from the industry to investors, though, appears to be fairly casual - don't take anything for granted, or "automatically assume" a standard model.  In other words, caveat emptor.

The real issue here - and one that must be addressed, sooner rather than later - is that post Madoff, post financial crisis, and post the greatest stress period the hedge fund industry has ever seen, hedge fund investors have increasing, not decreasing, exposure to managers pricing their own securities.  We would have thought that all this pain would leave us with more protections - but no, we continue with all the evident risks that go along with managers marking their own books.  Moreover, everyone concerned - managers, administrators, auditors - seem to assume that this is an entirely satisfactory state of play and, indeed, is "sound practice".  

As the boy said to the naked emperor, it is not.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence 

The Fraudster Next Door

The magazine for Canadian Chartered Accountants (yes, it is that exciting!) has just published an article on fraud in the Canadian corporate sector, drawing on research by KPMG.  Just to be clear, not everyone north of the border is engaged in defrauding penny stock mining companies!

KPMG's survey has the following introduction:

"Bad habits and personal need, along with opportunity and greed, can ignite the motivation to commit fraud in even the most hearty of economic environments. Now, as companies and individuals find themselves strapped for cash and credit in these challenged economic times, investors should be increasingly aware that fraudsters can come in all shapes and sizes. In the 2009 survey Profile of a Canadian Fraudster, KPMG Forensic exposed the common characteristics of fraud perpetrators. On the surface, the typical fraudster may appear to be not all that different from an average person or your next door neighbour."

An interesting read.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Rethinking Fund Administration: 1

Our comments on Risk Without Reward have frequently touched on the role, responsibilities, advantages and disadvantages of third party fund administration.  As a starting point, all of Castle Hall's partners have experience in the offshore hedge fund community, the traditional "home" of administration servicing ever since the days of the 10 commandments.  Given our backgrounds, we have always been very strong proponents of the value of third party oversight over hedge fund accounting and NAV calculation.  We continue to believe that effective administration servicing is universally the hedge fund investor's best protection against loss caused by operational failure, from honest mistakes to the worst case of dishonest fraud.  

We do, however, see a number of emerging trends in the administration industry which are gradually "changing the game".  Some developments in the administration servicing model, notably better application of technology, can be strongly positive for investors.  Other trends, however, appear to be less beneficial, with changes taking place outside the scope of investor input or intervention.  It is against this background that we would like to comment, in a series of posts, on areas where investors, managers and the administrators themselves could usefully rethink the third party oversight model.

Our first topic is, unsurprisingly, valuation.  In Castle Hall's recent white paper on hedge fund operational failures, "From Manhattan to Madoff" (available here) we noted that "misvaluation of fund assets is the most significant, unresolved operational risk for hedge fund investors."

Our particular concern was "the ongoing ability of some managers to price securities themselves."  We continued that "this practice is not in any way universal, but, unfortunately, becomes progressively more prevalent as instruments become more complex and harder to price.  It goes without saying that it is precisely those instruments which are the most difficult to value which are the most susceptible to pricing fraud - it is obviously very hard to fake the price of IBM common stock."  

We then commented on what appears to be a growing "expectations gap" in the administration industry, noting:

"Today, hedge fund investors continue to expect - rightly in our view - that third party administrators paid by investors to calculate a hedge fund's net asset value should independently value security positions.  However, many of today's administrators argue that they have no responsibility for pricing and that the administrator's role is limited to that of a 'verification' rather than 'valuation' agent. Indeed, we see an increasing trend for administrators to accept manager prices for hard to value securities without further checks."

It is against this background that we were interested to see GlobeOp's settlement with a hedge fund - which the Wall Street Journal and other news sources identified as the UK based Regents Park - related to "mis-priced position values provided by a principal of the hedge fund's investment manager."

According to GlobeOp's statement on interim results issued on August 27th:

"We have settled a long-standing claim brought in arbitration

by a former hedge fund client. The claim relates to GlobeOp's

obligation to calculate and distribute the net asset value of

the fund and the impact on that of mis-priced position values 

provided by a principal of the hedge fund's investment manager. 

The arbitration will be terminated and a settlement agreement 

was signed. GlobeOp expects that the cost of this settlement

will be approximately $27 million, net of $16.5 million

of applicable income tax benefits. The amount of the 

settlement is $43.5 million, with $20 million paid at 

settlement and the remainder paid over time with interest

equal to the U.S. prime rate. The last payment will be 

February 2011. The settlement will be paid out of existing

cash resources and will be a tax-deductible business

expense during the year in which each payment is made.

GlobeOp has no further liabilities outstanding in relation

to this matter and the issue will have no impact on

current and future clients. 

Regents Park itself was named by the UK FSA back in 2006 (see FSA news release here).  As an aside, it's interesting to see how the FSA can conduct an investigation which, at the time, did not involve "any finding of misconduct or breach of the FSA's rules" which nonetheless leaves the admin on the hook for nearly $50 million - we guess that's a different issue.  

The point of our discussion here is not to take GlobeOp to task with respect to whether they did or did not perform services in accordance with their contract with the Regents Park fund.  (We have not completed due diligence on Regents Park and, therefore, cannot comment on the specific administration servicing with respect to that fund.)  In this particular case, it is evident that GlobeOp have settled claims and have made a substantial payment to resolve the issue.

Rather, our observation is more general and is directed at the administration industry as a whole: it is self evidently a really bad idea to accept prices for securities that will be used in a hedge fund's monthly NAV calculation, when those prices have been provided "by a principal of the hedge fund's investment manager".  Guys, you need to check prices, and you need to check them independently.  As we have said before, a copy of Adobe Photoshop only costs a few hundred bucks if you happen to be a hedge fund manager who is keen on changing that broker quote which will then be forwarded to the admin.

Our next post in this series will consider some of the potential solutions for the valuation dilemma - our starting point is clear and transparent disclosure so it is at least evident what the administrator has priced and what they have not.  We will also touch on the use of third party valuation agents separate from the traditional administration companies: we see potential value in bifurcating the accounting function from the valuation process.  And, of course, we'll also say that investors will have to pay more money, including to the admins themselves, if we really want top tier servicing.

However, we do have one final observation in this post.  Anyone who completes due diligence on a reasonable number of hedge funds is familiar with the administration industry's attempts to avoid responsibility for pricing.  This is evident in the legal blurb now included in many fund offering documents, together with the pages of disclaimers in typical administration agreements (we particularly like the legal provisions stipulated by those administration companies owned by prime brokers, who are usually very clear to point out that they have absolutely no responsibility for pricing, even when a hedge fund uses prices different from what the same pb uses in its own businesses.)

Above, however, we have a case where a leading administrator did need to settle a case related to allegations of mispricing.  In GlobeOp's case, the $43.5 million settlement (pre-tax) needs to be set against the fact that the firm's revenues for the six months to June 30, 2009 were only $79.2 million. (GlobeOp, as a public company, does need to disclose its financial performance - as well, of course, as the terms of the settlement itself.  Privately owned administrators do not need to provide such disclosures, which makes it easier to shield such mishaps from public view.)

Taking a step back from all of this, what really strikes us is the huge business risk much of the administration industry seems to be taking each and every time they take a price from a manager without properly checking it.  

There are two potential problems.  Firstly, all an admin company needs is one of the firm's several hundred hedge fund clients to blow up due to faked valuations, and the financial impact could potentially be threatening to the entire administration firm.  We agree that the admins have sought to protect themselves with tight contracts which disclaim responsibility, but would a court of law actually uphold all of those terms?  We would expect that there is at least some chance that a court, dependent on the facts and circumstances involved, could find that an administrator did at least have some baseline duty of care to check for valuations which were clearly incorrect.  We remain puzzled as to why admins would accept the risk that one bad apple could wound - or even kill - the entire firm.

Secondly, the administrator's greatest friend is the investor, who continues to push for third party oversight.  Many managers, however, would quite happily operate without an admin if they had the choice and didn't face investor pressure.  Administrators, therefore, need to keep the investor community convinced that their servicing is valuable and worth the money.  

The risk here is that, if there was a significant hedge fund failure caused by mispricing, the administration industry would not make friends if their response was "ah, but we did not actually have any legal obligation to check prices and were entitled to rely upon information furnished to us by the investment manager."  The worst case scenario for the administration industry as a whole would be a loss of investor confidence, should investors be faced with a fund failure where it would seem that the admin got paid but didn't do their job.  A lack of investor confidence in such an outcome - which we certainly hope will not arrive - would hardly help anyone.

Again, our next post will examine some of the potential solutions here, with a focus on short term initiatives which could better clarify the role and limits to current admin servicing.  In the long term, however, the "expectations gap" remains.  Ultimately, if you don't price the portfolio yourself, you have not calculated the NAV.  That is the 800 pound gorilla at the back of the room for all administration service providers.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

 

A Little Light Relief

We recently came across this old Dilbert cartoon  - in the world of hedge funds, it would be funny if it wasn't so true.

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Hedge Fund Operational Due Diligence

Fund of Funds

The Hedge Fund Journal has just published a well presented list of the current Top 50 fund of funds (available here).

The sense of the introductory comments is that the fund of fund model, while evolving, is not facing an irreversible and terminal decline.  This is a notable shift from the doom and gloom message from at least some commentators earlier this year.

We certainly see plenty of ongoing need for fund of funds provided - and this is the caveat, to us at least - that fund of funds reorganize as providers of expertise rather than simply providers of capacity.  

Intuitively, one of the reasons for the rapid growth of the top 100 hedge funds between 2004 and 2008 was the commensurate growth of the largest fund of funds.  It's interesting to remember that, once a FoF is at $20 billion, a 1% allocation is $200 million.  At $40 billion AUM, a 1% allocation becomes $400 million.  Even in the good times at the peak of the hedge fund cycle, there were relatively few single strategy managers which could absorb allocations of that size.  The outcome, unsurprisingly, was a lot of "me too" allocations from the biggest FoF to the "usual suspect" multi strategy managers.

Going forward, investors will continue to have appetite to partner with fund of funds managers, but we expect them to be looking for nimbler (which probably means smaller), and more thoughtful organizations.  

Separately, fund of funds will have an opportunity to migrate, totally or partially, towards an alternate model of funds of managed accounts.  We continue to believe that managed accounts can add value but, in many cases, investors completely underestimate the degree of accounting and operational complexity involved if they bring even a modest portfolio of hedge funds onto their own systems.  Fund of funds are well placed to create the intermediary accounting and risk management platforms needed to maximize the benefits of a managed account structure.   

It will be interesting to follow these trends over the next six months.  

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence