Risk Without Reward

The Largest Sovereign Wealth Funds

A website dedicated to sovereign wealth funds has published a list of the largest SWF in the world - interesting reading.

http://www.swfinstitute.org/funds.php

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Hedge Fund Operational Due Diligence

European Hedge Fund Ranking

Alpha Magazine's latest ranking of European hedge fund managers shows the following assets as of January 1, 2009 (see press release):

Alpha's Europe Hedge Fund Top 5
Rank Firm				Total Capital ($ millions)
1  Brevan Howard Asset Management		26,840
2  Man Investments					24,400
3  Barclays Global Investors			17,000
4  BlueBay Asset Management			16,700
5  Bluecrest Capital Management		13,273

Overall, Alpha notes that the largest 50 firms in Europe managed $285 billion at the beginning of 2009 as compared to $405 billion a year earlier, representing a drop of 30%.

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Hedge Fund Operational Due Diligence 

Kroll Global Fraud Report

Kroll have recently published their latest Global Fraud Report.  This is a very interesting summary of the causes and impact of a range of global frauds across industries.

The introduction states:

"Ultimately fraud involves human beings, both as perpetrators and victims. Greed has again demonstrated that, even before the downturn, it was more than a match for good sense or ethics among many supposedly sophisticated investors – whether in the Madoff affair or the sub-prime follies which started the current economic slide. As this edition shows,  understanding the effect of bad economic times on people’s emotions is essential to seeing where fraud is headed, and what might be done about it. Some individuals will be more careful to protect their assets. Others, however, will be more desperate: those with a criminal bent may look to maintain lifestyles through running scams; more honest ones might be more susceptible to get-rich-quick schemes or self-proclaimed Robin Hoods that promise to restore depleted finances. Still others, normally perfectly honest, may even engage in fraud and misrepresentation for what they consider noble motives – to preserve the jobs of thousands of colleagues. 

As this edition notes, what role regulation can play in the face of people’s eternal willingness to believe the too-good-to-be-true is unclear.  This does not mean we are helpless.  Due diligence and compliance best practice, as well as applying the correct tools to fight back once fraudsters have struck, are all part of addressing this threat."

Couldn't agree more.

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Hedge Fund Operational Due Diligence

Regulating...the Canadian way?

The National Post newspaper in Canada today published an interesting opinion piece commenting on the Canadian financial system.  The article compares the fate of the US banking sector to the main Canadian banks – RBC, CIBC, TD, BMO, Scotiabank and National Bank.

The Post notes that “everywhere, economists are wondering how Canadian banks managed to avoid most of the crummy securitized debt that is crippling other democracies’ financial institutions.”  This is not to say that Canada should be too self-congratulatory, mind you, as the country’s financial system has hardly been immune from the delights of securitization – asset backed commercial paper was a home-grown fiasco.

The comments which caught our eye, however, were the concluding paragraphs.

“International observers have noticed that Canada’s ‘principles based’ financial regulation takes a very different form from the ‘rules based’ style prevailing in the United States.

Down South, lenders are engaged in a constant chess game with the government. Here, the bank executives and regulators have absorbed each other’s values to such a great degree – both taking the view that, quite simply, the first goal of the Royal Bank of Canada is to ensure that there is still a Royal Bank of Canada 100 years from now – that internal audit procedures are tougher than any regulator would dare demand, and arguably more effective than any regime created solely by a narrow, politically shifting rule set.  Plain old-school snobbery plays a role too.  Only by a means of noblesse oblige can you staff a modern banking system, as we have, without dangling big short-term rewards in front of top executives and doing away with substantive board oversight.

Unfortunately, it’s not going to be easy for any foreign banking institution to import Canada’s banking culture without having had Canada’s history.  But, hell, they could at least adopt some of the maxims.  Toronto-Dominion’s CEO told Marie-Josee Kravis that he pulled TD out of the game of buying securitized debt products years before the crisis, for one simple reason: the instruments had become inscrutable.  “If I cannot hold them for my mother-in-law,” he said, “I cannot hold them for my clients.”  Given the “in-law” part, that’s not setting the consciousness bar very high – but it is higher, at any rate, than where many foreign institutions put it over the last decade.”

Regulation will, of course, be front and center for both hedge fund managers and hedge fund investors over the coming months.  The debate over rules based or principle based regulation, however, is unlikely to be solved any time soon – principles lack specificity so we need rules; rules create loopholes, so we need principles.  This is one of the insoluble conundrums of our age.

Perhaps the point of this article, however, is to remind us that rules ultimately regulate people, not inanimate corporations.  What we need to think about, then, is the motivations of the decision makers ultimately subject to regulation.  To put it simply, if people are motivated by short term cash and have no longer term responsibility - which is unfortunately a fairly common theme in this financial crisis - then the tighter the rules the better, because tight rules are the only way to reign in self-interested behavior. 

On the other hand, if decision makers have a sense of accountability and an eye to the future, then we come back to the maxim that people can regulate themselves better than any government can.  Governments are concerned by re-election - which often puts their time horizon not much further out than the quarterly earnings cycle which preoccupies so many business executives.    

Against this background, we continue to believe that, in the hedge fund space, focus - and by focus we mean investor pressure - needs to be on alignment of interests between investors and managers.  At the very least, changing incentive fees to a longer time horizon with clawback mechanisms etc. will create more accountability and something of a longer term time horizon in the manager community.  Ultimately, that may well be far more effective at protecting investor interests than the regulatory rulebook.

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Hedge Fund Operational Due Diligence

Chrysler and the non TARP lenders - and investors' reputation risk

The judge in the Chrysler bankruptcy case has now forced the hedge funds forming the "Chrysler non TARP lenders" to identify themselves as they pursue their case.

According to Bloomberg, the funds involved (down from 20 late last week) are:

"The Chrysler Non-TARP Lenders are as follows, according to the filing: Schultze Master Fund Ltd. of Purchase, New York; Arrow Distressed Securities Fund at the same Purchase address; Schultze Apex Master Fund, at the same address; Uniondale, New York-based Stairway Capital Management II L.P; Group G Partners LP, based in New York; GGCP Sequoia L.P., at the same New York address; Oppenheimer Senior Floating Rate Fund, in New York; Oppenheimer Master Loan Fund LLC, at the same New York address; and Foxhill Opportunity Master Fund LP, based in Princeton, New Jersey."

We are not going to comment on the economic or political arguments for deciding to challenge either the US government or the US bankruptcy law (which one is being challenged, of course,depends on your point of view.)  What is worthwhile noting, however, is that investors in these hedge funds will have their own economic and political positions on this highly contentious issue and, particularly, will have their own sensitivities as to reputational risk.

Some investors, we expect, will applaud the non TARP managers, both in their stated intent to get a better return and also in their drive to uphold what could simplistically be called due process in bankruptcy proceedings.  Other investors would, we imagine, be horrified to see their capital used to impede what they consider to be a vital restructuring - think pension entities in Michigan.

As we all know, the hedge fund industry has progressively migrated from a model dominated by high net worth investors (where hedge funds were the secret club of the super rich) to a model dominated by institutions.  Many institutions are not low profile - they attract criticism (and acclaim) and are forced to spend substantial resources managing their reputations, their media coverage and their relationships with their many stakeholders.

For at least some institutional investors, we imagine that it would be highly negative for it to be exposed that their capital was allocated to a non TARP fund.  But - and this is the big but - these investors, as passive shareholders in a commingled investment vehicle, have absolutely no control over how managers deploy capital. Given transparency, they may not even know what their managers hold in the first place, and certainly have no right to be consulted before a manager engages in a strategy which is both public and highly controversial.  This has the potential to be a massive problem for certain allocators.

Issues such as fees, transparency and control (think managed accounts) have already been flagged as areas where the current hedge fund model can be at odds with the needs of many institutional investors. Reputational risk is another which is just as real, but has received much less attention to date.  Moreover, this is an issue that many hedge fund managers remain completely and comfortably oblivious to.  Hedge funds are not typically questioned by their investors on socially responsible investing practices, on their carbon footprint, on their human rights policies etc. etc.  For a subset of institutions, however, these are important, highly politicized issues which need to be considered.

Strategies which have more exposure to "reputational" risk are event driven styles such as distressed and equally activist investing.  There is also the more random risk of not wanting to be an investor with a manager who decides to go on a personal, political crusade which turns out to be opposed to your investing organization's own values and mission. 

The irony here is that distressed, certainly, is one of the strategies likely to be in favor over the next stage of the cycle.  Chrysler is not the last time some institutions will be waking up to wonder what is happening somewhere in their hedge fund portfolios.

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Hedge Fund Operational Due Diligence

2009 Manager Roll Call

Alpha Magazine has published its most recent update of the top 10 single strategy hedge funds.  This includes, helpfully, the position at January 1, 2009 - after Dec 31 redemptions.

The current list is:

"Alpha's" Hedge Fund 100 Top 10

Rank  Firm                 Total Capital ($ millions)
1    Bridgewater Associates           38,600
2    JPMorgan Asset Management          32,893
3    Paulson & Co.                29,000
4    D.E. Shaw & Co.               28,600
5    Brevan Howard Asset Management       26,840
6    Man Investments               24,400
7    Och-Ziff Capital Management Group      22,100
8    Soros Fund Management            21,000
9    Goldman Sachs Asset Management       20,585
10   Farallon Capital Management         20,000
10   Renaissance Technologies Corp.       20,000

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Hedge Fund Operational Due Diligence

RIP

We were shocked to learn of the untimely passing of Greg Newton, the voice behind the NakedShorts blog.  I first met Greg at a conference in Canada a number of years ago, and thereafter had the opportunity - and privilege -  to remain in contact on a range of blogging topics related to life, the universe, and sundry hedge fund everythings.  A sad, sad loss.

Our deepest sympathies to Greg's family and friends.   

$1 a year in salary?

On a (slightly) lighter note, we saw the attached cartoon in a Quebec magazine, L'actualite, this week. The cartoonist, Andre-Phillippe Cote, also drew the great panel on the Madoff scandal we referenced here.

The translation for this one:

Charles, I have accepted that they will reduce my salary to only a dollar a year during the financial crisis. I'm now waiting for you to do the same. 

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Hedge Fund Operational Due Diligence

Ponzimonium - is that even a word?

According to Reuters, Ponzimonium is breaking out in the US.  

"Hundreds of people in the United States are under investigation for financial scams, many involving Ponzi schemes, a U.S. regulator said on Friday, calling the phenomenon "rampant Ponzimonium."

While none are as mammoth as disgraced financier Bernard Madoff's $65 billion fraud, multimillion-dollar "mini Madoffs" are proliferating from New York to Hawaii, the head of the Commodity Futures Trading Commission said.

So far this year, the agency has uncovered 19 Ponzi schemes, which depend on an influx of new capital instead of investment profits to pay existing investors.

That compares with just 13 for all of 2008."

It's unsurprising that the hedge fund bubble which peaked in mid-2008 created a parallel bubble of criminality - fraudsters tend to go where the money is.  Already, though, there are some lessons for investors.

Firstly, this round of fund fraud and failures will help investors understand the psychology of managers who turn out to be crooks.  This, in turn, will help identify yellow flags next time.

Some managers are simply criminals from day one, but a surprising proportion start out honest. Only when they begin to incur losses do some make the tipping point decision to cook their books rather than reveal that they had lost money.  Tracking the critical moment at which each asset manager decides to "go Ponzi" is one of the most useful lessons from each of these schemes.

The biggest lessons, though, reflect on the investor.  As we have often said, investors have less appetite to ask tough questions when they are making money.  The tendency to delightedly accept rather than skeptically question great returns is, of course, the basic behavior exploited by every Ponzi criminal.  What does this mean for investors?

1) Due diligence is a necessity for every investor with respect to every investment.  Madoff is the obvious proof that no-one is too good, too established or too big not to be subject to tough, systematic questioning. 

2) Due diligence needs to be ongoing.  Managers may be honest at the beginning but, as above, go Ponzi when they decide to double up rather than admit failure.

3) Investors must focus just as much on great performers as they do on laggards on the "watch list".  It's precisely the fact that a fund has reported great returns that could be the clearest sign that all is not well.

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Hedge Fund Operational Due Diligence 

Obfuscation...or Prospectus Creep

Our recent post on the "SEC's dirty laundry" made reference to "prospectus creep", or the tendency for hedge fund attorneys to add ever more disclaimers and "flexibility" to hedge fund offering documents.

We came across a letter in the current edition of the Economist that makes the point so well that we wanted to quickly repeat it:

"Certain assertions in your article on transparency in financial markets deserve to be reconsidered (Economics focus, February 21st). You describe transparency as amorphous, criticise it as costly and say it takes second place to trust in the money markets. It is hardly surprising that shortcomings may arise from inaccurate, immaterial and incomparable publicly available information, but transparency as a principle cannot be blamed. A hefty prospectus veiled in legal jargon should not be considered a transparent tool of disclosure; it is a means of obfuscation."

Exactly.

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Hedge Fund Operational Due Diligence