The Wall Street Journal reported today that the DB Zwirn will wind down its largest hedge funds, returning some $4 billion of capital - 80% of current firm assets - to shareholders.
DB Zwirn's problems began nearly two years ago with allegations of accounting problems (see Bloomberg article, FT article). Among the questions raised were the firm's alleged failure to properly account for transfers between different hedge funds, prepayment of management fees, and misallocations of costs related to use of a private jet. Ouch.
The case of DB Zwirn is very interesting. On balance, the accounting mishaps (or at least those that have been reported) were relatively immaterial. Against a $5 billion fund, misallocation of a few million dollars of expenses is hardly going to break the bank. What was terminal, however, was the pervasive loss of confidence in the firm.
Where are the lessons for investors?
Firstly, shareholders will not get their money back instantly: given the reported 60% portfolio allocation to "illiquid" assets, we imagine that the repayment / distribution process will be lengthy. Investors do not need a catastrophic fraud to nonetheless find themselves in a long and potentially painful work-out situation.
Secondly, a hedge fund management company is a business, and the nuts and bolts of running a company matter. Hedge fund managers are not miraculously immune from exactly the same accounting and operational challenges that any business has to address day in, day out. As we have often said, hedge funds are not institutions: managers are small, entrepreneurial firms without - in virtually all cases - an "institutional" infrastructure. Even at the largest, standalone hedge funds, it is quite possible for asset growth and portfolio complexity to run significantly ahead of available back office resources. Moreover, the frantic back office teams can be so overwhelmed with day to day settlement and trading that it is easy to see how mundane management company accounting can get lost in the mix. Yet, a hedge fund is a business, and it's business 101 that you need to keep the books, keep them accurately, and keep them up to date. It's clearly a pity if you can afford a private jet but not a bookkeeper.
Thirdly, delays in the issuance of audited financial statements can have significant ramifications. Fund of funds, for instance, may have been unable to issue their own financial statements if DB Zwirn was a material position in their own portfolios. After six months of delay, if a fund of funds cannot issue its own financials, it may find itself violating SEC custody rules - we imagine that there were plenty of fund of fund CFO's pretty unhappy with the private jet accounting by this point. AU 332 also creates problems for investors needing to provide their own auditors with copies of underlying fund financial statements.
Next, the obvious protection for investors (and equally, in this case, for the manager himself) would have been for the DB Zwirn funds to appoint an administrator. Administrators can (and should) keep independent accounting records for non investment items such as fees, expenses, inter company transfers etc. etc. If a fund chooses to be self administered, however, investors must recognise that there is only one set of books, no independent checks and balances, and that the NAV is entirely dependent on the quality and accuracy of the firm's in house accountants.
But, therein lies the rub - prior to DB Zwirn, the largest fund which "failed" as a result of a breakdown in accounting was Archeus Animi. In that instance, the manager claimed that the fund's administrator, GlobeOp, had failed to maintain adequate portfolio accounting records. The result was the same untenable delay in the issuance of audited financial statements and the same vicious circle of lost investor confidence. The problem in this case, however, was that the manager chose to outsource all accounting and did not keep full, parallel records in house: they were hence unable to detect problems on a timely basis and unable to use their own records to correct the administrator's alleged mistakes.
From our side, we continue to believe that the best investor protection comes from the tried and tested model of true, third party administration, with both the investment manager and an administrator each running their own books and records. Two sets of books may seem like overkill, but DB Zwirn and Archeus are painful examples of why this is always necessary.
In reality, however, far too many of today's hedge funds do not follow this golden rule. On the one hand, many managers continue to believe that no administrator could keep up with their complex portfolios and choose self administration. On the other, several leading "administrators" now focus their businesses on outsourced back office services with little interest in the traditional admin model. The result is frequent weakness in core accounting controls: in this environment, we will be surprised if Archeus and Zwirn are the last funds to trip up on accounting 101.
Hedge fund operational due diligence