Credit Suisse announced last week that the bank will take a $2.65 billion - yes, that’s billion - write down related to debt securities which were, in Bloomberg’s words, “deliberately mispriced by traders”.
Bloomberg’s coverage continues: “An internal review found that the pricing errors, first announced last month, were made intentionally ‘by a small number’ of traders, who have since been fired or suspended....The Swiss bank hasn't disclosed the names of the traders responsible for the incorrect pricing of residential mortgage- backed bonds and collateralized debt obligations. Credit Suisse said it reassigned trading responsibility for the CDO business and took measures to improve controls to prevent and detect misconduct, which were ``not effective'' previously.”
Sound familiar? It should. A few days earlier, another Bloomberg article noted that Lehman had suspended two London-based equity traders after internal controls identified ``issues'' on share valuations.”
CS and Lehman are not the only institution with valuation problems - earlier in February, AIG announced multi billion dollar write downs on a portfolio of credit default swaps: Bloomberg stated “AIG's difficulty in valuing its derivatives portfolio earned it a rebuke from its auditor, which earlier this month cited "material weakness" in the company's internal controls.” While it’s not clear who was marking these instruments, we’d hazard a guess that front office investment professionals / risk takers who had a hand in developing the models underlying AIG’s initial marks.
These events merit close attention, because they highlight that in today’s investment banks, it is the front office traders who mark securities, subject to checks by mid / back office accountants and product controllers. Many hedge funds take the same approach, with marks for hard to value positions generated by the portfolio managers subject to checking by the fund’s back office and perhaps some form of verification by a fund administrator. Indeed, hedge funds often point to the “best practice” example of investment banks as justification for their own front office pricing approach.
The argument behind putting the front office in charge is simple: some instruments are so complicated, that only the traders who bought (or sold) them in the first place stand any change of valuing them correctly. Perhaps it is only the traders that have the contacts with other brokers and market markets who can give quotes and levels, or perhaps some derivative and structured products are so complex that the back office is (considered) incapable of understanding how valuations change.
Valuation is not a black and white story, and there is certainly merit to these arguments. Faced with three broker quotes, it probably is the case that the portfolio manager could know that one broker is short of inventory and will bid up, while another counterparty would laugh if the fund tried to trade at the level given on their price quote. (The complete lack of accountability Wall Street enjoys when providing these prices, notwithstanding the fact that the banks know that their hedge fund clients need those quotes to cut their monthly NAV’s is, of course, a topic for another day.)
These arguments roll together to form the view that the only way to price complicated hedge fund portfolios with “accuracy” is to put the front office in charge.
Sorry - we disagree. For two reasons.
Firstly, how much is any security actually worth? As we have said before, a security is worth what someone else will pay for it, at the time you want to sell it. The rest of the time, pricing is just an estimate. Let’s emphasize that point again: when pricing a hard to value security, we are not identifying an actual trade, but rather trying to figure out who can come up with the best estimate of what the position would be worth if it was sold. This is not a mathematical science where one price is right, and another wrong.
If a price is not tested in an actual transaction, there is absolutely no way to prove that the PM’s mark is more “accurate” than a price generated by the back office, be that the back office of a hedge fund or an institution. It is a flimsy argument at best for a PM to assume that his or her price of a distressed bond (based, say, on a single quote from Goldman with perhaps a subjective adjustment to make it more "conservative") is more accurate than a price generated by the back office, using, for example, the average of three broker quotes received from different dealers.
Secondly, putting the front office in charge ignores what is the bigger problem - the human dynamics of power and authority.
Risk takers are compensated - handsomely - based on performance. It is pretty unrealistic to assume that the back office has an equal seat at the table when challenging marks (after all, the trader usually has a pretty good story as to why his or her mark is right.) Let’s take an example: what happens if a back office professional making, say, $100k challenges the marks of a front office trader who stands to make a bonus of $10 million based on his or her trading P&L? We don’t think you need to be an advanced student of workplace psychology to understand the dynamics of that conversation.
Front office professionals are compensated based on their performance, and putting the front office in charge of valuation puts, to a significant degree, the front office in charge of their own compensation. Given this conflict, investors will consistently prefer to trade some front office “accuracy” for more back office “independence”, and a reduced risk of deliberate price manipulation.
The Credit Suisse and Lehman examples illustrate exactly this problem. The lesson for hedge fund investors? Just because institutions do something, it doesn’t mean that it’s a good idea.
Barely an hour after our last post, we came across the Bloomberg news that Endeavour Capital, a $3 billion London-based hedge fund, lost 28% in March after increases in the spreads of Japanese government bonds.
Performance had been steady: Bloomberg notes that the fund "gained 11 percent last year [and] had average returns of 8.1 percent annually until this year. It returned 0.74 percent through February, according to an investor letter." We expect that this translated into a very appealing Sharpe ratio.
Commenting on the loss, Bloomberg quoted the firm's founder, Paul Matthews:
``You've had a confluence of events that has led to extreme volatility and vast moves'' in Japanese government debt, said Matthews, 47, a former head of global fixed-income arbitrage at Salomon Smith Barney. ``The relative moves we've seen in Japan are not in the realm of anything we've ever seen for Japanese government bonds.''
The argument is simple - start a hedge fund selling options against the unlikely event that the stock market (or any other asset) will fall significantly. Since the odds of a crash are slim, there is a very good chance that the hedge fund strategy will be profitable for a number of years. Eventually, though, the "unlikely" meltdown will take place and the strategy will lose most or all of its capital.
Thanks to 2 and 20, each year the strategy survives, the hedge fund manager gets the 2% management fee as well as 20% of the gain. As the FT notes, "whatever subsequently happens, we never need give this money back....In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money."
The article highlights three problems:
- Many investment strategies have a high probability of a modest gain and a low probability of huge losses in any period. This is, of course, Nicolas Taleb's Black Swan argument.
- Because of 2 and 20, money managers have a clear incentive to exploit these return distributions for their own benefit.
- Because the low probability loss event may not happen for a number of years, it is exceptionally difficult to differentiate true investment skill from sheer luck.
The FT concludes with the following remarks:
"It is in the interests of insiders to game the system by exploiting the returns from higher probability events. This means that businesses will suddenly blow up when the low probability disaster occurs, as happened spectacularly at Northern Rock and Bear Stearns.
Moreover, if these unfavourable events - stock market crashes, mortgage failures, liquidity freezes - come in stampeding herds (because so many managers copy one another), they will say "nobody could have expected this, but, now that it has happened to all of us, the government must come to the rescue."
(As an aside, conventional wisdom suggests that if a hedge fund manager blows up, there is no way back - investors will not give the manager a second chance. However, this theory is about to be tested: if a lot of managers blow up at the same time, will investors accept the argument that "well, this happened to everyone due to unforeseeable and utterly exceptional market conditions. This was an (insert large number) standard deviation event. The strategy remains fundamentally sound, though, and we won't make the same mistake twice. As such, you should give us money in our new fund which has a reset high water mark.)
Finally, the FT comments:
"The more one believes this is how an unregulated financial system operates, the more worried one has to become. Rescue from this crisis may be on the way, but what about the next time and the time after next?"
In our recent post on the 2 and 20 structure, we touched on the issue of whether hedge fund managers choose to reinvest incentive fees in their funds. We received a couple of questions related to our comment:
"Things can get even more sneaky: don’t expect that just because a manager has x hundred million dollars “in the fund” that it is necessarily at risk with fund performance. There are certainly managers who will index part of their personal investment (usually when held as part of a tax deferral scheme) to other assets."
To give a little more detail on this point, it is possible that some (or even all) of a Manager's investment in a hedge fund can be linked or indexed to the performance of other assets and not the hedge fund itself. While unlikely onshore (at least for managers subject to US personal taxation), this is a situation which can arise in an offshore fund. In offshore vehicles, US taxable managers can elect to defer payment of incentive fee income for up to 10 years, which then grows on a tax free basis. Over time, these deferred fee balances can become very substantial and represent a material portion of offshore fund assets.
In some instances, the manager may elect, for reasons of personal investment diversification, to index some of these deferred fees to something other than fund performance. Treasuries are the most usual choice, which, in the scheme of things, is relatively uncontroversial. Things become more worrisome when managers index to other assets such as equity indices or even buy a portfolio of investments (such as holdings in other hedge funds) which are allocated solely to the deferred fee account, and not to external investors. Some funds also adopt leverage mechanisms on insider capital, which can add still more complexity.
The due diligence point, therefore, is to understand whether insider investment is allocated on a pari passu basis with external investors. Is there some indexation to assets other than the hedge fund and, if so, what assets are involved and to what proportion? It is also important to understand whether insiders choose to allocate some of their personal investment to co-investment vehicles or separate "partners funds" which might follow different strategies (more risk, less risk, more concentration, more private investments etc. etc. etc.) These structures, in turn, introduce additional potential for conflicts of interest.
So, when a manager claims that a large dollar amount of firm assets are held by the principals, it's always a good idea to check that those assets are invested in the same things as you.
Hedge funds have a remarkable fee structure – typically a 2% fixed management fee plus 20% of performance. This structure comes in for frequent criticism from “traditional” investment consultants, who simply cannot understand why institutional investors pay hedge fund fees – there’s clearly a contradiction between the determination institutional investors have shown to drive down the cost of acquiring market beta (indexing, futures strategies etc.), with their readiness to pay 2 and 20 for what may – or may not be – hedge fund alpha. The most commonly given reason for this paradox is simple supply and demand: there is ever more money chasing a finite pool of “good” hedge fund managers, so obviously those managers see little need to reduce their fees. Indeed, some of the “best” hedge fund managers disregard even the 2 and 20 rule and can charge up to twice as much.
Perhaps, though, that it about to change. 2 and 20 is fine when markets go up, but recent events – and no doubt events over the coming months – may cause a lot more hedge fund investors to question the industry’s fees.
In many ways, the recent demise of the Peloton ABS fund is an excellent case study for the issues raised by 2 and 20. As a disclaimer before we go any further, we note that we have not completed due diligence on this fund or firm and our only knowledge of the circumstances of Peloton’s losses come from the news media.
We don’t want to pick on Peloton, but the case highlights the fact that hedge fund managers get rewarded on the way up – handsomely – but do not have to repay fees on the way down. It is this asymmetric fee structure which, we expect, will come in for sharper criticism when more investors find funds down 10% in a month, let alone down 100%.
It has been reported that Peloton posted a spectacular 87% gain in 2007. As this is the net return to investors, the fund itself must have been up about 110% gross in ‘07, as the net gain is stated after the management fee (which we assume was 2%) and the 20% performance fee. It’s hard to estimate the dollar value of fees earned by Peloton during 2007 (by Feb 2008 the fund is reported to have had assets of $1.8 billion, but the amount earned across the’07 year will depend on the timing of subscriptions as well as the degree to which Peloton shared fee income with third party marketers.) As a conservative guess, let’s say management fees and incentive fees were at least $100m.
Let’s think about a number of issues.
Firstly, if a manager generates a substantial incentive fee, has any of that income been reinvested in the Fund? Peloton is an extreme example when a manager generated very high incentive fee income one year but then blew up less than two months later. We don’t know the circumstances of this case, but we imagine that investors would have a different view if Peloton had reinvested all the $100 million back into the Fund (to take our “guesstimate”, as above) - which is now worth nothing - compared to a situation in which the firm’s principals had taken the full amount out of the Fund and reinvested it elsewhere. Investors are unlikely to be happy with a manager who is up $100 million while they are down 100%.
The problem, though, is that there is no “standard” formula for whether managers will reinvest in the Fund and, if so, to what extent. Some managers reinvest a great deal, while others withdraw a much higher percentage. Some firms employ multi-year deferred compensation schemes, others pay year to year. Even if the principals of the firm reinvest a lot, the portfolio managers lower down the chain may well get paid in cash (let’s think of Amaranth and Mr. Hunter.)
Things can get even more sneaky: don’t expect that just because a manager has x hundred million dollars “in the fund” that it is necessarily at risk with fund performance. There are certainly managers who will index part of their personal investment (usually when held as part of a tax deferral scheme) to other assets.
In our mind, the question of whether hedge fund managers should reinvest performance fees in their funds raises a multitude of issues. One is the self evident moral hazard: unless the risk takers within each hedge fund are forced to reinvest a (significant) portion of their incentive fees in the fund, then performance objectives can become fixated on the annual compensation cycle, not long term performance. This is the prop desk mentality, not one of enduring alignment between manager and investor interests.
A second issue is much broader – is it actually a good idea that hedge fund managers should get their 20%, in full, on an annual basis?
1) Should there be a “look back period” for the performance fee? In other words, if the fund goes down, should the hedge fund manager return some of the fees earned in prior years? Taking a relatively mild application of this principle, should a manager return a pro rata proportion of the performance fee if the fund falls in the following year? In other words, if a fund is up 20% in the first year, but falls 10% in the next, should the performance fee be adjusted to reflect the fact that the fund was only up around 8% over the two year period?
2) Should the performance fee “vest” over a period of time? Would it be wiser for the 20% to vest, say, over three years on a one third, one third, one third basis? This would clearly act as a disincentive for short term hubris and risk taking – the strategy needs to sustain itself and generate ongoing performance if the manager is to receive the subsequent installments of the incentive fee.
3) Should the performance fee crystallize in line with manager redemption opportunities? If a fund imposes a three year lock up, for example, is it a good idea that the manager can nonetheless pay themselves every year? If a fund does follow a strategy with a multi year time horizon, should the manager receive their fees only at the point that investors can exit the fund and realize gains themselves?
There are no easy answers to any of these questions. What is clear, though, is that there should at least be more discussion of hedge fund fee structures. We are left with the thought that 2 and 20 provides an amazing “carrot” which has allowed a growing number of successful managers to generate stupendous personal wealth. It would certainly seem fair that investors make sure that there is a corresponding “stick”.
We are, we have to admit, often critical of some of the operational issues we see in the hedge fund industry. We did have to take pause, however, when we read a Bloomberg article this morning about the mutual fund giant, Fidelity.
According to the results of a three year SEC probe, some traders accepted inducements from brokers anxious to get more of the firm's colossal commission flow. In one extreme case, brokers picked up the tab - some $160,000 - for a trader's bachelor party which included a wide range of, ahem, entertainment for those participating.
Needless to say, all those involved did not admit or deny wrongdoing, which is a phrase we're familiar with on the hedge fund side of the fence.
The world is getting very busy - MF Global, Peleton, Sailfish, Richmond to name but a few.
As ex UK Prime Minister Howard Wilson once said, a week is a long time in politics, and it certainly is a long time in the markets. Given current events, Soc Gen's Mr. Kerviel is rapidly drifting off the radar screen, but we wanted to highlight a very good Bloomberg article.
The last comment is particularly insightful:
"The incident highlights the inherent tension between middle offices and the trading floor.
``You have two people: one makes the bank richer and one prevents the bank from earning because of risk of loss,'' said Tamar Frankel, a law professor at Boston University. ``So guess who has the upper hand?''