We commented a few days ago that Morgan Stanley had identified a $120 million "negative adjustment" related to a trader's deliberate mismarking of his portfolio.
A pretty unlikely source - computerworlduk (the "voice of IT management") - has just published an excellent article on the debacle.
The article quotes Ralph Silva, a senior analyst at the Tower Group, a financial services advisory firm. According to Mr. Silva, "firms were 'not taking seriously enough' threats from their own traders".
He continues: "there was a fundamental cultural problem in trading firms, where they were loathe to put in extra controls in case it meant they lost their edge over rivals. 'They don't want too many controls or it would kill aggressiveness,' he said. 'But the problem is that the traders are held at such high esteem, they have carte blanche to do what they want."
Sobering stuff. Particularly when you remember that many hedge funds are founded by traders who wanted to free themselves of the "bureaucratic restrictions" of having to work in a large investment bank.
Bloomberg reports today that Morgan Stanley London has suspended a credit trader and made a $120 million "negative adjustment"related to "erroneous values of his positions."
This comes, of course, after Merrill London identified a $20 million loss due to deliberate mismarking by a trader on the equity derivatives desk (see our earlier post.)
We shouldn't pick on Merill and Morgan, mind you: their misfortunes fall into insignificance compared to Credit Suisse's stunning $2.65 billion write down related to a trading group that mispriced CDO's (also, see our earlier post.) Lehman has also had some difficulties, let alone the Bank of Montreal which had a near $500 million loss due to two natural gas traders providing bogus prices to their head office.
We continue to believe that pay structures dominated by incentive compensation (be it a hedge fund's "20%" in 2 and 20, or the "eat what you kill" model of prop desk compensation) create an unavoidable conflict of interest (incidentally, hedge funds which have 2 and 20 and then pay their staff on individual P&L is probably the most toxic combination of all).
As such, best pratice must always be for the security pricing process to be owned by the back office, independent of the traders. Yes, we may give up some market color and "accuracy" if we put the back office in charge, but we gain independence. We have yet to find the investor who is not prepared to accept a few basis points of difference between front and back office marks across the aggregate book in return for removing the risk of a 5,000 basis point loss in the event of a hedge fund pricing fraud.
Clearly, if a global, regulated institution like CS, Morgan, Merrill and Lehman can have a pricing problem, then so can a hedge fund. So how can investors respond?
The recent best practice papers from the President's Working Group, the hedge fund working group, AIMA etc. have all emphasized the need for segregation of duties, although with varying degrees of "weasel words" which let the PM's get involved on the hard to price positions. It's time to get rid of these exceptions and make sure that the hedge fund industry adopts a clear and consistent back office pricing regime.
In other words, it's time to walk the walk, not just talk the talk.
As we all know, many hedge funds are established in offshore jurisdictions. The Cayman Islands has the world's largest number of hedge funds on its corporate register, with many other funds established in Bermuda, the British Virgin Islands and other tropical locales.
It is easy for onshore politicians to criticize offshore jurisdictions (living in Quebec, we often read the French term "paradis fiscaux" - "tax paradise" seems to have even worse connotations than the English phrase "tax haven").
Following on from our last post on the new Cayman Islands electronic reporting database, however, we thought that we could suggest three changes where the Cayman regulator (and those in other jurisdictions) could address major problems in today's hedge fund industry. Let's go from easy to hard.
It would be very useful to have an independent means of verifying the directors of a Cayman based hedge fund. The Cayman Islands Monetary Authority ("CIMA") could therefore allow electronic searching, by fund, to identify and confirm the identities of fund directors.
As a second benefit, search capability would allow investors to determine exactly how many directorships each individual holds. Certain familiar names serve on hundreds and hundreds of hedge fund boards: with this information, investors could make a far more informed decision as to whether the directors in question have time to exercise meaningful governance over the activities of the fund in question.
2) Administration Agreements
One of our perpetual bugbears is the ongoing effort of administration companies to prevent distribution of their administration agreements to fund investors. This is an ever increasing concern as, on the one hand, funds become more difficult to price while, on the other, administrators now include ever tighter language denying responsibility and liability for security valuation. (As we have said before, exactly how an offering memorandum can state that an administrator is responsible for "calculating" the NAV when they do not, in fact, price the securities is something of a conceptual mystery, but anyway.)
As the administrator is paid by investors and plays a (hopefully) material role in protecting investors' interests, access to the admin agreement is a necessary element of any due diligence review. As such, CIMA should require that the administration agreement be listed as a "material contract" in the offering document of any Cayman fund. This would make it mandatory for each agreement to be available for inspection by shareholders.
Incidentally, Bermuda funds typically do include the admin agreement as a material contract: we would prefer to see Cayman adopt the same process.
3) Auditor confirmation
And finally....one of the most unsatisfactory developments in hedge fund operational due diligence over the last couple of years has been the adoption by all major audit firms of a policy whereby each firm will refuse to confirm that they are, in fact, the auditor.
The auditors' concern is once more liability driven: by speaking direct to investors, the auditor would extend their liability to those individuals. Evidently, investors may take the view that it would be no bad thing if the auditors were liable to them, but in the current environment the accountants' mantra appears to be "plausible deniability".
Putting aside the liability question (anyone ever read a current audit engagement letter, by the way?!) investors' main concern is simple: fraud. If the auditor will not even confirm that they are the auditor, how do investors know that the audited financial statements they have received (usually provided by the manager) are, in fact, genuine?
To combat this huge problem, we would like to see two things:
- CIMA should maintain a database which confirms the current auditor of record for each Caymanian hedge fund (NB: under Cayman law, every Cayman fund must have a local Caymanian auditor, making this easy to police). With some form of periodic confirmation from the auditors involved to ensure that the list is current, this would provide a materially improved mechanism for investors.
- The second issue is more profound. At present, virtually all investors receive financial statements from the investment manager, meaning that there is no effective control against a manager who chooses to deliberately change some or all of the numbers and disclosures in those accounts (as we all know, a copy of Adobe Photoshop costs $500 if someone is of a mind to change the PDF file).
We would like to see a central clearing house, maintained by CIMA, under which investors can register and request copies of financial statements. Each manager could log in to approve and authorise the release of those accounts, which could then be downloaded by the investor direct from CIMA. This would create the confidence that the accounts are genuine and are the financial statements officially filed by the hedge fund (via their auditor) with the regulator. Investors would certainly pay a fee for accessing this information.
We see an opportunity for the Cayman Islands to step up and provide an enormously valuable function as intermediary in information transfer between hedge funds and investors. How about it, Ugland House?
A few days ago, the Cayman Islands Monetary Authority published their "Investments Statistical Digest", which is a summary of the "e-reports" that all Cayman hedge funds now have to submit to the local regulator.
The statistics cover 5,052 Cayman domiciled hedge funds which filed as of December 31, 2006. This represents 81% of the funds which were due to publish their annual returns as of that date (although what happened to the remaining 19% remains unclear).
The key figures are:
- The 5,000 funds included in the survey had a net asset value of $1.38 trillion
- In all, Cayman reports some 9,413 regulated hedge funds as of December 31, 2007 - these include entities which were formed in 2007, as well as those which do not have December 31 year ends and are hence excluded from the 5,052 sample above.
Total net assets of Cayman funds will hence be significantly above the $1.38 trillion noted above (although, as many of these entities will be fund of funds, there will be a lot of "double counting" of industry assets).
- Average leverage is described as 67% although this will, of course, be calculated on an on balance sheet basis and hence significant understate economic leverage obtained via derivatives.
The CIMA database could be a very useful source of information going forward - definitely something for investors to monitor.
A few weeks ago we added a number of posts commenting on the standard hedge fund structure, 2 and 20 - a 2% management fee, together with an allocation of 20% of any net profits. You can find out post "Time to rethink 2 and 20?) here.
Against this background, it was interesting to read Business Week's article on the Abu Dhabi Investment Authority ("ADIA"), the world's largest sovereign wealth fund (with estimated assets of $875 billion, ADIA is considerably more than three times as big as CalPERS, the largest US fund.)
According to the magazine, in 2006 Sheik Ahmed bin Zayed Al Nahyan, ADIA's managing director:
"ordered his investment committee to figure out why passive investments in indexes were outperforming some of ADIA's high-paid fund managers. ADIA hired a consultant who found, after several months, that many endowments used index funds for as much as 80% of their investments. Through 2007, the team conducted an extensive study of its own money managers and others in the industry, and eventually concluded that few firms that invest in developed markets like the U.S. and Europe consistently outperform their benchmarks over the long haul.
With the findings in hand, ADIA, in the last six months, has increased the amount, from 45% to 60%, of the portfolio that is indexed. It has also halved the number of hedge funds it is considering for its portfolio. "ADIA is keen on identifying real management skills and real talent and is not prepared to pay the usual fees charged by funds for strategies that can be replicated in an index," says Al-Hajeri."
While we read frequent articles about the growth of the hedge fund industry, with that growth being driven by institutional investors, here is the other size of the coin - the largest investors exercising growing discrimination to pay outsize fees (and, while we take it for granted, 2 and 20 is a very outsize fee arrangement) only for measurable and sustained outperformance.
A welcome trend, indeed.
Reverting back to our original post on hedge fund fees, we expect increasing investor pressure to revisit the "standard" hedge fund fee structure. As we noted in our earlier discussion:
- Should hedge fund managers receive a performance fee only above a hurdle rate? (It's a very fair question to ask why a hedge fund manager should receive 20% of LIBOR.)
- Should a manager's performance fee vest over a multi-year period, remaining at risk with the fund's performance during that period?
This would address the scenario of a fund which does well one year, paying the manager a handsome performance fee, but makes a significant loss shortly thereafter. It's hardly optimal if the manager is up $50 million while investors are down 50%.
Indeed, the recent report from the Investors' Committee of the President's Working Group (link) made the comment (page 50) that:
Performance fees should be calculated over a period of time that is appropriate given
the volatility of the hedge fund strategy’s returns and any lock-up period required by
the hedge fund manager. Generally, the more volatile the investment strategy, the
longer the period included for calculating the performance fee.
This is a very far reaching suggestion: it suggests that the standard 12 month period may be too short to measure the volatility of a strategy and accurately determine whether, in effect, a manager has generated any performance on which an incentive fee should be paid.
The second inference is equally significant: if hedge funds impose ever longer lock ups, should performance fees be measured over a time period matched to investor liquidity? If a fund imposes a three year lock, for example, why is it that the manager can take a performance fee every year (or, in some cases, every quarter?)
Finally, we think investors should consider whether the performance fee should be paid only on realized gains. As we have noted before, hedge funds differ from private equity structures in that the incentive fee is paid on unrealized appreciation - paper profits - as well as realized gains. As hedge fund managers (and particularly managers investing in esoteric, hard to value securities) can value their own portfolios, there is a self evident conflict of interest when a manager receives a performance fee based on their own marks.
As hedge funds allocate greater capital to ever more esoteric positions, investors should remember that the only true indication of value for an illiquid security is when that asset is actually sold. As we have often said, a security is only worth what someone will pay for it, at the time the seller wishes to sell. While managers (and equally the investment banks) continue to argue that their valuation models are sophisticated, tested, frequently updated, developed by multiple PhD's, approved by the auditors etc. etc. etc., they provide only valuation estimates. The proof is in the pudding only when someone actually buys - what was the price they were actually prepared to pay?
When thinking of today's illiquid hedge fund assets, we are far from convinced that valuation estimates, be they from broker quotes or models, provide a reliable enough indication of value to be used as the basis of manager compensation. This is definitely a topic which needs more attention from the investor community.
Following on from our recent comments on the Hedgefund.net administration survey - which showed industry assets at $2.759 trillion - the FT reports today on a further administration survey, this time by HFM Week, which puts industry assets at $2.9 trillion. We await the first survey which puts industry assets above the $3 trillion bar.
In fact, we may well be over $3 trillion already: the Hedgefund.net survey did not include the substantial assets administered by Fortis and IFS which amount to at least $300 billion.
Aside from the question of industry growth, one other comment in the FT caught our eye. Providing a description of hedge fund administrators, the paper commented:
"They are used by almost all European hedge funds and an increasing number of US funds, who are under pressure from investors to provide independent valuations."
Readers of this blog will be familiar with our opinion that today's hedge fund administrators increasingly provide less and less oversight over valuation (as our prior post, "should administrators stand behind their work" discussed.)
One of the biggest fallacies in the current hedge fund industry is the ongoing assumption by far too many investors that, if a recognized administrator has been appointed, that administrator will calculate the NAV and price the portfolio. As we have discussed before, most administrators are emphatic that they are not responsible for security valuation (although exactly who is responsible for pricing remains a legal game of musical chairs). We then have all the variations of NAV Light and, even on full service engagements, the increasing trend for administrators to accept manager marks for that portion of the portfolio which is truly hard to value. It goes without saying that it is precisely these challenging instruments where investors have the greatest need for independent oversight and control.
We continue to believe that effective, vigilant oversight from an independent administrator remains by far the most effective - and cost effective - protection investors have against manager errors, be they honest or dishonest. Investors need to focus their due diligence, however, to determine which administrators meet these objectives, and which do not. After all, if the administrator does not compute an independent NAV, exactly why are investors footing the bill?
Some while ago we touched on the topic of "prospectus creep", or the habit of hedge fund lawyers to gradually add new clauses, exclusions and indemnifications to hedge fund offering documents.
We thought that we would comment on another example of prospectus creep - trade errors.
A trade error occurs when a hedge fund manager does something they didn't mean to do. A simple example would be for a trader to buy a security when the portfolio manager wanted to sell. Alternatively, perhaps the wrong security identifier is entered into an order management system, meaning that the hedge fund buys the wrong instrument. Or, perhaps there is a reconciliation error meaning that a fund ends up trading from an incorrect holdings list and, as a result, purchases too many stocks to cover a short position.
The question becomes who should assume the cost of that error, being the cost of trading out of the incorrect position and bringing the portfolio back to where it should have been.
Best practice remains for hedge fund managers to reimburse a hedge fund - and make investors whole - if they make a trade error. This was traditionally the policy applied by virtually all hedge funds and, until a couple of years ago, it was very unusual to find a fund manager who sought to charge the cost of trade errors to the fund.
Indeed, the UK Financial Services Authority ("FSA") touched on the topic of trade errors in their 2005 discussion paper (05/4) "Hedge Funds: A Discussion of Risk and Regulatory Engagement." In section 3.52 of this document, the FSA noted that:
"There appears to be no common understanding among hedge fund managerson whether trading errors should be borne by the fund manager or the fund.We think that the hedge fund manger, as a matter of law, must bear the costsof any errors for which it is responsible, in dealing with fund assets. To not doso would not only cause reputational damage but could also have regulatoryor legal consequences."
The FSA must have changed their mind, because this policy no longer seems to apply. The change is to specifically include trade errors within the scope of activities for which the investment manager is indemnified under the terms of the investment management agreement. In these agreements, the manager is indemnified against losses arising from anything and everything except gross negligence, willful default and fraud (as an aside, the latest trend is to try and exclude even the words "gross negligence", but that is a topic for another day.)
Our friendly hedge fund lawyers now seek to define trade errors as run of the mill, unavoidable hazards of running an asset management business. We have seen an increasing trend for offering documents to note that items such as reconciliation errors, "fat finger" errors, inaccurate recording of corporate actions, errors related to margin requirements, other accounting and profit and loss reporting mistakes - and of course trade errors themselves - do not constitute gross negligence. One well known hedge fund law firm even likes to add the helpful phrase "and shareholders should assume that such errors will occur."
In most areas of business, if you make a mistake, you pay for it. This all leaves us very puzzled as to why hedge fund lawyers believe that the rules of commerce don't need to apply to fund offering documents.
Which leads us to our final point, which is the particular irony. All this legal brainpower does not come cheap: it is expensive to think of new ways to constantly tighten hedge fund terms and conditions. Who pays the legal bills for drafting new offering documents with ever more restrictive terms?
It's the investors, of course, as legal bills are charged to the fund, not paid by the manager.