Nakedshorts has just published an excellent post on the FSA's response to the recent pricing problems uncovered at a variety of investment banks based in London.
According to a Bloomberg article referenced by Nakedshorts, a "large number" of UK banks have mismarked securities. Ouch, to say the least.
The blog also includes a link to the FSA's "dear CEO" letter regarding valuation. Some highlights:
- "Firms should proactively review their processes and controls to ensure that they are commensurate with the challenges and issues posed by the increased market illiquidity and valuation uncertainty."
- "In the current market environment, characterised by illiquidity, constrained profitability and management stretch, firms are more susceptible to mis-marking frauds perpetuated by trading staff. In the current environment, we are more concerned that weaknesses in processes and controls are more likely to be exploited and exposed."
- "Product Control Staff (i.e. the back office) were unable to adequately challenge the front-office staff, through lack of skills or seniority. Against this background Product Control seemed to be acting too much as a business facilitation function and not enough as a control function."
Once more, we make the same comment as in prior posts. If this is the environment in an investment bank, what is it like in a hedge fund, free of these "bureaucratic controls"?
When thinking of hedge funds, investors must be ever conscious of the clear conflicts of interest and potential for valuation manipulation when portfolio managers mark their own books. Just because the investment banks do it, doesn't mean that it's a good idea.
According to this letter, the fund is suspending redemptions and will consider "multiple options that direct the future course of the partnership" including appointing a new manager or liquidating the fund.
From an operational perspective, there are a couple of points. Firstly, the company had evident key man risk, which would suggest that investors should have considered a key man clause in the offering documents. However, this would actually have made little difference: the Insana letter points out that, due to lock ups on many of the underlying positions, it will take at least a year to turn the fund to cash. Having a key man clause would not, therefore, have helped investors get their money back any quicker.
The main issue seems to be the overall set of circumstances at play here. It's unusual, to say the least, when a manager can leave his own firm to go and work for someone else with apparent impunity. While Mr. Insana finds new employment, investors in his fund will have their capital tied up during what could become a protracted work out situation.
The lesson here is that investors may need to look beyond key man clauses. Perhaps what investors actually need is a non competition clause - i.e. if you're hired by investors as a money manager, you can't simply resign to go and join another one. That would be an interesting concept.
Some time ago, we commented on Credit Suisse's London office, where a group of CDO traders managed to "deliberately misprice" their portfolios to the tune of nearly $3 billion.
The regulatory process has made some progress: according to the FT, the UK's FSA is close to agreeing a GBP5 million settlement (we wonder how that compares to the bonuses the traders in question hoped to earn based on their fictional prices.)
The FT describes the mispricing event as follows:
"Credit Suisse’s losses occurred in trading books dealing in residential mortgage-backed securities and collateralised debt obligations. They emerged within days of the bank hailing a resilient set of annual results which it argued demonstrated the strengths both of its risk management and risk culture. The mismarkings came to light in an ad hoc review, and there had been no specific indicators that there was any cause for concern."
As always, we remind investors that if this could happen in an investment bank, it could certainly happen in a hedge fund. How many hedge funds, for example, have a process of "ad hoc" reviews of their pricing?
According to Pensions and Investment, the Boston office of the US Department of Labor (the “DOL”) recently issued a letter to an (unidentified) US Pension Plan subject to ERISA (the Employee Retirement Income Security Act) stating that the plan was in violation of ERISA regulations. The DOL is responsible for monitoring - and sanctioning - ERISA plans and, in their letter, threatened legal action if the plan in question did not remedy the noted violations.
When valuing hedge funds and other alternative assets for purposes of the Plan’s annual filing, the pension investor had apparently relied upon valuations provided by the underlying funds’ general partners and, in some cases, on audited financial statements for those funds.
This is, of course, standard practice for many hedge fund investors. It appears, however, that this approach could create a major roadblock for ERISA plans.
According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan. Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy. In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value. A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”
In other words, the entity which has to value all assets – and especially hard to value assets – is the pension investor subject to ERISA. There is no way of dodging this poison chalice - the ERISA investor cannot simply rely on the hedge fund’s own valuation.
This is an enormously challenging obligation, particularly in the context of the severe fiduciary standards set by ERISA. Indeed, the DOL position raises a broad question - is it even possible for ERISA plans (or indeed any hedge fund investor) to meet this duty of care?
We have three observations.
Firstly, very few hedge funds provide position level transparency. However, it is stating the obvious to say that, without position level transparency, it is impossible for an ERISA investor (or any other investor for that matter) to have a “complete” understanding of the underlying investments and the fund’s investment strategy. Moreover, even if managers do provide position information, how can investors ensure that it is timely and accurate? The best solution to the transparency issue is a managed account – as such, would one outcome of the DOL’s position, if enforced, be for ERISA plans to only invest through managed account structures?
Secondly, the DOL states that ERISA plans must have a “thorough knowledge of the general partner’s valuation methodology”. However, in practice, most hedge fund offering documents have deliberately vague and unspecific clauses as to valuation and calculation of the net asset value, especially in relation to hard to value instruments. To add salt to the wound, every prospectus we have ever read includes a final caveat along the lines of “notwithstanding the above policies, the general partner (or the Board of directors in “consultation” with the investment manager for an offshore fund) may elect any “alternative method” of fair valuation. “ There is hence very limited specificity as to valuation procedures in virtually all hedge fund offering materials, and certainly insufficient information to provide a “thorough knowledge” of the valuation methodology which will be applied.
If the prospectus gives an inadequate description of the valuation process, investors need to turn to supplementary information from the hedge fund manager. At this point, however, things get worse - many hedge fund managers have not developed any internal, written valuation policy at all. For those funds which do have a valuation document, there is no standardization, and many valuation policies remain uncomfortably vague and unspecific (although, in fairness, we congratulate the minority of managers who have some stepped up and do furnish investors with comprehensive valuation information.)
The worst case is when a manager does have a valuation document, but will not provide it to the investor. Ironically, the worst culprits in this situation are some of the industry’s largest and most well known hedge fund managers. The issue is liability: hedge fund lawyers now appear to advise managers that the more information provided to investors, the more the potential liability. (As an aside, we recently spoke with the CFO of a large hedge fund: he noted that the sight of the Bear Stearns hedge fund managers being led away in 'cuffs had resulted in urgent calls from the firm's lawyers, advising the manager to reduce the amount of information it provided to investors.)
The third area of concern is the ongoing assumption by many investors, including many ERISA plans, that third party administrators assume responsibility for valuing hedge fund portfolios. As such, the administrator, it is perceived, can provide the necessary independence in the valuation process.
Not so fast. As we have noted before, much of today’s administration industry is now emphatic that they perform only the services of a “calculation agent” not a “valuation agent”. This is a relatively mute point when dealing with exchange traded securities, but it is an enormous issue when looking at a hedge fund which trades hard to value instruments (it goes without saying that we need help to value exotic CDOs, not IBM stock).
As a “calculation agent”, many administrators have amended their legal contracts to retain the right to “consult with” the manager and, indeed, accept prices from the hedge fund manager without further verification. Again, we hate to make an “emperor has no clothes” comment, but this is obviously nonsense: taking prices from the manager is like a police officer issuing speeding tickets on the basis of asking drivers how fast they were going.
These issues, in our mind, share a common theme. In recent years, with an ever-accelerating pace, we have watched the legal pendulum which defines how investors and hedge fund managers transact drift ever further in favor of the manager at the expense of the investor. It is trite, but uncomfortably accurate, to say that, in today’s hedge fund industry, no-one wants to be responsible for anything. Everyone is instead seeking to be indemnified to the point of invulnerability.
And this is the disconnect between the hedge fund industry and DOL. ERISA establishes onerous standards of fiduciary responsibility, deliberately designed to make those responsible for ERISA plans accountable, responsible and liable for their actions. Today’s hedge funds, however, are increasingly structured to ensure the lowest possible degree of accountability and liability on the part of pretty much everyone involved.
Against this background, we will watch with great interest ongoing developments as the DOL monitors ERISA plans with material hedge fund portfolios. The question, of course, is whether investing in opaque, uncommunicative hedge funds (even when they are some of the largest in the world) is too close to pushing a square peg in a round hole for investors who do operate within a strict fiduciary framework.
The Economist this week published an article "confessions of a risk manager."
One of the most interesting sections related to the potential conflict between investment bankers - tasked with making money - and the risk managers, too readily considered an obstacle to making money. We touched on this before: "one makes the bank richer, and one prevents the bank from earning because of the risk of loss."
According to the article, risk managers were "spoilsports":
"In their eyes [i.e. the traders], we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.
At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.
Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions."
Food for thought, especially when you think how this dynamic can play out in a hedge fund.