After having prepared Castle Hall's list of redemption gates, suspensions and restructurings, we wanted to highlight several other blogs which have also touched on this issue.
"Ten seconds into the future", back in October, commented on the coming logjam of redemptions in the fund of fund industry as at December 31. The post touches on the prisoner's dilemma - even if you don't necessarily want to redeem, it may well be a good idea to get out first....
All About Alpha comments that the "stigma of redemption gates is fading fast."
Finally, Pension Pulse brings together a summary of articles...please close the gate behind you.
The number of hedge funds which have imposed gates, suspended redemptions and / or proposed a form of restructuring has grown rapidly.
Castle Hall has accumulated a list of "gated, suspended or restructured" funds which have been mentioned in the financial press: to date, our list stands at 75. Our document, which includes a brief summary of each case and links to various news articles, can be downloaded here (update: given the large number of additional gates, suspensions and restructurings, we have removed our original document as it is now superceded.)
"Huertas also said some institutional investors could be doing a better job in performing due diligence on hedge funds, which are generally less transparent than mutual funds.
"Investors in UK-managed hedge funds are large institutional investors and they have a duty to their end investors to perform due diligence. They need to do what they're supposed to do as institutional investors.
"Some investors, shall we say, could be doing more due diligence. There is probably a high degree of correlation between poor due diligence and large losses."
We have commented before on the supposed trends of "institutionalization" of the hedge fund industry. Huertas' remarks highlight the achilles heel of this process: institutions will only make a difference to the extent they have both the knowledge and thereafter the commitment to invest time, people and money at each stage of their investment process, both before capital is allocated and post investment.
Castle Hall has had the opportunity to complete due diligence on many of the world's largest hedge funds and, while some are exceptionally well run, many do not meet "best practice" standards, at least across every aspect of their organization. Equally, the quality of oversight provided by these funds' third party service providers can vary from great to pretty much useless. The most lasting impression is the lack of operational standardization amongst multi-billion dollar hedge funds: there has, to date, been no standard "model" imposed upon the industry by institutional investors. Just ask 10 large funds how they value their positions, and listen to the 10 different answers.
Going forward, we are entering a new period of "caveat emptor". It certainly is true that relatively few people have an appetite to ask tough questions at a time when everyone is making money: going forward, those tough questions will be mandatory for every investor. The days have gone when hedge funds could be selected "safely" based on fund size, reputation, prior track record or the identity of other investors who must have already "passed" the fund.
There never have been any short cuts to good due diligence. The change, as we look towards 2009, is that good due diligence is now unavoidable. Many hedge fund investors will certainly be surprised at the answers they receive when they do, finally, begin to ask the tough questions.
Having just posted comments on FAS 157 ourselves, the audit firm Rothstein Kass has just published a paper providing implementation guidance on the new fair value accounting standard as it applies to hedge funds.
For those with interest, this paper, along with other accounting and best practice resources, is available on the Resources section of Castle Hall's website.
We have now seen a growing number of funds suspend redemptions or propose restructurings, and expect that many more will follow over the coming weeks.
There are many implications here, but we wanted to focus on three issues related to accounting and valuation, particularly in light of FAS 157.
1) Is any sale a "fire sale"?
As part of the suspension process, there is a growing trend for funds to segregate securities into a liquidating portfolio. As such, the proportion of the portfolio which needs to be liquidated to meet redemption requests is set aside and separated from the "ongoing" portfolio. The securities will be sold and the proceeds - whatever they may be - will be paid to those investors who require short term liquidity and choose not to rescind their redemptions. In other words, think fund of funds.
The question, though, is how those sales will impact the NAV calculation for securities held in the "ongoing" portfolio.
At first glance, it would seem obvious that if a hedge fund sells a security from the liquidating portfolio at a 25% discount, then that is the price which should be used for identical securities held in the ongoing portfolio. After all, here we have tangible, specific evidence of a transaction and, at the moment at least, no-one is willing to pay more.
Not so fast. We expect that many managers will argue that sales from the liquidating portfolios are involuntary - markets are so bad, that the managers,or so the argument will go, would not sell the securities by choice. They are only doing so because they are forced to raise cash to meet redemptions and, therefore, all such sales must be fire sale, distressed or forced - take your pick as to the terminology.
If you follow this argument through, then it would be possible for managers to ignore the prices from actual sales in the liquidating portfolio. Securities held in the ongoing portfolio would be valued using other methods and could, of course, be recorded at higher prices than the actual sales.
To this point, we were very interested to read an interview with a managing director from the valuation firm Duff and Phelps who commented that hedge funds "within the last couple of weeks" had increasingly returned to mark to model pricing. The reason for adoption of mark to myth, sorry, mark to model methods is that "in illiquid markets the range of broker prices can be too wide to be very meaningful."
There have, of course, been some recent "clarifications" as to the implications of mark to market accounting and FAS 157. These include the FASB staff position 157-3 and the SEC guidance on fair value accounting (both available from Castle Hall's website). Both provide new latitude to ignore "fire sales" when considering the prices to be used for identical or similar securities in a portfolio.
This is a huge issue that impacts, firstly, NAV calculations at November 30 and December 31 and then the audited financial statements as of year end. We certainly agree that markets are tumultuous and the lack of market depth is unprecedented. There is, therefore, definitely an argument that when markets are gripped by fear and transactions underestimate the "fair value" of a security, then those prices should be ignored or at least questioned.
Mind you, this would be a stronger argument if people were more vocal to mark prices down at times when markets were unduly confident and prices clearly over-estimated fair value. Everyone is, of course, very happy to mark assets up in a period of irrational exuberance (and get paid on those marks), but more than a little hesitant to mark them down in a period of irrational pessimism.
2) Investors have to make their own determination of fair value
Some time ago, we commented on a recent letter sent by the Department of Labor to an un-named US ERISA pension entity. The emphasis of the letter was that it is the investor who is responsible for determining the fair value of all investments, including hedge funds. As we said at the time:
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.”
The audit profession makes exactly the same point: the financial statements are the responsibility of management, who must select appropriate accounting policies and then implement controls and procedures to ensure that the financial position and performance of the reporting entity is correctly stated within the parameters of materiality.
Against this background, let's pose a question. If I am a hedge fund investor - a fund of funds or an institution with positions in numerous, single strategy hedge funds - what happens if I have 5 underlying funds who adopt some variant of the restructuring discussed above? Each underlying manager will make their own determination as to how they should cut their NAV, potentially making their own, different assumptions about what prices they should ignore as being "distressed" or "fire sale".
What happens, though, if those underlying managers do not make consistent decisions? How do I, as an investor, ensure that the valuations I have used are consistent and comparable if I have underlying managers who have adopted differing valuation techniques in these markets?
Equally, what happens if I, as the investing entity, disagree with the underlying manager's accounting policy - perhaps I believe that at least some of the actual, realized transactions actually are representative of fair value and should not simply be ignored. This means that the underlying manager's accounting policy flows through to become the investor's problem.
On this point, investors should also remember that the auditors of underlying hedge funds are not responsible for those funds' accounting policies: those, too, are set by the management of the underlying fund. As such, different funds holding the same security, audited by the same audit firm, may well hold that same security at different prices, yet still receive unqualified audit opinions. The auditors are not, to be clear, imposing any form of pricing standardization or consistency: the auditors do not have a central master pricing file that they force all hedge funds to use.
There is clearly a huge challenge for the auditors across all these points, and we very much appreciate that the auditors will have an enormously difficult time trying to work through these tortuous valuation issues. Equally, though, we have to highlight a conflict: auditors serve both to audit underlying hedge funds and then also to audit the accounts for investors who allocate to those hedge funds.
As the audit firms work through these issues, therefore, we have to hope that they will have a mind to both constituencies. The challenge is one of chronology: the underlying hedge funds usually complete their audits before the end investor (after all, the end investors need the financial statements from the underlying funds before they can finish their own audits.)
What would be completely unacceptable for investors is to find that the auditors first complete the underlying hedge funds' accounts and work hard with each manager, client by client, to "justify" each fund's individual accounting treatment. It would be ironic indeed if those same auditors then turn round to investors and make an audit issue of the lack of accounting consistency and comparability across a portfolio of those underlying funds.
This is a time for the accounting profession to step up to the plate. When auditing a hedge fund, the client is not the hedge fund manager. The client is the fund, which is owned by the investors. If there was ever a time for the auditors to remember who they are preparing financial statements for, this is it.
3) If a hedge fund has suspended redemptions, is it restricted from sale?
The argument was that hedge funds are restricted from sale as they offer infrequent redemption opportunities. If I invest in a fund with a five year lock up, therefore, should I still carry it at par as I cannot exit from that fund for 60 months?
The industry has side-stepped this one (albeit more for reasons of practicality than technical rigor). The issue is still out there, though, for funds which suddenly suspend redemptions indefinitely. If I am an investor in one of these hedge funds, must I make some allowance for the lack of liquidity and restriction as to sale which has suddenly been imposed? Is it still appropriate to carry these funds at the reported NAV, or should I take some form of discount?
We await audit guidance on this point as well.
Again, these tumultuous times create unprecedented issues for everyone involved in the hedge fund industry. These issues also do not have any easy answer. At times like these, we also have to applaud the efforts of many managers to "do the right thing", even when it is not clear - today at least - what the "right thing" actually is.
It is a fair point, however, to state that the decisions made now by the managers will flow through to the investors post year end. We certainly do hope that the lawyers and accountants giving advice to the managers this weekend do stop to think about the impact their advice will have on the investors next year.