Risk Without Reward

$1 a year in salary?

On a (slightly) lighter note, we saw the attached cartoon in a Quebec magazine, L'actualite, this week. The cartoonist, Andre-Phillippe Cote, also drew the great panel on the Madoff scandal we referenced here.

The translation for this one:

Charles, I have accepted that they will reduce my salary to only a dollar a year during the financial crisis. I'm now waiting for you to do the same. 

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Hedge Fund Operational Due Diligence

Ponzimonium - is that even a word?

According to Reuters, Ponzimonium is breaking out in the US.  

"Hundreds of people in the United States are under investigation for financial scams, many involving Ponzi schemes, a U.S. regulator said on Friday, calling the phenomenon "rampant Ponzimonium."

While none are as mammoth as disgraced financier Bernard Madoff's $65 billion fraud, multimillion-dollar "mini Madoffs" are proliferating from New York to Hawaii, the head of the Commodity Futures Trading Commission said.

So far this year, the agency has uncovered 19 Ponzi schemes, which depend on an influx of new capital instead of investment profits to pay existing investors.

That compares with just 13 for all of 2008."

It's unsurprising that the hedge fund bubble which peaked in mid-2008 created a parallel bubble of criminality - fraudsters tend to go where the money is.  Already, though, there are some lessons for investors.

Firstly, this round of fund fraud and failures will help investors understand the psychology of managers who turn out to be crooks.  This, in turn, will help identify yellow flags next time.

Some managers are simply criminals from day one, but a surprising proportion start out honest. Only when they begin to incur losses do some make the tipping point decision to cook their books rather than reveal that they had lost money.  Tracking the critical moment at which each asset manager decides to "go Ponzi" is one of the most useful lessons from each of these schemes.

The biggest lessons, though, reflect on the investor.  As we have often said, investors have less appetite to ask tough questions when they are making money.  The tendency to delightedly accept rather than skeptically question great returns is, of course, the basic behavior exploited by every Ponzi criminal.  What does this mean for investors?

1) Due diligence is a necessity for every investor with respect to every investment.  Madoff is the obvious proof that no-one is too good, too established or too big not to be subject to tough, systematic questioning. 

2) Due diligence needs to be ongoing.  Managers may be honest at the beginning but, as above, go Ponzi when they decide to double up rather than admit failure.

3) Investors must focus just as much on great performers as they do on laggards on the "watch list".  It's precisely the fact that a fund has reported great returns that could be the clearest sign that all is not well.

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Hedge Fund Operational Due Diligence 

Obfuscation...or Prospectus Creep

Our recent post on the "SEC's dirty laundry" made reference to "prospectus creep", or the tendency for hedge fund attorneys to add ever more disclaimers and "flexibility" to hedge fund offering documents.

We came across a letter in the current edition of the Economist that makes the point so well that we wanted to quickly repeat it:

"Certain assertions in your article on transparency in financial markets deserve to be reconsidered (Economics focus, February 21st). You describe transparency as amorphous, criticise it as costly and say it takes second place to trust in the money markets. It is hardly surprising that shortcomings may arise from inaccurate, immaterial and incomparable publicly available information, but transparency as a principle cannot be blamed. A hefty prospectus veiled in legal jargon should not be considered a transparent tool of disclosure; it is a means of obfuscation."

Exactly.

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Hedge Fund Operational Due Diligence

Lessons from the bonus debacle

As has been well reported, AIG has paid some $165 million of bonuses to a select group of employees in its Financial Products Division.  Some 73 individuals received "retention bonuses" of at least $1 million each - including 11 who were no longer with the firm.

According to Bloomberg:

"The insurer provided a list of bonus amounts and contract terms to Connecticut Attorney General Richard Blumenthal, who said the information supports his view that the basis for paying the bonuses is “completely unjustified,” according to a statement he issued today.

“These contracts rip the rug from under AIG’s excuses -- revealing no basis under Connecticut law for these mega taxpayer-funded bonuses,” Blumenthal said. “AIG’s own documents reveal that it turned an emergency bailout into a meritless handout, paying windfalls to employees as reward for financial failure.”

There is more nuance to this issue than the the populist press - or populist politicians - would have us believe.  But, to be honest, not that much more.

The bottom line is very simple.  AIG, one of the US's largest companies, went bust.  Whether the reason was an utter failure of risk control, an utter failure of risk management, an utter failure of underwriting standards, or an utter failure of management common sense, the company could only continue operations thanks to a massive injection of taxpayer money. An initial payment of $85 billion in September 2008 has now swelled to some $173 billion.

$173 billion amounts to nearly $600 for every single man, woman and child in the United States.  Looking at it another way, according to this page there are about 260 towns and cities in the US with a population of more than 100,000: with the AIG money you could give each of them $665 million for new schools, hospitals, universities etc.  And yes, that emphatically is a fair comparison.

Against this background, the fact that a tiny group of employees think that they deserve million dollar plus payouts funded from taxpayer money - merely to be incentivized to keep working - leaves us, quite simply, speechless.

The issues raised by this debacle do impact hedge funds because, once more, they go to the heart of the psyche and culture of today's financial system.  Or, more accurately, they reflect the psyche and culture of the "talented people" on Wall Street, in London and in Tokyo who lead today's financial system.

We touched on these themes in a recent post, "The bonus debate: investment banker or heart surgeon."  In the light of AIG's lunacy, we wanted to add more color to this topic by making two further points.

1) Asymmetric bonuses are fatally flawed

This one is easy - today's financial system has a warped incentive system which rewards participants on the way up but does not require any repayment on the way down.  The outcome is obvious - you encourage aggressive personality types to take risk knowing that the upside far outweighs the downside.

Put another way, we liked the analogy from our earlier post:"it's like a balloon blowing contest where the person who blows the biggest balloon gets paid the most, but does not have to repay anything if it bursts a moment later."

In the AIG context, this actually highlights a different point.  In our mind, the issue of the current $165 million of retention bonuses is, from one perspective, almost immaterial.  The real issue is how much was paid to the Financial Products Masters of the Derivatives Universe when times were good, even though, of course, their business was really nothing more than writing out of the money puts in front of the proverbial steamroller.  Anyone trying to get any of that back?

(As an aside, we remember one of our posts back in March 2008.  This noted:

CS and Lehman are not the only institution with valuation problems - earlier in February [2008], 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.) 

The lesson for hedge funds: 2 and 20, as we have noted on numerous occasions, contains exactly the same flaw.

2) Incentivization and accountability.

AIG is a perfect laboratory experiment to illustrate the push and pull of "talent" in the financial markets.  There is also a direct parallel with hedge funds: the thought process at AIG is identical to the thought process of a hedge fund which claims that, even though it is below its high water mark, the firm needs to modify its performance fee structure so that it can retain its "talent".

The situation is very simple: AIG's traders built a book of almost incomprehensible complexity that then lost untold billions of dollars.  As an investment strategy, ex post, this portfolio has proved to be an utter disaster.  This clearly generates blatant questions as to whether the individuals who ran this portfolio are in any way competent.

But...the fact that the trades are so complex means that there is a prisoner's dilemma: the only people who understand the trades are the people who put them on in the first place.  Therefore, if the trades are to be unwound in anything like an efficient manner, you need the original traders to continue to manage the portfolio.  

It is absolutely correct that keeping these individuals on board to sell the portfolio "efficiently" could save huge amounts of money as compared to a naive fire sale to dump the positions in the market.  The money saved - or more accurately losses avoided - by careful management of the wind-down of AIG's book could make $165 million in incentivization bonuses look like a drop in the ocean.

As a rational economic decision maker, this makes complete sense.  There is, however, just one problem.  Say we are naive, say we live in utopia, say we are irrational - but this is just not fair.

To give another analogy, this whole situation is a bit like being in the wild west and finding yourself shot in a duel.  This is not a good situation - you're about to die.  It then turns out that your opponent, who has just shot you, is the town's only doctor.  He agrees to save you, as long as you pay him all the money you've got.

Would you do it?  Of course.  Is it fair?  Well, no.   

The root of the outrage over the AIG mess is Main Street's inability to understand Wall Street.  To Main Street, the notion that you screwed up but then demand to be paid more money to fix your own mistakes is, of course, quite incomprehensible.  To Wall Street, this is a rational economic decision.

What is missing here is accountability.  At some point, someone does need to say that they screwed up, and that they will work every waking hour to fix their own mistakes.  Not because someone will pay them to make it worth their while, but because it is the right thing to do.  The fact that this is evidently an alien notion to so many senior participants in today's financial services industry is the real issue.

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Hedge Fund Operational Due Diligence     

The SEC's shopping list for hedge fund dirty laundry

In a post on Bloomberg today, the SEC is reported to have "dozens of active investigations" related to hedge funds.

The specific topic of the Bloomberg story is the potential for hedge funds to give their own principals and management, together with favored investors, beneficial treatment when imposing redemption restrictions.  The risk is that funds may have let themselves - and their best clients - get to the exit first, particularly during Q4 2008 when many imposed gates, suspended redemptions or otherwise restricted investors' ability to access their capital.

An interlinked topic here is likely to be the use of side letters, which is a much broader topic best saved for another post.  The whole issue, however, of whether it is fair to let some investors get out quicker than others based on a side deal was always likely to come to a head at some point. 

Side letters were a topic of concern a couple of years ago, with the main outcome that funds were advised to improve disclosures. However, in a classic example of prospectus creep, the friendly hedge fund attornies responded by adding new disclaimer language in many fund offering documents which simply allowed managers to issue side letters amending absolutely any term in the prospectus.  Against this background, what also needs to come to a head is the broader topic of whether risk disclosures in fund offering documents.  Caveat emptor is a fine principle, but unfortunately becomes a mockery when offering documents have been drafted to allow flexibility for pretty much anything "in the sole discretion of the investment manager". 

There is also a related question as to whether many side letters related to offshore funds are even enforceable.  This is particularly the case for US managers who signed them themselves, completely ignoring the fact that offshore funds are corporate entities with - supposedly - a Board of Directors responsible for corporate governance.

As an aside, both the topic of fund offering documents as well as the need for better corporate governance were discussed in Castle Hall's White Paper, "Hedge Fund Investing in a New World."  The paper is available here for interested readers.

Bloomberg also gives a laundry list of other hedge fund sins under the SEC microscope:

• whether feeder funds who direct money to other organizations completed the due diligence they promised to their clients (Madoff, Petters etc.); 
• improper valuation of illiquid assets; 
• manipulation of securities prices;
• insider trading, including in the markets for credit derivatives. 

Add to these topics yesterday's investigation of ex-executives at the New York State Common Retirement Fund who allegedly took kickbacks from investee funds, and it seems as if the regulators have a wide range of rocks to look under.

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Hedge Fund Operational Due Diligence

Hedge Fund Closures

Reuters reports today that UBP, at its peak managing US$60 billion of hedge fund assets, foresees and industry that could shrink by up to two thirds.  Particularly notable is the reported comment that UBP's approved list, currently with 270 managers, could shrink to 100 by the end of the year.

Looking backwards, Absolute Return magazine has prepared a list of the ten largest hedge funds which closed in 2008.  While a number are related to Madoff, there are also some notable ex-high flyers in the list.

TOP TEN 2008 HEDGE FUND CLOSURES
	Firm name	Fund name	Strategy	Peak Assets (in $ billions)
1	Fairfield Greenwich Group	Fairfield Sentry	Madoff feeder fund	6.9
2	Drake Management	Global Opp, Low Volatility, Abs. Return	Macro/Multi	4.7
3	Citigroup	Old Lane Partners	Multistrategy	4.4
4	D.B. Zwirn	Zwirn Special Opp. Fund	Multistrategy	4
5	Tontine Capital Management	Tontine Capital, Tontine Partners	Equity Long/Short	4
6	Ospraie Management	Ospraie Fund	Commodities	3.8
7	Highland Capital Management	Crusader, Highland Credit	Credit	3.5
8	Peloton Partners	Peloton ABS, Peloton Multistrategy	ABS, Multistrategy	3.5
9	Tremont Group Holdings	Rye  Investment Management	Madoff feeder fund	3.1
10	Kingate Management	Kingate Global Fund	Madoff feeder fund	2.7

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Hedge Fund Operational Due Diligence 

Kickbacks, anyone?

The SEC has today filed suit against David Loglisci, a 38 year old ex-investment banker who, from 2004 to 2007, served as CIO and Deputy Controller of the New York State Common Retirement Fund together with his alleged accomplice, Henry Morris.

According to the SEC's website,

The SEC's complaint alleges that Henry "Hank" Morris, the top political advisor and chief fundraiser for former New York State Comptroller Alan Hevesi, and David Loglisci, former Deputy Comptroller and Chief Investment Officer of the New York State Common Retirement Fund, orchestrated a fraudulent scheme from 2003 through late 2006 that corrupted the integrity of the New York State Common Retirement Fund in order to enrich Morris as well as others with close ties to Morris and Loglisci.

Specifically, the SEC alleges that Loglisci caused the fund to invest billions of dollars with private equity firms and hedge fund managers who together paid millions of dollars in the form of sham "finder" or "placement agent" fees to obtain investments from the fund. As asserted in the SEC's complaint, Morris made more than $15 million in such purported placement and finder fees.

The SEC Litigation Release and detailed complaint - which names a wide variety of hedge funds and private equity managers - can be downloaded here.

It remains to be seen whether this will be an isolated case or whether, with this example, other investors will be found to have abused the web of retrocessions, finders fees, third party marketing costs etc. etc.

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Hedge Fund Operational Due Diligence

Hedge Funds: The Road Back

TheStreet.com has published an interesting article entitled "hedge funds: the road back".  The author is Eric Jackson, president of Ironfire Capital based in Naples, Florida.

Jackson makes the following points:

1) Gating while charging fees is unacceptable

2) Pay for performance works

3) Don't tinker with high water marks

The basic argument - with which we wholeheartedly agree - is that managers should be well paid if they perform.  However, managers should not expect to have their cake and eat it: changing the rules of the game halfway through and continuing to manipulate the system in favor of the manager is unacceptable.

As we read commentaries such as Jackson, we are also struck with another point.  In many ways, the best insight as to how a manager will behave when times are tough is how they behave when times are good.  Managers who were arrogant and unresponsive when performance was strong and capacity was scarce do have quite a tendency to behave the same way when the tide turns.  Definitely food for thought.     

Jackson's conclusion:

"The hedge fund industry will work out its excesses carried over from the last five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons should be learned. But in one, five, and 10 years from now -- no matter the macro environment -- investors will still flock to hedge funds because it attracts the best managers with the most creative strategies."

Interesting ideas.

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Hedge Fund Operational Due Diligence

Madoff's Confession

Madoff has, of course, now pleaded guilty and has just enjoyed his first night at the pleasure of a federal correction facility.   Estimated losses - in terms of the reported value of investor accounts - is now thought to be as high as $65 billion.

Madoff's plea statement before the court is also now available (Download Madoff Plea) It confirms that, quite simply, he never placed any trades related to the purported split strike conversion program.  His fraud began in the early 1990s and continued until the day Bernie "knew would inevitably come"....almost 20 years later.

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Hedge Fund Operational Due Diligence.

More Industry Statistics

Two further studies of industry size and ranking.

Hedgefund.net has published its most recent survey of hedge fund administrators.  Citco remains the reported largest admin, with assets under administration of $375 billion.  State Street, Goldman, Citi and BoNY Mellon round out the top 5.

Separately,InvestHedge has prepared an updated summary of the industry's largest fund of funds as of December 31, 2008 - although it is unclear whether these numbers include redemptions as of Dec 31 / Jan 1.

Investhedge`s top 10 largest FoHFs

Top 10 largest Funds of Funds	Assets in $bln, 31 December 2008
UBS Global Asset Management A&Q	34.00
Union Bancaire Privée	33.00
HSBC Alternative Investments	31.88
Permal Investment Management	24.40
Blackstone Alternative Asset Management	23.65
Goldman Sachs Asset Management	23.50
Credit Suisse	21.90
Grosvenor Capital Management	20.50
RMF	19.30
GAM Multi-Manager	18.40

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Hedge Fund Operational Due Diligence