Our comments on Risk Without Reward have frequently touched on the role, responsibilities, advantages and disadvantages of third party fund administration. As a starting point, all of Castle Hall's partners have experience in the offshore hedge fund community, the traditional "home" of administration servicing ever since the days of the 10 commandments. Given our backgrounds, we have always been very strong proponents of the value of third party oversight over hedge fund accounting and NAV calculation. We continue to believe that effective administration servicing is universally the hedge fund investor's best protection against loss caused by operational failure, from honest mistakes to the worst case of dishonest fraud.
We do, however, see a number of emerging trends in the administration industry which are gradually "changing the game". Some developments in the administration servicing model, notably better application of technology, can be strongly positive for investors. Other trends, however, appear to be less beneficial, with changes taking place outside the scope of investor input or intervention. It is against this background that we would like to comment, in a series of posts, on areas where investors, managers and the administrators themselves could usefully rethink the third party oversight model.
Our first topic is, unsurprisingly, valuation. In Castle Hall's recent white paper on hedge fund operational failures, "From Manhattan to Madoff" (available here) we noted that "misvaluation of fund assets is the most significant, unresolved operational risk for hedge fund investors."
Our particular concern was "the ongoing ability of some managers to price securities themselves." We continued that "this practice is not in any way universal, but, unfortunately, becomes progressively more prevalent as instruments become more complex and harder to price. It goes without saying that it is precisely those instruments which are the most difficult to value which are the most susceptible to pricing fraud - it is obviously very hard to fake the price of IBM common stock."
We then commented on what appears to be a growing "expectations gap" in the administration industry, noting:
"Today, hedge fund investors continue to expect - rightly in our view - that third party administrators paid by investors to calculate a hedge fund's net asset value should independently value security positions. However, many of today's administrators argue that they have no responsibility for pricing and that the administrator's role is limited to that of a 'verification' rather than 'valuation' agent. Indeed, we see an increasing trend for administrators to accept manager prices for hard to value securities without further checks."
It is against this background that we were interested to see GlobeOp's settlement with a hedge fund - which the Wall Street Journal and other news sources identified as the UK based Regents Park - related to "mis-priced position values provided by a principal of the hedge fund's investment manager."
According to GlobeOp's statement on interim results issued on August 27th:
"We have settled a long-standing claim brought in arbitrationby a former hedge fund client. The claim relates to GlobeOp'sobligation to calculate and distribute the net asset value ofthe fund and the impact on that of mis-priced position values provided by a principal of the hedge fund's investment manager. The arbitration will be terminated and a settlement agreement was signed. GlobeOp expects that the cost of this settlementwill be approximately $27 million, net of $16.5 millionof applicable income tax benefits. The amount of the settlement is $43.5 million, with $20 million paid at settlement and the remainder paid over time with interestequal to the U.S. prime rate. The last payment will be February 2011. The settlement will be paid out of existingcash resources and will be a tax-deductible businessexpense during the year in which each payment is made.GlobeOp has no further liabilities outstanding in relationto this matter and the issue will have no impact oncurrent and future clients. Regents Park itself was named by the UK FSA back in 2006 (see FSA news release here). As an aside, it's interesting to see how the FSA can conduct an investigation which, at the time, did not involve "any finding of misconduct or breach of the FSA's rules" which nonetheless leaves the admin on the hook for nearly $50 million - we guess that's a different issue.
The point of our discussion here is not to take GlobeOp to task with respect to whether they did or did not perform services in accordance with their contract with the Regents Park fund. (We have not completed due diligence on Regents Park and, therefore, cannot comment on the specific administration servicing with respect to that fund.) In this particular case, it is evident that GlobeOp have settled claims and have made a substantial payment to resolve the issue.
Rather, our observation is more general and is directed at the administration industry as a whole: it is self evidently a really bad idea to accept prices for securities that will be used in a hedge fund's monthly NAV calculation, when those prices have been provided "by a principal of the hedge fund's investment manager". Guys, you need to check prices, and you need to check them independently. As we have said before, a copy of Adobe Photoshop only costs a few hundred bucks if you happen to be a hedge fund manager who is keen on changing that broker quote which will then be forwarded to the admin.
Our next post in this series will consider some of the potential solutions for the valuation dilemma - our starting point is clear and transparent disclosure so it is at least evident what the administrator has priced and what they have not. We will also touch on the use of third party valuation agents separate from the traditional administration companies: we see potential value in bifurcating the accounting function from the valuation process. And, of course, we'll also say that investors will have to pay more money, including to the admins themselves, if we really want top tier servicing.
However, we do have one final observation in this post. Anyone who completes due diligence on a reasonable number of hedge funds is familiar with the administration industry's attempts to avoid responsibility for pricing. This is evident in the legal blurb now included in many fund offering documents, together with the pages of disclaimers in typical administration agreements (we particularly like the legal provisions stipulated by those administration companies owned by prime brokers, who are usually very clear to point out that they have absolutely no responsibility for pricing, even when a hedge fund uses prices different from what the same pb uses in its own businesses.)
Above, however, we have a case where a leading administrator did need to settle a case related to allegations of mispricing. In GlobeOp's case, the $43.5 million settlement (pre-tax) needs to be set against the fact that the firm's revenues for the six months to June 30, 2009 were only $79.2 million. (GlobeOp, as a public company, does need to disclose its financial performance - as well, of course, as the terms of the settlement itself. Privately owned administrators do not need to provide such disclosures, which makes it easier to shield such mishaps from public view.)
Taking a step back from all of this, what really strikes us is the huge business risk much of the administration industry seems to be taking each and every time they take a price from a manager without properly checking it.
There are two potential problems. Firstly, all an admin company needs is one of the firm's several hundred hedge fund clients to blow up due to faked valuations, and the financial impact could potentially be threatening to the entire administration firm. We agree that the admins have sought to protect themselves with tight contracts which disclaim responsibility, but would a court of law actually uphold all of those terms? We would expect that there is at least some chance that a court, dependent on the facts and circumstances involved, could find that an administrator did at least have some baseline duty of care to check for valuations which were clearly incorrect. We remain puzzled as to why admins would accept the risk that one bad apple could wound - or even kill - the entire firm.
Secondly, the administrator's greatest friend is the investor, who continues to push for third party oversight. Many managers, however, would quite happily operate without an admin if they had the choice and didn't face investor pressure. Administrators, therefore, need to keep the investor community convinced that their servicing is valuable and worth the money.
The risk here is that, if there was a significant hedge fund failure caused by mispricing, the administration industry would not make friends if their response was "ah, but we did not actually have any legal obligation to check prices and were entitled to rely upon information furnished to us by the investment manager." The worst case scenario for the administration industry as a whole would be a loss of investor confidence, should investors be faced with a fund failure where it would seem that the admin got paid but didn't do their job. A lack of investor confidence in such an outcome - which we certainly hope will not arrive - would hardly help anyone.
Again, our next post will examine some of the potential solutions here, with a focus on short term initiatives which could better clarify the role and limits to current admin servicing. In the long term, however, the "expectations gap" remains. Ultimately, if you don't price the portfolio yourself, you have not calculated the NAV. That is the 800 pound gorilla at the back of the room for all administration service providers.
Hedge Fund Operational Due Diligence
Actually, true business risk to an administrator would come from agreeing to formulate independent valuations - the opposite of what Castle Hall believes. Just one mistaken valuation on a position could bring the firm down. Surely any staff member good at valuing something exotic would be paid more at a hedge fund, leaving the juniors at the administrators. Insurance would be prohibative and administrators would have to charge more. NAV's would come out much later as managers argued with the administrator and refused to sign off on a NAV driven by a valuation given by an administrator employee who has never traded in their life.
Without the details of the GlobeOp case we can't know where the failing was. If the pricing policy in the OM said that the administrator should use the manager's price for the asset type in question then I can't really see any liability. Perhaps it called for other steps which were not followed. In any case, perhaps GlobeOp is looking to do less valuation work in future, not more, as a result of this...
The investors should read the pricing policy. If it says a manager's price will be used under certain circumstances, then those circumstances might arise. The administrator has done its job if it follows the pricing policy approved by the auditor.
Posted by: Laura Borg | September 02, 2009 at 06:48 AM