One of the most helpful initiatives to come out of the credit crisis - and Madoff in particular - is the concept of the administrator transparency report. These documents, now in use by several administration firms and in development by a number of others, provide key metrics focused on the two primary hedge fund operational risks, existence and valuation. Each transparency report usually indicates the percentage of assets which have been vouched to independent asset confirmations (PB, custody, counterparty statements etc.) and the percentage of the portfolio which has been independently priced by the administrator. As an extension, some form of FAS 157 (now ASC820) presentation of the portfolio by asset pricing "level" is often included.
These reports are helpful and unambiguously demonstrate the ability of the administrator to provide more meaningful information to the investor. That is, we must remind everyone, the primary role of the entire administration industry...admins are meant to be, first and foremost, an independent watchdog appointed to ensure an accurate, independent and fraud free NAV calculation.
One thing that is particularly helpful in each transparency document is independent confirmation of asset existence. While "trust but verify" is a wonderful soundbite, we think it is actually pretty unreasonable for each individual investor to turn operational due diligence into a forensic audit, with each investor looking to contact PBs and counterparties to confirm asset existence. While this process looks wonderful in a fund of funds marketing document, in reality it is simply impossible - for every fund in the portfolio - to (i) get all managers to agree to an asset circularization, then (ii) to get all counterparties to respond (or at least respond with anything other than a no and a disclaimer), and (iii) receive from each counterparty comparable information in terms of data presentation and cut off date. (As an aside, an asset confirmation request to Madoff Securities would have provided a wonderfully clean, check the box investor confirm). It is, in our view, far more efficient to place the administrator in the role of intermediary; the admin can then confirm to the investor base as a whole that asset confirmations have been received independent of the asset manager and, moreover, have been reconciled back to the underlying fund accounting records.
We are therefore, one step forward - but, as in so many things, solutions are not perfect.
With respect to asset existence, we see a couple of problems. The first is that not every document provided by a PB is necessarily unambiguous evidence of asset ownership. A prime brokerage statement pulled from a web portal, for example, may not be an actual custody statement and can, in some cases, include "memo" assets reported by the manager. Practices vary PB to PB, but it is worth remembering that the legacy Lancer fraud (which will finally get to court soon) relied on PB rather than custody statements to convince reputable administrators that fake assets actually existed. In fairness, this problem is less prevalent than in the past, but investors still need to speak with each admin to ensure that they are reconciling to true, "blue border" statements, not something produced by a web reporting group separate from the bank's custody function. The underlying issue, of course, is that junior staff at an admin may not know the difference.
Separately, are investors certain that every piece of information supporting existence of assets has been received by the administrator independently? What happens, for example, if a counterparty statement is forwarded to the administrator by the manager? Is this included or excluded in the "independent" verification?
Finally, many funds hold assets such as bank debt, loan originations, private equity, other hedge funds etc. which are not "custodied". How does an administrator vouch the existence of these assets? Would, for example, an administrator accept a binder of closing documentation and share certificates in support of a new private investment? The snag here is that, unless the admin contacts the investee company to obtain such documents directly, there is no direct control to prevent a manager creating a fake set of transaction papers. Moreover, private company share certificates sent to the PB for "custody" may equally not be checked for accuracy, but may be considered to be "independent" evidence of existance.
It is valuation, however, which creates the more significant issues. The underlying point, as we have discussed before, is the shift in the administration industry from the role of "valuation" agent to "verification" agent. When an administrator sends a transparency report, therefore, some of the prices may have been sourced by the admin, but some of them may be the manager's marks thereafter "verified" by the administrator. Pointing out the obvious, it is usually the easy, hard to fake stuff - Level 1 exchange traded equities - which are priced by the admin, while the harder to price securities are manager marks subject to verification.
For investors, therefore, a number of questions arise. Firstly, if prices have been verified, what are the tolerances that have been used? Are tolerances applied at both the individual security level as well as the overall portfolio level? (investors need to ensure that a number of small differences, all in the same direction, do not become material across the entire book). Tolerances differ by administrator, meaning that "verifications" performed by different admins may not be comparable.
Secondly, is verification passive or active? Has, for example, the manager established a valuation policy which states that the administrator is only "responsible" for checking prices to ABC pricing feed, a designated counterparty statement, a pre-specified pricing model or quotes received from only certain brokers? This type of "passive" process may only check prices to a pre-determined, limited selection of valuation sources, with such sources designated and potentially controlled by the manager. "Active" verification would involve the admin applying its own valuation policies and independently searching out alternative pricing sources; there is, of course, a great difference between a process which seeks to accumulate enough evidence to justify a price, as distinct from a procedure which actively searches out evidence to disprove a valuation. One simple starting point, for example, would be for each admin to utilize a centralized, security master pricing file to identify - and investigate - situations where other fund clients hold the same security.....but at a different price.
The final concern relates to the source of pricing data. As above, would some administrators assume that a broker quote forwarded to them by the manager is "independent"? As a more sophisticated example, we have encountered administrators who claimed to receive all broker quotes independently (and would, we assume, have represented as such on their transparency report). On investigation, however, we have identified cases where managers may use a centralized "pricing" email box which receives quotes and then auto-forwards emails to the admin. In practice, this can be very convenient but, of course, an email account hosted on a manager's server could obviously be manipulated.
The above points are not to dismiss the challenges of pricing hard to value securities and we continue to recognize - and appreciate - the hard work completed by administrators as they grapple with valuation issues across a myriad of asset types. However, this discussion does demonstrate, as is always the case in effective due diligence, that the devil is in the detail. Even with a transparency report, investors still need to ask detailed questions to the administrator to understand source, scope and process.
Unsurprisingly, the "step backward" in this transparency initiative is actually the risk of reduced transparency. In some of our recent discussions with administrators, we have seen the beginning of a view that "we are now providing the transparency report, and that is the only information that will be available to investors." Again, transparency reporting is a great initiative which we welcome - but it emphatically does not remove the need to ask follow on questions. Indeed, simply relying on a transparency report without those additional questions may mean allocating capital with false confidence.
Hedge Fund Operational Due Diligence
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