Risk Without Reward

A Little Light Relief

We recently came across this old Dilbert cartoon  - in the world of hedge funds, it would be funny if it wasn't so true.

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Hedge Fund Operational Due Diligence

Caveat Emptor

Bear with us - we'd like to tell a story....

A man walks into an auto dealership, having decided to buy a new vehicle.

The dealer and the customer agree terms, after which the dealer hands the customer the purchase contract to sign.

"Wow", says the customer.  "This document is thicker than the last time I bought a car”.

"Ah", says the dealer.  "Our attorneys continuously update our purchase agreement so that it reflects auto industy best practice."

The dealer is surprised when our customer asks to read the document – apparently many customers don’t bother to read the 72 pages of fine print.

Settling down, the customer turns to the first section, "Purpose of the Vehicle".  Page 1 states "you have purchased a compact sedan, which is designed to provide efficient, trouble free motoring."  There is a two page description of the specifications of the vehicle, including the bios of the chief designers, which all sounds pretty good.  However, the final paragraph of the section states "while it is anticipated that the vehicle will focus on high fuel economy, efficient transportation, the Manufacturer will retain a broad and flexible manufacturing mandate.  As such, the vehicle may also be lighter, heavier, bigger, smaller, more fuel efficient, use more fuel, have fewer or more seats, be a different color or otherwise differ in specification.  Nothing in this document shall in any way limit the Manufacturer’s ability to change the specifications, performance or characteristics of the vehicle, and such changes may be made at the sole discretion of the Manufacturer without notice to the Customer."

"Hang on a minute" says the Customer.  "It says here that, in the sole discretion of the Manufacturer, you can make the vehicle different in pretty much any way – don’t you have any responsibility to stick to what you originally sold me?"

"Oh don’t worry about that" responds the dealer.  "That’s just some standard language put in by our lawyers and we have no intention of doing anything different.  Don’t worry, you’ll be getting a great compact sedan."

The customer is a bit uneasy, particularly when he realizes that the phrase "in the sole discretion of the Manufacturer" turns up pretty regularly throughout the document.  It’s also noticeable that nothing can be decided "in the sole discretion of the Customer."

 

A few pages later in the contract, the Customer gets to a section called "Manufacturing Errors".   It says "vehicle manufacturing is a complex and sophisticated process.  The Manufacturer will not be liable for any loss arising from errors or actions taken (or omitted to be taken) by it, howsoever arising, except to the extent that any such error is due to the gross negligence, willful default or fraud of the Manufacturer.  As such, the Customer should be aware that bad fitting panels, incorrectly installed trim details, faulty electrics and similar items (collectively, "errors") are a normal part of the manufacturing process and will not represent gross negligence, willful default or fraud.  Moreover, the customer should expect such errors to occur."  

"Great" thinks the investor.  "Pity I can’t say that sort of thing to my customers in my own business – they’d laugh me out of town if I tried that one."

The next section deals with disposal of the vehicle.  The Customer wants to lease the car, so turns to the section which outlines how he can return the vehicle to the dealer: this is possible after a two year initial period, and thereafter every quarter with 45 days’ notice.  There is also a section which allows him to return the vehicle early on payment of a 5% fee – all sounds fair enough.

There are a couple of extra sections, however.  One says that the Manufacturer can elect to suspend the Customer’s ability to return the vehicle during any period in which, in the sole opinion of the Manufacturer, an emergency exists as a result of which the repurchase of the vehicle would not be "practically feasible".  The Manufacturer also has the ability to create a "Repurchase Trust" at which time the vehicle will be transferred to the Trust and the Manufacturer will repay the customer over such time period as the Manufacturer, in its sole discretion, believes to be reasonable and appropriate.  The Customer will, however, continue to pay the regular lease costs on the vehicle until the Manufacturer finally decides to sell.

The final pages deal with "risk factors".  The list is pretty long, describing that motoring and usage of a car are hazardous activities.  The many pages of risk disclosures remind the Customer, for example, that the car cannot be guaranteed to protect its occupants in any form of accident, that driving on rough roads could break the suspension, that the stability control can’t be guaranteed to work in wet weather and that wear and tear could impede any of the car’s capabilities and functions.  The contract concludes that the Customer recognizes that he or she is a "sophisticated consumer" and that he or she will only purchase the car if they could afford to lose the entire vehicle and its purchase price.

The Customer has now taken more than an hour to read all this legalese and has a nasty headache.  He calls over the salesman, who is still looking pretty confident.

"I have to say" says the Customer, "I really don’t like this contract.  It’s a lot different to the one I signed a few years ago when I bought my last car, and there are so many terms in here which protect you in case something goes wrong.  I really don’t understand – I’m giving you guys a lot of money and you are, you have to admit, a pretty wealthy and well-resourced company.  It just seems like you don’t want to stand behind your product."

As it happens, the dealership’s manager is passing and overhears the Customer’s comments.  "I appreciate your concerns" says the manager, fiddling with his Rolex.  "However, this contract is based on the legal principle of ‘caveat emptor’, or ‘buyer beware’.   We just want to be clear that we have told you what could happen after you have purchased the vehicle.  In that way there are no surprises."

"Yes, but", replies the Customer.  "Your risk factors, for example, outline virtually every possible eventuality.  You guys are meant to be experts at manufacturing cars so I’m expecting you to build a good one that I can rely on.  That’s certainly why I’m giving you quite a lot of my money.  It seems very unreasonable that you are telling me that all sorts of bad things could happen and, pretty much no matter what happens, it’s not your fault."

The dealership’s manager thought for a moment and then looked back at the Customer.  "Well, I hear what you’re saying but, unfortunately, I have no room to manoeuvre as this contract was drafted by our lawyers. You might also want to know that all the other car manufacturers use the same legal firm.  As a result, all the car firms have the same sort of contract nowadays.  Basically, it’s not possible for you to buy a vehicle at all unless you agree to these terms."

The Customer is very annoyed but realizes that, at the end of the day, he doesn’t have a choice.  He’d like to argue about all these points but, if he wants to drive any sort of car, irrespective of the manufacturer, it seems that he’s going to be stuck with exactly the same legal shenanigans.

"OK, I’ll sign" he says, upon which the salesman produces the final invoice with a flourish.  "Here you are" the salesman says.  "You can see the purchase price, the destination and delivery charges, the taxes, and the legal and professional fees."

"I’m sorry" responds the Customer, surprised once more.  "Legal and professional fees?"

"Oh yes" replies the salesman.  "The costs of the attorneys we hire to prepare our purchase contracts are an out of pocket expense and are billed to our customers as part of the purchase price."

"Do you mean to say…." starts the Customer, as he begins to realizes how all this works….

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Hedge Fund Operational Due Diligence

Our Wish List for the Regulators

One of Castle Hall's partners recently shared their "wish list" of changes which would improve industry oversight and investor protection.  The suggestion was that investors should write to regulators - not to lobby against efforts to impose regulation and rail against impediments to capital formation (always the lobbyists' favorite phrase) - but to call for industry constituents to provide improved servicing and, particularly, to accept liability for their actions.

In no particular order, the wish list contained:

1. Limitation of liability in audit eng letters
2. Administrators accepting no responsibility for pricing securities in admin agreements
3. Inactive boards and non-independent boards, performing no corp governance (esp delegating task of ratifying key agreements to mgt)
4. Prime brokers that will not accept resp for enforcing a dual sign policy on wire transfers
5. HF managers refusing to be transparent with investors and provide them will access to senior people in organization.
6. Legislation allowing h.f managers to issue share classes with better terms than existing classes with no shareholder pre approval.

In addition, several other items immediately spring to mind:

1. A clear and simple process for auditors to confirm that they are, in fact the auditor of the fund

2. A clear and simple mechanism for investors to obtain funds' audited financial statements from the auditor, not the fund manager

3. Universal access to administrators' SAS 70 reports - why is it that certain administrators are happy to take the marketing benefits of  their SAS 70 certifications, yet refuse to provide copies of those reports to investors? 

4. Elimination of attempts by administrators to ask investors to limit the admin's liability prior to any due diligence discussion, particularly clauses which state that the administrator takes "no responsibility for the accuracy or completeness" of any information provided to the investor.

5. Clarity that the administrator's "client" is the investor, not the fund as an inanimate corporate object and not the manager.

Our list could be much longer, but these points provide a flavor for some of the issues we see on a day to day basis during our due diligence engagements.  

We certainly agree that Rome was not built in a day and, over time, investors need to work constructively and collaboratively with both managers and other industry participants.  Constructively does not, however, mean passively: we encourage investors to become far more vocal with respect to unhelpful and unjustified disclaimers, exclusions, limitations and waivers.  As we said in our last post, if hedge funds are to move forward, we need to get past the model of everyone wanting to be paid, but no=one wanting to take responsibility.

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Hedge Fund Operational Due Diligence 

Kroll Global Fraud Report

Kroll have recently published their latest Global Fraud Report.  This is a very interesting summary of the causes and impact of a range of global frauds across industries.

The introduction states:

"Ultimately fraud involves human beings, both as perpetrators and victims. Greed has again demonstrated that, even before the downturn, it was more than a match for good sense or ethics among many supposedly sophisticated investors – whether in the Madoff affair or the sub-prime follies which started the current economic slide. As this edition shows,  understanding the effect of bad economic times on people’s emotions is essential to seeing where fraud is headed, and what might be done about it. Some individuals will be more careful to protect their assets. Others, however, will be more desperate: those with a criminal bent may look to maintain lifestyles through running scams; more honest ones might be more susceptible to get-rich-quick schemes or self-proclaimed Robin Hoods that promise to restore depleted finances. Still others, normally perfectly honest, may even engage in fraud and misrepresentation for what they consider noble motives – to preserve the jobs of thousands of colleagues. 

As this edition notes, what role regulation can play in the face of people’s eternal willingness to believe the too-good-to-be-true is unclear.  This does not mean we are helpless.  Due diligence and compliance best practice, as well as applying the correct tools to fight back once fraudsters have struck, are all part of addressing this threat."

Couldn't agree more.

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Hedge Fund Operational Due Diligence

Regulating...the Canadian way?

The National Post newspaper in Canada today published an interesting opinion piece commenting on the Canadian financial system.  The article compares the fate of the US banking sector to the main Canadian banks - RBC, CIBC, TD, BMO, Scotiabank and National Bank.

The Post notes that “everywhere, economists are wondering how Canadian banks managed to avoid most of the crummy securitized debt that is crippling other democracies’ financial institutions.”  This is not to say that Canada should be too self-congratulatory, mind you, as the country’s financial system has hardly been immune from the delights of securitization – asset backed commercial paper was a home-grown fiasco.

The comments which caught our eye, however, were the concluding paragraphs.

“International observers have noticed that Canada’s ‘principles based’ financial regulation takes a very different form from the ‘rules based’ style prevailing in the United States.

Down South, lenders are engaged in a constant chess game with the government. Here, the bank executives and regulators have absorbed each other’s values to such a great degree – both taking the view that, quite simply, the first goal of the Royal Bank of Canada is to ensure that there is still a Royal Bank of Canada 100 years from now – that internal audit procedures are tougher than any regulator would dare demand, and arguably more effective than any regime created solely by a narrow, politically shifting rule set.  Plain old-school snobbery plays a role too.  Only by a means of noblesse oblige can you staff a modern banking system, as we have, without dangling big short-term rewards in front of top executives and doing away with substantive board oversight.

Unfortunately, it’s not going to be easy for any foreign banking institution to import Canada’s banking culture without having had Canada’s history.  But, hell, they could at least adopt some of the maxims.  Toronto-Dominion’s CEO told Marie-Josee Kravis that he pulled TD out of the game of buying securitized debt products years before the crisis, for one simple reason: the instruments had become inscrutable.  “If I cannot hold them for my mother-in-law,” he said, “I cannot hold them for my clients.”  Given the “in-law” part, that’s not setting the consciousness bar very high – but it is higher, at any rate, than where many foreign institutions put it over the last decade.”

Regulation will, of course, be front and center for both hedge fund managers and hedge fund investors over the coming months.  The debate over rules based or principle based regulation, however, is unlikely to be solved any time soon – principles lack specificity so we need rules; rules create loopholes, so we need principles.  This is one of the insoluble conundrums of our age.

Perhaps the point of this article, however, is to remind us that rules ultimately regulate people, not inanimate corporations.  What we need to think about, then, is the motivations of the decision makers ultimately subject to regulation.  To put it simply, if people are motivated by short term cash and have no longer term responsibility - which is unfortunately a fairly common theme in this financial crisis - then the tighter the rules the better, because tight rules are the only way to reign in self-interested behavior. 

On the other hand, if decision makers have a sense of accountability and an eye to the future, then we come back to the maxim that people can regulate themselves better than any government can.  Governments are concerned by re-election - which often puts their time horizon not much further out than the quarterly earnings cycle which preoccupies so many business executives.    

Against this background, we continue to believe that, in the hedge fund space, focus - and by focus we mean investor pressure - needs to be on alignment of interests between investors and managers.  At the very least, changing incentive fees to a longer time horizon with clawback mechanisms etc. will create more accountability and something of a longer term time horizon in the manager community.  Ultimately, that may well be far more effective at protecting investor interests than the regulatory rulebook.

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Hedge Fund Operational Due Diligence

Chrysler and the non TARP lenders - and investors' reputation risk

The judge in the Chrysler bankruptcy case has now forced the hedge funds forming the "Chrysler non TARP lenders" to identify themselves as they pursue their case.

According to Bloomberg, the funds involved (down from 20 late last week) are:

"The Chrysler Non-TARP Lenders are as follows, according to the filing: Schultze Master Fund Ltd. of Purchase, New York; Arrow Distressed Securities Fund at the same Purchase address; Schultze Apex Master Fund, at the same address; Uniondale, New York-based Stairway Capital Management II L.P; Group G Partners LP, based in New York; GGCP Sequoia L.P., at the same New York address; Oppenheimer Senior Floating Rate Fund, in New York; Oppenheimer Master Loan Fund LLC, at the same New York address; and Foxhill Opportunity Master Fund LP, based in Princeton, New Jersey."

We are not going to comment on the economic or political arguments for deciding to challenge either the US government or the US bankruptcy law (which one is being challenged, of course,depends on your point of view.)  What is worthwhile noting, however, is that investors in these hedge funds will have their own economic and political positions on this highly contentious issue and, particularly, will have their own sensitivities as to reputational risk.

Some investors, we expect, will applaud the non TARP managers, both in their stated intent to get a better return and also in their drive to uphold what could simplistically be called due process in bankruptcy proceedings.  Other investors would, we imagine, be horrified to see their capital used to impede what they consider to be a vital restructuring - think pension entities in Michigan.

As we all know, the hedge fund industry has progressively migrated from a model dominated by high net worth investors (where hedge funds were the secret club of the super rich) to a model dominated by institutions.  Many institutions are not low profile - they attract criticism (and acclaim) and are forced to spend substantial resources managing their reputations, their media coverage and their relationships with their many stakeholders.

For at least some institutional investors, we imagine that it would be highly negative for it to be exposed that their capital was allocated to a non TARP fund.  But - and this is the big but - these investors, as passive shareholders in a commingled investment vehicle, have absolutely no control over how managers deploy capital. Given transparency, they may not even know what their managers hold in the first place, and certainly have no right to be consulted before a manager engages in a strategy which is both public and highly controversial.  This has the potential to be a massive problem for certain allocators.

Issues such as fees, transparency and control (think managed accounts) have already been flagged as areas where the current hedge fund model can be at odds with the needs of many institutional investors. Reputational risk is another which is just as real, but has received much less attention to date.  Moreover, this is an issue that many hedge fund managers remain completely and comfortably oblivious to.  Hedge funds are not typically questioned by their investors on socially responsible investing practices, on their carbon footprint, on their human rights policies etc. etc.  For a subset of institutions, however, these are important, highly politicized issues which need to be considered.

Strategies which have more exposure to "reputational" risk are event driven styles such as distressed and equally activist investing.  There is also the more random risk of not wanting to be an investor with a manager who decides to go on a personal, political crusade which turns out to be opposed to your investing organization's own values and mission. 

The irony here is that distressed, certainly, is one of the strategies likely to be in favor over the next stage of the cycle.  Chrysler is not the last time some institutions will be waking up to wonder what is happening somewhere in their hedge fund portfolios.

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Hedge Fund Operational Due Diligence

RIP

We were shocked to learn of the untimely passing of Greg Newton, the voice behind the NakedShorts blog.  I first met Greg at a conference in Canada a number of years ago, and thereafter had the opportunity - and privilege -  to remain in contact on a range of blogging topics related to life, the universe, and sundry hedge fund everythings.  A sad, sad loss.

Our deepest sympathies to Greg's family and friends.   

$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