In mid 2008 we commented on the London branch of the Toronto Dominion bank in London, where a "senior male trader" had "incorrectly priced credit derivatives" resulting in a loss of nearly $100 million. At the time, we emphasized the lesson that this mispricing was not the work of a junior, green employee, but the senior head of a bank's trading desk.
The wheels of justice can move slowly, but an industry friend (to whom we express our thanks) forwarded some updated information. The FSA have just published a final notice on the case:
This notice is issued to Nabeel Naqui as a result of his conduct during the period July 2006 to June 2008 (the "Relevant Period"), during which he was employed by Toronto Dominion as Head of the Credit Products Group (“CPG”), Europe and Asia Pacific desk. During this period, Mr Naqui deliberately:
(1) mismarked his trading book; and
(2) subverted the independent process by which Toronto Dominion checked the valuation of its trading positions at the end of each month. Mr Naqui altered prices he had obtained from independent dealers to correspond to the prices at which he had marked positions in his book. Mr Naqui then provided these altered price runs to those responsible for conducting the independent valuation process, knowing that they would be used as the basis of their valuation.
As our industry friend noted, the first question is obvious: exactly how can pricing runs provided by the trader be helpful for those "conducting the independent valuation process"?
The FSA, helpfully, gives some more information:
"The CPG [Credit Products Group] Europe and Asia Pacific desk was run from London and headed by Nabeel Naqui, a Managing Director. As well as being Head of Desk and responsible for other traders, Mr Naqui was also responsible for trading credit default index and tranche products (“the Products”)....
All CPG trading positions were subject to a month end Independent Price Verification (“IPV”) process in Toronto Dominion during the Relevant Period. The IPV process required the Global Middle Office (“GMO”) to revalue all positions held by the firm’s traders at month end on the basis of independently sourced market price information. The objective of the IPV process was to reveal any error or bias in pricing so that this could be corrected and inaccurate marks eliminated.
OK, fair enough. But let's learn a little more about the "revaluation" conducted based on "independently sourced market price information":
Mr Naqui was aware that in order to conduct the IPV, GMO used series of market price quotes, known as runs, which he provided to them every month, rather than sourcing these independently from dealers. Mr Naqui was regularly asked by GMO to provide particular runs for use in the IPV process. Mr Naqui obtained runs in electronic messages from independent dealers, and then forwarded them to the relevant individual within GMO.
Yep - the trader was the one who gave the back office the "independent" broker runs. And guess what happened next...
Before Mr Naqui sent the runs on to GMO, however, he altered particular prices within the runs to correspond to the prices at which he had mismarked his front office positions. He did not alter all prices in which he held positions on his trading book. Mr Naqui did not mark or highlight the altered figures, or provide any indication within the message that some of the figures it contained were not figures supplied by the independent dealer. As a result of this method of circumvention Mr Naqui’s mismarking remained undetected for a period of approximately two years, until after he was informed that Toronto Dominion proposed to make him redundant.
Well, predictable stuff so far (and sound like any administrators we know?) We do, however, like Mr. Naqui's response:
Mr Naqui asserted that he had amended the quotes for a number of valid reasons. Mr Naqui claimed that one of the principal reasons why he had been obliged to amend the forwarded quotes was so that he was able to negate the impact of what he characterised as systems issues. Mr Naqui explained that there were flaws within the systems used by Toronto Dominion and that these resulted in inaccurate valuations. Mr Naqui relied on evidence which tended to show that he had raised these issues with others within the bank; however Mr Naqui complained that he had not received a satisfactory response to the document he had drafted. Mr Naqui claimed that thereafter he had only ever escalated his concerns about the systems difficulties during the course of face to face meetings with his immediate superior. Mr Naqui accepted that there was no record of any of these attempts to complain about the systems issues, though he did complain that his immediate superior was not a credible witness. Therefore and notwithstanding his reservations about the systems Mr Naqui had been obliged to forward quotes to GMO and thus he had decided to amend certain quotes.
The conclusion of the FSA:
It is clear from the foregoing that the FSA finds that ‘systems issues’ do not excuse or explain Mr Naqui’s conduct. The FSA does not accept the criticisms made by Mr Naqui of both the reports produced for Toronto Dominion. In particular the FSA finds that the recent expert report rebuts Mr Naqui’s contention that he was obliged to amend particular quotes to negate the effects of systemic problems. The FSA finds that Mr Naqui selectively amended quotes only where it was necessary to disguise losses in his book. The FSA finds that were Mr Naqui to have been seeking to cater for systemic issues then it would have been more appropriate for Mr Naqui to have amended all of the quotes that he forwarded to GMO. The FSA finds that whilst there may have been some problems within the systems these did not excuse his decision to amend quotes and nor did they explain the extent of the losses created by his mismarking. The FSA also rejects Mr Naqui’s claim that, having attempted to highlight the systems issues to senior management through a paper on the topic, he then only ever escalated this to his immediate superior in the course of face to face discussions.
One of favorite maxims is this: we have yet to meet a trader who is not supremely confident that his marks are correct, especially when he or she knows that they are wrong...
And on a lighter note, we were amused by an article in the UK's Daily Mail discussing a blog written by "Austerity Mum". In today's economic climate, the author - Lisa Unwin - has been documenting her family's efforts to tighten their belts, including (wait for it) fewer helicopter rides, no family vacation in the Maldives and even (gasp!) the decision to resole her husband's Berluti shoes rather than simply buy a new pair.
What is a little more surprising is the source of the family's wealth - Lisa's husband, Ashley, is the head of PricewaterhouseCoopers' consulting practice serving the City of London, which we assume includes hedge funds. It is interesting to see just how lucrative the Big 4's consulting services can apparently be - certainly more lucrative than the mundane audit process. And yet, for investors, which is more important - consulting to the manager or completing a vigilant and professionally skeptical GAAP audit?
A couple of years ago, Castle Hall commented on finance industry compensation as compared to other disciplines which also attract top tier intellectual and personal talent. In case of interest, one of the members of our team noticed a very thorough article in Bloomberg on the same topic.
The excellent Hedge Fund Law Report recently reported on the case of Joseph Sullivan, who was fired as COO and Chief Compliance Officer of the hedge fund Peconic Partners LLC back in 2008. According to a Bloomberg article at the time:
"The former compliance officer of Peconic Partners LLC accused the hedge-fund firm's owner of trading his own shares in a company ahead of clients' holdings in violation of securities laws.
Joseph W. Sullivan, who said he was fired Oct. 10  for objecting to the trades, made the claims in a lawsuit filed in New York state court in Manhattan against the principal, William F. Harnisch, as well as New York-based Peconic Partners and Peconic Asset Managers LLC...
Harnisch on Sept. 29 sold his entire personal holdings ofPotash Corp. of Saskatchewan Inc., about 600,000 shares, for an average $130 each, according to the complaint. Three days later, he sold about 1 million Potash shares held by Peconic clients for about $90 each, Sullivan claimed. Potash, the world's largest producer of the crop nutrient, had 301.9 million shares outstanding as of Oct. 31."
Bloomberg has more details as to the alleged activities:
"Sullivan, who also was chief operating officer, said his compliance software stopped working shortly before the Potash trades, and he never found out why. After the trades, his office computers became disabled in ``an apparent attempt to avoid his detection,'' of the trades, according to the complaint."
The particular twist to all of this: as with virtually all US hedge fund professionals, Mr. Sullivan was employed "at will". This US legal concept allows the employer to fire the employee (or equally for the employee to resign) with no notice and with no need to demonstrate cause or, indeed, give any reason at all.
According to the Hedge Fund Law Report (and another article in HedgeWorld), while Mr. Sullivan won his initial litigation for unfair dismissal, an appeals court has recently overturned that decision. The appeals court has apparently ruled that, irrespective of the circumstances, there can be no exceptions to the principle of at will employment. In other words, if you are a compliance professional and you do find that your boss has apparently been engaged in doubtful behaviour; or worse you find behaviour which definitely does violate internal compliance policies; or even worse the PM's behaviour is plain illegal....if you challenge him or her, the first thing that can easily happen is that you will get fired. Moreover you will have - it would appear - absolutely no recourse as an employee in relation to your own employment status.
Of course, the concept of "at will" employment is quite bizarre to anyone outside the US. Other countries generally do have a defined body of law protecting employees from unfair dismissal, which would obviously provide much more protection for whistle blower employees.
Within the US, however, this case certainly raises a significant red flag. As we all know, most hedge funds are small organizations dominated by the founding principal: it goes without saying that everyone else's job (especially everyone in the back office and compliance groups) depends on staying in the good graces of the king. We wonder how many compliance professionals will think twice about looking under the PM's stone if asking the tough question could mean losing your livelihood.
The scope, scale and focus of the insider trading investigation continues apace. Of the reports we have read, we wanted to quickly highlight something from the tech industry which shows a different direction.
According to "Fast Company", analysts who cover Apple are being investigated for using possible "channel checks":
Apple analysts on Wall Street are under increased SEC scrutiny for insider trading, centered on the "normal" habit of channel checks--working out what Apple may be up to by speaking to its suppliers. Is this unfair? Or are the analysts really cheating?
We're used to reading analyst reports about Apple that cite Apple's (mainly Far Eastern) suppliers, leading to rumors about how many units of such-and-such an iDevice are being sold, or if components of an upcoming piece of Apple hardware can tell us what capabilities it will have--thus revealing information about how it'll fare against its competition. Wall Street analysts use these data to form opinions about how Apple's business will perform in the future, and thereby guide their clients on whether to buy or sell Apple stock. The rest of us use their data to learn about upcoming Apple gear, and you can be sure Apple's rivals pay attention for the same sorts of reasons.
But the Securities and Exchange Commission is now busily involved in scrutiny of this "channel check" habit, on the grounds that it's a form of insider trading. The argument runs that Apple's suppliers should be keeping this information confidential, and are probably breaking their confidentiality agreements with Apple by revealing any facts. By involving themselves in this NDA breaking, the analysts are accessing privileged information in exactly the same way they'd be committing insider trading if they recommended stock activity based on information leaked from inside Apple's executive team.
So, in this analysis, will we reach a point where speaking to a janitor at a Taiwan fab plant to get a sense of production volumes is a criminal act - equivalent before the law to receiving a copy of Apple's draft 10K 2 days before it's issued direct from the firm's CFO? We seem to be reaching the law of unintended consequences very quickly.
We like how Fast Company concludes:
Is this too much of an expansion of the SEC's powers? We know Apple's a hot topic in terms of investment, but we wish that the authorities treatment of intellectual property laws was as sensitive to the intricacies of the dynamic world of high tech as the SEC is--then we'd see less patent trolling, like the anti-Apple cases that are popping up all the time.
One sign of the revival of the hedge fund industry is a return of M&A activity. In 2006 and 2007 some managers listed on stock exchanges, notably Och Ziff and BlueBay; some funds sold minority stakes to investment banks, including DE Shaw, Avenue and Lansdowne. The Petershill Fund, a product managed by Goldman, has purchased minority stakes in a number of funds including Trafalgar, Winton and more recently Shumway.
2010 has seen renewed M&A activity, with the biggest deal to date being Man Group's purchase of GLG. This week, the Royal Bank of Canada used some of the fees it charges Castle Hall on every wire transfer to buy Blue Bay in London (yep, we bank with RBC, and it certainly feels like our bank charges are $1.5 billion!) and Orix purchased a majority stake in Mariner.
In the aftermath of these transactions - and in anticipation of new ones - we thought it helpful to outline some operational considerations.
1) The institutional parent will likely not impose its systems on the asset management subsidiary. In general, institutional parents - even when they assume majority control - do not intervene in the day to day operations of the newly acquired asset management company. Investors should not, therefore, assume that systems and day to day operational procedures will be upgraded to full "institutional" quality. Typically, systems remain much as before - so a strong manager with strong controls will remain good, while a firm with a weaker infrastructure will not get a sudden boost in operational quality.
2) The institutional parent can provide more oversight. Having made point #1, we would agree that having an institutional parent can increase oversight, at least when the parent is a majority owner. In the US, the parent entity may be subject to the Bank Holding Company Act and will bring the full weight of Sarbanes Oxley. Equally, we would expect to see the benefits of a properly conducted internal audit function and particularly more compliance resources. All can be favorable to investors.
3) The institutional parent can provide deep pockets. Purely practically, perhaps the strongest benefit for an institutional "takeover" of a hedge fund manager is deep pockets. In the event of financial loss caused by honest error - or dishonesty - at the fund manager subsidiary, there is a helpfully increased likelihood that the parent company will step in to make investors whole. BlueBay, of course, already experienced this situation as a listed company, when a portfolio manager amended prices to fool both the back office and the fund's administrator. Once discovered, the firm immediately reimbursed the fund (and therefore investors) for all losses.
4) Institutional control gives more comfort than a minority shareholding. Points 2 and 3 above are far stronger when the management company is a majority owned subsidiary and is therefore subject to the governance of the parent entity. A minority shareholding, however, is typically structured as a passive investment, giving the institution a participation in profits but no management or governance control. What a minority stake does do is create a monetizing event for the management company's principals.
5) Reinvestment of sales proceeds is critical. One of the biggest due diligence issues is always what happens with the proceeds from an M&A transaction. Investors should have a very strong preference to see virtually all proceeds reinvested back into the firm's products, ideally with a long lock up and / or some form of earn out structure. This will create an enduring - and potentially strengthened - alignment of interests. What is less optimal, of course, is for the PMs to cash out. Having made several tens of millions of dollars in a sale - and then taken that money off the table - will certainly cushion the blow if the business gets into difficulties a couple of years later. Investors should, therefore, always be very conscious of the changed dynamic if a sale would allow the principals to walk away, having banked proceeds which fall in the "I'm now safe for life" category.
6) What is the new business plan? Access to an institutional parent's distribution platform can transform the capital raising capability of a management company. That may be wonderful news, enabling the manager to scale up its capacity and investment capability. However, new assets and new products may also place huge stress on the manager's back office, especially in the short term. Investors need to be very watchful should a manager face the high class problem of rapidly increasing AUM. Managers should have a business plan which considers back office resources, and make commensurate investments to improve both systems and people as AUM increase.
7) Beware new conflicts of interest. Purchases of asset management companies by investment banks can create new conflicts. Is the new owner a major prime broker or derivative counterparty to the fund? Is the new owner also the fund's administrator? Sometimes closer economic relationships can help, but sometimes they create conflicts which require changes in structure and service providers.
8) What about changes in control? In the corporate world, change of control clauses often provide a comfortably golden parachute for key executives. For a hedge fund investor, however, there is no ability to break a lock up if an investment management company is purchased. In some instances, investors may not care and be strongly in favor of the new parent; in other situations, however, we can imagine investors who wanted to allocate to an independent, boutique firm, and have no desire whatsoever to serve out the remaining 19 months of their lock up with a new parent. This raises an interesting question - funds can have a key man provision in their offering docs. If M&A activity picks up, should they also have a change of control clause?
9) What happens in the long term? As a final point, investors always need to consider the long term outcome of M&A activity. In some instances, deals are hugely successful - JPM's purchase of HIghbridge would be a great example of an enduring deal. The landscape of other transactions, however, may change over time - even if the hedge fund manager can do nothing about it. Back in March 2007, for example, DE Shaw noted that "Lehman has demonstrated a strong commitment to investment management, and will be a valuable resource to us as we continue to innovate." More recently Front Point, having been purchased by Morgan Stanley in 2006, was yesterday subject to a management buy out to take the company back into private ownership.
Every deal will always be sold as a winning transaction on Day 1, and some will turn out, over time, to be materially beneficial for investors - not just lucrative for the manager. To be realistic, though, we must acknowledge that other transactions will be less positive, and some will be a complete disaster. The observation for investors, then, is that M&A activity introduces another moving piece to the due diligence process, increasing the spectrum of issues, risks and outcomes faced by the manager. Ironically, bringing an institution to the table may actually increase the need for ongoing due diligence.
The UK's Daily Telegraph recently reported on what were described as the "rip off" of hedge fund management charges. The article was based on underlying research by Terry Smith - a well known executive in the UK financial services industry - who claimed that an individual who invested $1,000 with Warren Buffett in 1965 would currently hold a nest egg of $4.3 million. However, if Berkshire Hathaway had been a hedge fund charging 2 and 20, that $4.3 million would have accrued $300k to the investor with a stunning $4m to the manager. Certainly sounds like a rip off to us.
However, one of Castle Hall's analysts reviewed Mr Smith's calculations (an underlying spreadsheet is available on the above link) and found that the analysis - while creating a great headline - does not reflect the full story.
At a micro level, there are a number of calculation problems:
1) Mr. Smith had assumed that the management fee is paid on year end assets. In fact, it is typically paid quarterly; an accurate calculation would therefore take 2% of the average of beginning and end of year capital.
2) Mr. Smith had assumed that the incentive fee is paid on gross end of year assets before the deduction of the management fee. In fact, the incentive fee is paid on net end of year assets, i.e. after the 2%.
3) Mr. Smith had not taken account of the high water mark feature embedded in virtually all 2 and 20 structures.
We agree that the mechanics of NAV calculation are not always the most exciting topic. However, it is nonetheless interesting to see how investors can easily misunderstand the process to calculate first the management fee, then take the incentive fee, and then take account of a HWM.
As a first observation, therefore, correcting for these calculation errors "gives" the investor $650k, more than doubling their return. However, it's still the case that the manager allocation, even with corrected data, comes in at $3.7m. Still firmly in the land of "rip off".
We need to turn to the bigger picture to understand what is happening. The key to this analysis is that Mr. Smith's calculation assumes that the hedge fund manager can reinvest his annual compensation (the sum of each year's management and incentive fees) back into Berkshire Hathaway stock; this will then compound based on Mr. Buffett's ongoing performance. It goes without saying that that performance is firstly very good, and that we moreover have a very long time period over which to consider compounding.
Based on our revised calculation, over the 45 years involved, the investor will pay total fees of $256,000; it is this number which has turned into $3.7 million, or a 15 times return. The investor, mind you, makes an initial investment of only $1,000 which increases to $650k - a 650 times return.
There is a further problem: the original analysis assumes that the hedge fund manager can reinvest his fee income without paying tax. Fine if you happen to run the fund from the Cayman Islands; not so fine if you live elsewhere. Applying a 30% tax rate reduces the manager's "take" to $2.5 million (we won't speculate as to whether the government could have taken their tax revenue each year and, in turn, reinvest that back into Berkshire Hathaway stock!) Carrying on to a final point, the original analysis also assumes that not only does the hedge fund manager pay no tax, but that he also does not need to use any of his fee income to pay his staff or cover the overhead of his business. In reality this would, of course, further reduce the amount which would be available for reinvestment.
What we have here, therefore, is an extreme example of the magic of compounding - which is, of course, a key element of Warren Buffett's phenomenal success. In the big picture, an investor in Berkshire Hathaway stock has received a compound IRR of approximately 20.5% over the 45 years involved. A hedge fund structure would take that gross return and deduct 2% for a management fee and then take 20% of what remains as an incentive allocation; this would leave the investor with a baseline IRR of 14.8%. Overall, therefore, 75% of the compound IRR goes to the investor, and 25% to the manager.
That certainly seems fair to us for a manager able to generate an IRR of 15% over the best part of half a century.
Today's Wall Street Journal reports on recent estimates of the proportion of UK hedge fund employees who have - or likely may - move to Geneva and other locations in Switzerland. One UK consultancy firm was quoted giving an estimate that up to 25% of UK hedge fund professionals could emigrate; the WSJ, however, reports on various other estimates closer to the 10% range.
Irrespective of how many people leave the UK, there remain some interesting issues which can impact operational and business risks.
The first is the obvious point that Switzerland, while offering a wonderful quality of life, is an extremely expensive place to live. It is also resource constrained, especially in key infrastructure areas such as available school places for children. For the top echelons of hedge fund managers who are not financially constrained, these issues are irrelevant: for many employees who are not as well compensated - and that would especially include many in the back office - cost and infrastructure issues can be punitive.
What could emerge, therefore, is a situation where key front office professionals choose to move, but many in the back office are left behind to continue working from London. Equally, firms that do relocate their entire operation will find that a sizeable proportion of their teams either do not want to move due to family and personal ties or, equally, just simply can't afford it and hence leave.
Turnover in back office operations clearly increases operational risk. Separately, a situation where front office risk takers operate from a location separate from the back office changes the culture of an organization, reduces cohesion between the teams, and increases the risk of miscommunication, inefficiency and error in trade processing. All material issues for investors.
Secondly, the near term reason for moving to Switzerland is tax avoidance, given the growing disparity between UK and Swiss tax rates at high income levels. However, a medium term motivation is the issue that Switzerland is not in the EU and is therefore outside the scope of the proposed EU Alternative Investment Fund Managers ("AIFM") Directive. While the final form of the AIFM may well have negative features (just as mandatory SEC registration is not unambiguously positive, either), net net, the privilege of managing someone else's money is a fundamental, fiduciary responsibility which should be subject to regulatory oversight. Investors, therefore, may well question why firms elect to leave the well regulated UK jurisdiction and, in due course, the AIFM framework.
Perhaps the most interesting question is what investors think about moves to Switzerland, Bermuda, Singapore or other offshore locales. Consultants eager to earn fees assisting with the redomiciliation process have been very vocal as to the benefits of leaving the UK. What we have not seen, however, is a survey which asks institutional investors whether they would prefer to see their managers stay in the UK or leave. We can guess as to the answer, but it would be very interesting to see that data point.
UPDATE: A few days after the above post, we were interested to see an article in the Swiss press commenting on the pressures faced by Geneva as it welcomes new workers. According to the article, "Geneva struggles to attract foreign business":
"Geneva may be an international player in the big city stakes, but its economic chief has admitted that it does not have any room for any more large companies.
The city has been at a housing and transport standstill for years, and without the necessary infrastructure, Geneva could not cope with a large influx of people should a major firm want to relocate there."