Risk Without Reward

And how much is that ABS worth again?

The SEC have just settled a case under which Morgan Keegan, a Tennessee subsidiary of Regions Bank, agreed to pay $200 million (without - of course - admitting or denying any of the findings!) to settle fraud charges related to deliberate mismarking of ABS / subprime positions in a 1940 Act registered mutual fund.  The SEC's press release is available here, and the full text of the SEC's order is presented here.

According to the latter document, Morgan Keegan was responsible for valuing securities in its own mutual funds.  The first warning sign, therefore, is the absence of a third party administrator or valuation agent.  Despite being a highly regulated mutual fund, the funds were still exposed to the unavoidable conflict of the management company marking its own book.

In this case, things went predictably wrong as the sub prime market fell apart in early 2008.  According to the SEC, the alleged actions included:

- Morgan Keegan's fund accounting group periodically obtained broker-dealer price confirmations for certain fair valued securities.  Unbeknownst to the fund accounting group and the fund's independent auditor, the portfolio manager actively screened and influenced a broker-dealer to change the price confirmations that the fund accounting group and auditor obtained from that broker dealer;

- Morgan Keegan's valuation committee left pricing decisions to lower level employees in the fund accounting who "did not have the training or qualifications to make fair value pricing determinations";

- Fund accounting personnel relied on the portfolio manager's "price adjustments" to determine the prices assigned to portfolio assets.  Per the SEC, these adjustments were "arbitrary and did not reflect fair value.  The price adjustments were routinely entered upon receipt by the staff accountant in a spreadsheet used to calculate the NAV of the Funds."  (They are using a spreadsheet to calculate the NAV of a 40 Act mutual fund??) Further, "Fund accounting and the Funds did not record which securities had been assigned values by the portfolio manager"';

- Fund accounting personnel gave the portfolio manager discretion...to determine which dealer price confirmations to use and which to ignore, without obtaining documentation to support his adjustments;

- The valuation committee and fund accounting did not ensure that the fair value prices assigned to many of the portfolio securities were periodically re-evaluated, allowing them to be carried at stale values for months at a time (months??);

- In some instances, when price confirmations were received that were substantially lower than current portfolio values, Fund Accounting personnel, acting at the discretion of the portfolio manager, lowered values of bonds over a period of days, in a series of pre-planned reductions to values at or closer to, but still above, the price confirmations.

Cherry picking of broker quotes, manipulation of broker dealer information, control of the pricing process by the portfolio manager without challenge from the back office - this one has it all.  

For hedge fund investors, this case is yet another reminder that some portfolio managers - either to make more money or to cover up losses - will push pricing issues to the edge.  Some will inevitably push beyond into deliberate misvaluation.  In this instance, the strongest form of regulated fund structure - a 40 Act mutual fund - made not one bit of difference to prevent the PM cooking the pricing books.

As such, this case is a $200 million reminder that, as always, best practice must be to separate portfolio management from the valuation process, with an independent, third party responsible for pricing portfolio securities in the NAV.  After all, even the most honest portfolio manager can make an honest mistake and, inevitably, a handful of portfolio managers will be dishonest.  

Equally, Morgan Keegan shows the enormous value that an effective, third party administrator can provide to the hedge fund investor.  However, readers of Risk Without Reward will not be surprised with our final comment = investors need (and are prepared to pay for) an administrator who prices the portfolio themselves, not as directed by the manager, and who applies a degree of skill and expertise far beyond the apparent level of the back office employees in this case.  

As always, it is the most difficult to price securities which are the most susceptible to deliberate mispricing, so it is these securities where investors need administrators to focus their greatest efforts on independent pricing.  Otherwise the next Morgan Keegan could very easily be a hedge fund.

 

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved. 

 

Broker quotes...or what happens when the trader doesn't like third party prices

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...

 

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All Rights Reserved.

Transparency - One Step Forward, but Half a Step Back?

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.

  

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

More institutional mispricing

To quickly note another example of deliberate mispricing by a trader in a financial institution: the FT reports that the Hong Kong Securities and Futures Commission has just fined Merrill Lynch $450,000 after a managing director based in HK deliberately "mismarked a trading book of illiquid securities." 

Per the report:

"For almost a year – from December 2007 to October 2008 – the director illicitly gained access to the US investment bank’s computer systems and changed the pricing parameters on a book of exotic options"

As always, it remains a really bad idea to put the traders in charge of marking their own books...and, as always, it raises the question as to why the Merrill Lynch product control group in the back office was unable to challenge the trader's marks - over the course of an entire year.  Systems access rights seem to be an issue.  

We will let our readers connect the usual dots when thinking of a hedge fund administrator marking illiquid securities.

   

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.  All Rights Reserved.

Misvaluation - in the world of investment banks

One of our more recent posts touched on the case of Simon Treacher, the erstwhile portfolio manager of the BlueBay Emerging Market Total Return Fund.  Treacher admitted forging broker quotes for certain hard to value emerging market bond positions and then giving those quotes to his back office who, in turn, passed them to the fund's administrator.  The focus of our post was to remind investors of the ongoing risk of misvaluation and, as a related issue, to highlight once more that investors should not expect administrators to independently price securities: or at least not to independently price the hard to value instruments which might actually be subject to pricing fraud.

Against this background, we were interested to read of another mispricing case, this time in a highly regulated, tightly controlled and fully Sarbaned Oxley investment bank.  According to the Independent newspaper in the UK:

"The City watchdog has banned a former senior trader at Merrill Lynch in London after he inflated the value of his trading book by more than $100m (£66m) to cover up huge losses.

The Financial Services Authority (FSA) announced Alexis Stenfors was "not a fit and proper person" to work in financial operations in the City and banned him for five years.

Managers at Merrill Lynch International Bank (MLIB) started asking questions about the value of the book run by Mr Stenfors, a short-term interest-rate trader, last February while he was on holiday. When he returned, he admitted "mismarking" his trading positions during the previous month.

He increased the value of his positions to hide increased losses when the market moved against him during a period of huge volatility in the markets. This caused the financial services group, now Bank of America Merrill Lynch, to write down its books by $456m (£299m) after the manipulation had been discovered.

Margaret Cole, the FSA's director of enforcement and financial crime, said: "Stenfors' actions in deliberately mismarking his positions fell far short of the FSA's expectations. Market confidence is likely to be damaged by sudden and unexpected write-downs and revaluations of securities."

She added that the regulator had banned Mr Stenfors "because his misconduct was deliberate, frequent and repeated over a one-month period. He was a senior and experienced trader who held a position of trust at the firm." The FSA capped the ban at five years because Mr Stenfors "expressed remorse for his actions and agreed to settle at an early stage".

We have commented before on a number of mispricing issues at investment banks (as a separate issue, these typically seem to be uncovered in the UK; we remain cautious to draw the conclusion that only UK based traders are prone to mismarking).  This latest case displays the same themes, being (i) that the trader involved was "senior and experienced" and (ii) that the trader was responsible for marking his positions with, we assume some "verification" thereafter by a back office / product control group.  To this latter point, it is interesting that the mismarking was discovered when the trader was on holiday, but not at any point during the prior month when the trader had been at his desk (and presumably when the trader was able, in person, to shout loudly at any meek accountant who had the audacity to question his marks.)

As always, a cautionary data point to keep in mind as we consider due diligence on the valuation practices of hedge funds.

  

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.  All Rights Reserved.

The neverending staircase

You may have seen various versions of the optical illusion of the neverending staircase - a stairway under which, no matter how far you walk, you don't get any higher.  One of the most famous versions is the drawing by M.C. Escher, "Ascending and Descending" (see wiki article)

Why this analogy?  Well, we thought that we would open 2010 with another comment on the issue of responsibility for valuation of hedge fund portfolio securities.  Based on the various prospectuses that have recently come across our desks, "up to date" offering documents seem to be converging around a standard set of disclosures.  Unfortunately, the cumulative effect, for the investor at least, is pretty much the same as the neverending staircase.

The starting point in most PPM's (Private Placement Memorandum) is usually to state that the board of directors is responsible for managing the business of the fund, which would include, inter alia, valuation and calculation of the NAV.  Indeed, to this point, many best practice guidance papers (AIMA, IOSCO etc.) all state that the "governing body", i.e. the Board, is the entity "responsible" for valuation.

However, not so fast.

This structure creates multiple problems.  The first is obvious - corporate secretaries in the Cayman Islands, serving on the board of hundreds and hundreds of hedge funds, clearly have no capability whatsoever to value complex financial instruments.  Directors get round this minor hiccup in two ways: (i) to specify that they may rely upon information furnished to them by the Investment Manager and (ii) to delegate the calculation of the NAV to the Administrator, as we will discuss in a moment.  

While we are not lawyers ourselves, we can give a layman's view as to the degree of liability and responsibility Cayman law places on a fund director -  in simple terms, not much.  We stand to be corrected by more informed legal minds, but, in our understanding, Cayman directors have a fiduciary duty to the fund (not to the shareholders) simply to act honestly and in good faith.  The problem with this logic is that, unless a director is presented with direct evidence of fraud, every director will always be of the view that their reliance on the investment manager's security prices, for example, is undertaken honestly and in good faith.

(As an aside, as we discussed recently, one of the latest innovations from Cayman counsel is simply to put in the PPM that the Directors are not responsible for valuation at all.  Not helpful for investors, but at least one of the Cayman directorship shops tells it like it is).

So let's turn to the admin.  Usually, the prospectus starts with reassuring language that the board has delegated the calculation of the NAV to the administrator.  However, the offering document will then state that the administrator is obligated to follow the procedures outlined in the PPM related to "calculation of the net asset value".

Here the fun really starts, as this section of the PPM will usually state that it is the Investment Manager, not the administrator, who will determine the prices for any hard to value securities (such as those not listed on an exchange).  While the PPM may say that the Manager must act in "good faith", the phrase "in the sole discretion of the Investment Manager" will likely be repeated on multiple occasions.  As we have often noted, it goes without saying that if investors are to lose money due to valuation fraud, it is unlikely to be as a result of deliberate mismarking of IBM common stock - the culprits will be hard to value, Level 2 and 3 positions.

Moreover, the final paragraph of the PPM's net asset section usually ends with something along the lines of "the Board of Directors, in consultant with the Investment Manager, may permit any other method of valuation to be used which is considered to better represent fair value".  As above, the directors can, of course, accept any recommendation from the manager provided that, in doing so, they act honestly and in good faith. 

Just in case this framework was not clear enough, the administrator usually inserts a PPM disclosure stating that they are entitled to rely upon (and shall not be responsible for the accuracy of) financial data provided to them by prime broker, third party pricing services or the investment manager.  Moreover, the administrator will state that if the Board or the Investment Manager is involved in the pricing of any of the Fund's securities, the Administrator may accept such prices without any further liability.

So we come to the neverending staircase - investors hoping for independent pricing look to the board, then to the administrator...and find themselves back just where they started, with pricing responsibility - at least for anything where prices could be more easily manipulated - back with the manager.

As we look towards 2010 and the renewed growth of our industry, this issue is, in our view at least, the achilles heel of hedge fund investing.  It is nearly a decade since Lipper, Lancer and Beacon Hill, yet the core issue in these cases - managers pricing their own books without effective administrator oversight - remains unresolved.  Indeed, as we have illustrated above, the biggest change since 2002 is for fund offering documents to be far more explicit to disclose and disclaim responsibility.  This is the exact opposite of working to close this control loophole.

There are many possible solutions, starting, of course, with careful due diligence.  Looking forward, we see potential for a redefinition of service provider roles and responsibilities, realignment of fee structures with a focus on vesting and deferral, emergence of new valuation specialists in addition to traditional administrators and wider use of managed accounts.  These are just a handful of suggestions among a much longer list of tools which could be deployed.  We encourage both investors and managers to challenge the legal status quo and look for better solutions - being proactive is clearly preferable to waiting for Lipper 2.0.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence.

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

Are Directors Responsible for Valuation?

Risk Without Reward frequently focuses on the issue of security valuation within a hedge fund.  One of the thorniest questions is, of course, who is actually responsible for valuation.

Many investors assume that, if an administrator has been appointed, then it is the administrator who will be responsible for pricing.  As we have often noted, this is not true - today's administrators argue that they are a "verification" not "valuation" agent.  Indeed, current "best practice" guidance for the administration industry makes this clear: as we noted in a recent post,

"It should be noted that while some HFAs [Hedge Fund Administrators] have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility."

So if the admin is out of the question, we are left with the hedge fund manager and, if we are looking at an offshore fund, the Board of Directors.  Many recent best practice documents (see Castle Hall's resources page), notably AIMA guidance and the IOSCO paper on hedge fund valuation, identify the Directors, as the "Governing Body" of the fund, to be the entity with ultimate responsibility for valuation.  Indeed, the Hedge Fund Standards Board guidance asks the hedge fund manager to "do what it reasonably can to enable and encourage the fund Governing Body" nearly 50 times: seems pretty clear that it's not the UK domiciled hedge fund manager driving the bus (now, that wouldn't have anything to do with UK tax rules, would it??)

It is against this background that we have been very interested to read a couple of recent hedge fund offering documents.  Both used directors provided by one of the usual suspect group of Cayman law firms who, in these instances, were also the offshore counsel for the funds in question.  In both cases, the offering documents contained a specific disclosure stating that the Directors were not responsible, in any way, for:

• the commercial structuring of the fund (fair enough - even though the same law firm was very responsible for the commercial structuring of the fund)
• the purchase and sale of any investment on behalf of the fund
• the valuation of assets of the fund
• any loss or damage, unless such loss or damage is caused by the fraud or wilful default of the Directors (we note that this clause specifically does not hold the directors to a gross negligence standard, but we guess that's a topic for another day)

Where, then, does this leave investors?  On one level, it is hardly surprising that the Directors of a Caymanian hedge fund are now saying that they are not responsible for the valuation of the fund's assets: after all, if you serve on several hundred boards, it's pretty difficult to keep track of current valuation issues on fund 132. 

On the other, this explicit attempt to disclaim any responsibility for valuation is new.  In our view, this illustrates, clearly and specifically, that the directors of an offshore hedge fund cannot be expected to provide anything more than a basic, corporate secretarial service designed to meet local filing requirements and comply with local business law.  There is, it is clear, no attempt to provide any form of meaningful, active corporate governance.

As always, caveat emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

PwC Proposal on Fair Value Accounting

PwC has recently released an interesting discussion paper proposing changes to fair value accounting.  They do not propose eliminating fair value accounting - thankfully - but they do suggest that, for banks, only "credit related" losses be reflected in net income (this is, of course, the headline number that everyone focuses on for publicly traded entities.)  Other changes in current market value unrelated to the borrower's ability to repay a loan, such as write downs due to an illiquid or dysfunctional market, would be recorded in "other comprehensive income".  OCI is essentially a bucket for items that companies don't want to pass through their reported, "business" P&L.

Interesting reading, albeit more focused on banks rather than hedge funds.  However, the underlying theme is that only realized gains are "real", while unrealized gains are transitory and have less validity as measures of true business performance.  According to PwC:

"Removing liquidity and other transitory charges from the net income of institutions with a “buy and hold” business model may reduce distortion from excessive market pessimism in distressed markets and excessive market optimism in euphoric markets." 

The implication for hedge funds reverts back to a theme we have commented on frequently: that one of the flaws of the typical hedge fund structure is that investment managers can pay themselves on unrealized appreciation as well as realized P&L.  This remains a key issue that should be at the forefront of investor re-evaluation of the hedge fund model going forward.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

NAV Suspensions: Will FAS 157 Create Unintended Consequences?

We have now seen a growing number of funds suspend redemptions or propose restructurings, and expect that many more will follow over the coming weeks.

There are many implications here, but we wanted to focus on three issues related to accounting and valuation, particularly in light of FAS 157.

1) Is any sale a "fire sale"?

As part of the suspension process, there is a growing trend for funds to segregate securities into a liquidating portfolio.  As such, the proportion of the portfolio which needs to be liquidated to meet redemption requests is set aside and separated from the "ongoing" portfolio.  The securities will be sold and the proceeds - whatever they may be - will be paid to those investors who require short term liquidity and choose not to rescind their redemptions.  In other words, think fund of funds.

The question, though, is how those sales will impact the NAV calculation for securities held in the "ongoing" portfolio.

At first glance, it would seem obvious that if a hedge fund sells a security from the liquidating portfolio at a 25% discount, then that is the price which should be used for identical securities held in the ongoing portfolio.  After all, here we have tangible, specific evidence of a transaction and, at the moment at least, no-one is willing to pay more.

Not so fast.  We expect that many managers will argue that sales from the liquidating portfolios are involuntary - markets are so bad, that the managers,or so the argument will go, would not sell the securities by choice.  They are only doing so because they are forced to raise cash to meet redemptions and, therefore, all such sales must be fire sale, distressed or forced - take your pick as to the terminology.  

If you follow this argument through, then it would be possible for managers to ignore the prices from actual sales in the liquidating portfolio.  Securities held in the ongoing portfolio would be valued using other methods and could, of course, be recorded at higher prices than the actual sales.  

To this point, we were very interested to read an interview with a managing director from the valuation firm Duff and Phelps who commented that hedge funds "within the last couple of weeks" had increasingly returned to mark to model pricing.  The reason for adoption of mark to myth, sorry, mark to model methods is that "in illiquid markets the range of broker prices can be too wide to be very meaningful."  

There have, of course, been some recent "clarifications" as to the implications of mark to market accounting and FAS 157.  These include the FASB staff position 157-3 and the SEC guidance on fair value accounting (both available from Castle Hall's website).  Both provide new latitude to ignore "fire sales" when considering the prices to be used for identical or similar securities in a portfolio.

This is a huge issue that impacts, firstly, NAV calculations at November 30 and December 31 and then the audited financial statements as of year end.  We certainly agree that markets are tumultuous and the lack of market depth is unprecedented.  There is, therefore, definitely an argument that when markets are gripped by fear and transactions underestimate the "fair value" of a security, then those prices should be ignored or at least questioned. 

Mind you, this would be a stronger argument if people were more vocal to mark prices down at times when markets were unduly confident and prices clearly over-estimated fair value.  Everyone is, of course, very happy to mark assets up in a period of irrational exuberance (and get paid on those marks), but more than a little hesitant to mark them down in a period of irrational pessimism.

2) Investors have to make their own determination of fair value

Some time ago, we commented on a recent letter sent by the Department of Labor to an un-named US ERISA pension entity.  The emphasis of the letter was that it is the investor who is responsible for determining the fair value of all investments, including hedge funds.  As we said at the time:

According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan.  Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy.  In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value.  A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

The audit profession makes exactly the same point: the financial statements are the responsibility of management, who must select appropriate accounting policies and then implement controls and procedures to ensure that the financial position and performance of the reporting entity is correctly stated within the parameters of materiality.

Against this background, let's pose a question.  If I am a hedge fund investor - a fund of funds or an institution with positions in numerous, single strategy hedge funds - what happens if I have 5 underlying funds who adopt some variant of the restructuring discussed above?  Each underlying manager will make their own determination as to how they should cut their NAV, potentially making their own, different assumptions about what prices they should ignore as being "distressed" or "fire sale".

What happens, though, if those underlying managers do not make consistent decisions?  How do I, as an investor, ensure that the valuations I have used are consistent and comparable if I have underlying managers who have adopted differing valuation techniques in these markets?  

Equally, what happens if I, as the investing entity, disagree with the underlying manager's accounting policy - perhaps I believe that at least some of the actual, realized transactions actually are representative of fair value and should not simply be ignored.  This means that the underlying manager's accounting policy flows through to become the investor's problem.

On this point, investors should also remember that the auditors of underlying hedge funds are not responsible for those funds' accounting policies: those, too, are set by the management of the underlying fund.  As such, different funds holding the same security, audited by the same audit firm, may well hold that same security at different prices, yet still receive unqualified audit opinions.  The auditors are not, to be clear, imposing any form of pricing standardization or consistency: the auditors do not have a central master pricing file that they force all hedge funds to use.

There is clearly a huge challenge for the auditors across all these points, and we very much appreciate that the auditors will have an enormously difficult time trying to work through these tortuous valuation issues.  Equally, though, we have to highlight a conflict: auditors serve both to audit underlying hedge funds and then also to audit the accounts for investors who allocate to those hedge funds.  

As the audit firms work through these issues, therefore, we have to hope that they will have a mind to both constituencies.  The challenge is one of chronology: the underlying hedge funds usually complete their audits before the end investor (after all, the end investors need the financial statements from the underlying funds before they can finish their own audits.)

What would be completely unacceptable for investors is to find that the auditors first complete the underlying hedge funds' accounts and work hard with each manager, client by client, to "justify" each fund's individual accounting treatment.  It would be ironic indeed if those same auditors then turn round to investors and make an audit issue of the lack of accounting consistency and comparability across a portfolio of those underlying funds.

This is a time for the accounting profession to step up to the plate.  When auditing a hedge fund, the client is not the hedge fund manager.  The client is the fund, which is owned by the investors.  If there was ever a time for the auditors to remember who they are preparing financial statements for, this is it.

3) If a hedge fund has suspended redemptions, is it restricted from sale?

And last but not least.  Pretty much exactly a year ago, in November 2007, we wrote a post with the dramatic title "will FAS 157 destroy the hedge fund industry."

The argument was that hedge funds are restricted from sale as they offer infrequent redemption opportunities.  If I invest in a fund with a five year lock up, therefore, should I still carry it at par as I cannot exit from that fund for 60 months?

The industry has side-stepped this one (albeit more for reasons of practicality than technical rigor). The issue is still out there, though, for funds which suddenly suspend redemptions indefinitely.  If I am an investor in one of these hedge funds, must I make some allowance for the lack of liquidity and restriction as to sale which has suddenly been imposed?  Is it still appropriate to carry these funds at the reported NAV, or should I take some form of discount?

We await audit guidance on this point as well.

Again, these tumultuous times create unprecedented issues for everyone involved in the hedge fund industry.  These issues also do not have any easy answer.  At times like these, we also have to applaud the efforts of many managers to "do the right thing", even when it is not clear - today at least - what the "right thing" actually is.  

It is a fair point, however, to state that the decisions made now by the managers will flow through to the investors post year end.  We certainly do hope that the lawyers and accountants giving advice to the managers this weekend do stop to think about the impact their advice will have on the investors next year.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence  

Performance Smoothing

An article in the FT this week commented that "hedge fund investors seek shelter from meltdown."  The discussion touched on the Bear Stearns' funds, raising the broader question of whether investors do - or can - properly adjust hedge fund returns for illiquidity.  In other words, is that nice, smooth "carry trade" return with very low volatility and an exceptionally high Sharpe ratio hiding a risk of significant loss if markets become illiquid? 

One of the other sources quoted by the FT was a study by Riskdata: 

"Olivier le Marois, chief executive of Paris-based Riskdata, a provider of software solutions that helps asset managers and hedge funds control risk, says that given the potential illiquidity of Bear Stearns’ assets, the funds’ steady returns could have raised a red flag. The reason: in a Riskdata study of 3,216 hedge funds and funds of hedge funds, he found that nearly one-third of funds trading illiquid securities may be smoothing their returns, which could mislead investors about actual underlying turbulence."

Riskdata's website has a number of interesting resources, including a more detailed article (see link) called "return smoothing practices: a potential threat to alternative asset growth."

This is very interesting reading, and concludes that procedures should be put in place to "ban" performance smoothing.  To achieve this, the firm makes four recommendations:

"First, thorough due diligence should be made on the valuation process, whether it is performed with in house calculations, vendors software or third parties quotes. Not only should valuations be fair and based on appropriate input data, but all available quotes should be considered without discretionary selection. This point is especially important, due to possible conflicts of interest between managers and brokers about fair valuation when dealing with illiquid securities. 

 

Second, a notable progress in the direction of investors mastering their investments is to give them a quantitative means to detect return smoothing practices. The Bias Ratio – along with Riskdata risk profiling techniques – offers one effective way to alert on possible return smoothing. By itself, quantitative analysis is not sufficient and ought to be supplemented by effective control of managers’ practice. But conversely, quantitative techniques are a necessary add to due diligence and monitoring of investments, as only them can provide an unbiased alert system of managers unfair behaviour. 

 

Third, a complete alarm system should be put in place, which includes not only regular contact with managers, but also a systematic and regular quantitative analysis of their returns, in order to detect biases – like the Bias Ratio – and style drift, as well as to identify sources of risk and potentially hurting scenarios. 

 

Finally, each fund should not only be analysed by itself, but also in the context of a portfolio. For this purpose, the individual risk of one single fund should not hide the risk of diversification – or rather lack of – at the global portfolio level. In other words, this means identifying market scenarios under which investments become correlated and diversification vanishes." 

These remain very sensible and necessary recommendations, and ever more timely as the industry moves towards a new cycle of launching distressed funds trading harder to value securities.

What are some of the lessons to be learned?

1) Investors should always remember the paramount principle of valuation: absent an actual sale, prices used in a NAV calculation are only estimates.  Estimates are, of course, open to manipulation.

2) Best practice universally calls for the valuation process to be segregated from front office investment professionals.  Allowing the front office to price securities creates a clear conflict of interest and an obvious potential for performance smoothing.

3) Investors should take heed of Riskdata's recommendation that all available quotes are included in the pricing process.

4) Very careful due diligence is always required to evaluate valuation procedures adopted by the manager as well as the administrator.  In Castle Hall's experience across the industry, we continue to see enormous variation in valuation procedures.  Investors need to understand, in detail, the valuation process adopted by each fund: investors should not assume that large funds always have good valuation procedures and, as we have commented frequently, should definitely not assume that the administrator is actually pricing the portfolio independently.  Investors must also be conscious that funds which adopt different valuation procedures may not produce directly comparable NAVs.

As always, caveat emptor.

www.castlehallalternatives.com

Hedge fund operational due diligence