Hedge Fund Appraisal

Cayman's Fund governance: reigning the board of directors

2013-01-23T08:45:00.002-08:00

Following similar steps by other jurisdictions the Cayman Islands Monetary Authority ("CIMA") intend to update its corporate governance guidance The regulator has posted a consultation paper on its website and has appointed Ernst&Young to perform an industry survey on the topic.

Beyond the reshuffle of its broad corporate governance principles, to align them with international standards, the CIMA is again questioning the right approach to directors supervision. The regulator is considering several improvements to govern the directors' population:

Require all the individuals providing directorship services to Cayman's regulated entities to register with the CIMA
Require individuals acting as directors on more than 6 regulated entities to seek approval from the regulator
In order to improve transparency, the CIMA intend to develop a public database providing limited information on the directors of Cayman's regulated entities.

Through the industry survey, the CIMA wants to evaluate the pertinence of other measures pertaining to the total number of directorship held by a director. The regulator is considering to require the total number of directorship to be disclosed in the fund's constituting documents and even to impose a limit on this number.

Those steps are clearly aimed at better controlling two categories of directors: the professional directors who sit on a large number of boards and the "blank check" directors who do not provide any oversight and just collect their coupon.

Comparing the current and proposed "Standards of Corporate Governance", the following changes are interesting:

the requirement for directors to request regular information from their funds' service providers
the new text emphasizes the need for a documented distribution of responsibilities between the various stakeholders and and appropriate oversight of those delegated functions
the new standards require the setup of a compliance committee and other sub-committees as needed

Those changes will require from the directors a proactive stance in seeking information from the service providers and the setup of an appropriate oversight framework of the delegated functions.

The proposed guidance is bringing the Cayman Islands closer to the standards used in European UCIT funds. Several improvements specific to the fund industry could be incorporated in the updated standards like:

a majority of independent directors
quarterly board meetings with at least one meeting per year with physical attendance by the directors
increased transparency through the proposed public database (i.e, name of the service providers, last audit date)

Investing with a three years time horizon

2012-12-19T02:40:00.000-08:00

Typically, investors claim that they look several years out when they choose an investment. In reality, the turnover of their portfolios will tend to be much faster due to drawdowns. Even with pension funds' assets/liabilities management style, it is sometimes difficult to convince trustees to hold a loosing investments. The graph below represents the 3 years rolling returns of hedge funds and US equities. Hedge funds have overperformed US equities in 75.5% of the 192 three years period between December 1993 and November 2012. Furthermore, hedge funds have lost money (-1.33%) in only one period compared to US equities which were in a drawdown during 69 periods. A pension fund targeting a 2% annualized return over three years will have delivered in 80% of the period by being fully invested in hedge funds.

3 Years rolling returns from December 1993 to November 2012
Dow Jones Credit Suisse Hedge Fund Core Index/S&P 500 (^GSPC)

Disappointment is all relative

2012-12-18T06:42:00.001-08:00

In general, investors feel disappointed by the recent performance of hedge funds. The level of disappointment is a function of the distance between facts and expectations. In the case of hedge funds, both variables are misunderstood and biased.

The facts, or the risk/reward of hedge funds in our case, measured by returns and volatility, are not easily observable. Several indices, like the Dow Jones Credit Suisse index series, try to capture the overall hedge funds' characteristics. They differ in their construction methodologies, components and are distorted by well known biases like the survirvorship bias. Therefore, results can differ significantly from one to the other. The return YTD at the end of November was 6.10% and 2.57% according to the Dow Jones Broad Hedge Fund Index and the HFRX Global Hedge Fund Index respectively. A significant 3.5% difference. Even if we assume that anyone of them provide a good representation of the hedge fund investment universe, none of them is investable, compared to equity indices which are accessible to investors through many instruments (ETF, futures, mutual funds ...). In fact, each investor have only a subset of the 7'867 single manager hedge funds reporting at the end of November 2012. Therefore, investors' individual performance will likely diverge particularly since performance dispersion has been high recently. For the 12-month period ended Sept. 30, the top 10 percent of funds reported an average gain of 34 percent, while the bottom 10 percent saw an average 19 percent loss, according to Hedge Fund Research Inc. of Chicago.

As we have seen, the benchmark that actual or potential investors shall use to measure their disappointment is to say the least blur. The problem become even more acute when we look at investors' expectations from hedge funds.
There is two way to define risk/reward expectations, absolute or relative. The absolute expectation will take the form of a minimum threshold. The investor can be simply looking for an absolute return (not loosing money in any market environment) or for an annualized return of X%. The relative expectation will look for overperforming a benchmark for example +2% over an equity index on an annual basis. The volatility, or another measure of risk, can also be used to define expectations. An important feature of hedge funds has been their low correlation to other asset classes. If an investors's expectations from his hedge fund investment is diversification, he will likely emphasis correlation measures.

Another significant parameter in defining expectations is the time frame. Over which period will we be measuring the facts against your expectations.

Let's take the example of an investors looking for relative overperformance of hedge funds, represented by the Dow Jones Credit Suisse Core index, compared to the equity market.

If we look at 5 years returns, hedge funds, represented by the yellow line, have outperformed equities, represented by the green line , for almost all the period since 2001. The results are almost the same if we look at 3 years time windows except since September 2011 when equities started to outperform. As usual, investors tend to emphasis recent history and to forget that over the past 18 years hedge funds have been ahead most of the time.

In the case of an investors looking for an absolute return investment, we see from the graph that hedge funds never had a 5 years period with a negative return and only one 3 year negative window for the period ending in April 2009.

As we have seen disappointment is all very relative and even if recent returns from hedge funds have marked low investors should review their motivations in investing with hedge fund managers and clearly define their benchmarks and expectations.

Funds of funds reinventing themselves

2011-02-09T12:30:00.000-08:00

Infovest21, a New-York based provider of information and research to the hedge fund industry, has just released its 2010 fund of hedge funds survey. The main finding, brought forward in the firm’s related announcement, is that “Funds of funds add more nimble managers, prefer small to medium-sized managers”. The contrary would have surprised me.

The last financial crisis has allowed investors to distinguish between the good and the bad (less the lucky ones) in the fund of funds industry. During the glorious years for hedge funds, between 2003 and 2007, managing a fund of funds was a reasonably easy task. According to the Dow Jones Credit Suisse Hedge Fund index, the hedge funds delivered a total net return of almost 75%, corresponding to a compound annualized ROR of 11.79%, during those 5 years. The low barrier to entry drove to the industry a lot of managers who realized the strong potential to earn over 2% (based on the standard 1% management fee and 10% performance fee) on managed assets with little research costs (who ever heard about due diligence at that time anyway). According to the Infovest21 survey, today the average fee structure is a 1.1% management fee with a 6.1% performance fee. All those new entries brought strong competition for assets amongst fund of funds managers and therefore a need to develop a real edge. The development of a real competitive advantage was not about adding leverage or investing in exotic/ not well known “alphabet soup” strategies but it was about building a strong research and adheres to high due diligence standards. The ones who picked the first two options are probably no longer in existence today or are still struggling to liquidate their portfolios.

According to the survey’s respondents, who were themselves above this threshold, on average, at least $1.4 billion is needed to "survive and thrive". With this level of assets, the managers earn on average (assuming an 8% annualized return) an annual fee of approximately $25 million. When considering making an investment with a fund of funds manager, investors should be mindful of how much budget is allocated to the company’s resources and not entrust their money with a manager who is looking to increase his margin at the expense of his investors (inadequate resources are the recipe for future disaster).

The move toward smaller hedge fund managers is not really a surprise. Post 2008, in the urgency, fund of funds managers had to rebuild quickly the confidence of their investors and achieved that by moving assets toward the well known, large and liquid hedge fund managers. Most of those managers are today well above their end of 2007 AUM due to this flight to “size” and are therefore likely to close to new assets soon. Furthermore, those managers founded in the late 80’s, early 90’s have to think proactively about their succession planning. Investors need to assess what will be the impact of the historical founders stepping down on the business and on the returns. Chris Shumway, Stanley Druckenmiller, John Horseman and Leon M. Wagner are a few examples of star fund managers who stepped down and retuned assets to investors in the last twelve months. Also big is not always beautiful, several academic studies have demonstrated that smaller and nimbler funds tend to outperform their larger peers. An additional incentive for fund of funds to diversify away from the blue chips is to differentiate themselves from the competition. An investment analyst in one of the big Swiss private bank recently told me that the biggest problem today was the high level of overlap between funds of funds’ underlying positions. In order to stand apart, the managers need to go off-road and find the gems wherever they are. Furthermore, institutional investors are more and more contemplating investing directly into hedge funds and if they realize that the end game is just to pick funds among the larger ones, they will certainly conclude that they can do it on their own.

Another interesting trend highlighted by the survey is the move toward industry consolidation. Almost two-thirds of the respondents have considered a strategic partnership while almost one-half considered acquiring another entity. Another 30% have considered merging or have merged with another firm. Adding to assets and/or distribution channels was the main motivation in these efforts.

The fund of hedge funds industry is changing fast to rebuild investors’ confidence and to prove that they can add value. I hope that they really learned the lessons from the last crisis and that bad habits are gone for good. Unfortunately complacency and greediness are very sticky within the finance industry and investors need to keep vigilant for not falling in the next trap.

Useful links page

2011-01-17T06:44:00.000-08:00

I have compile a list of useful links to facilitate the search of public information about your favorite hedge fund managers.

Click here to access the list or clisk on the "Useful links" tab on the menu at the top of the page.

I hope you will find this ressource useful.

Don't hesitate to suggest additional ressources.

Operational staff challenged by investors' expectations

2011-01-15T13:45:00.000-08:00

In order to raise assets for your hedge fund, it is no longer enough to involve the portfolio manager and a client rep. Every employee of the firm need to work at meeting the investors' expectations.

The good news for investors is that, according to a poll recently released by SEI, it appears that CFOs are aware of this new obligation.

According to the poll, conducted recently at the company’s annual Hedge Fund CFO Forum, addressing new regulatory requirements and meeting evolving investor expectations are the biggest challenges for 2011.

Read the press release from SEI here.

A new Star(r) in the Wall Street's hall of shame

2010-12-20T02:23:00.000-08:00

Kenneth Ira Starr was arrested in May 2010 for a fraudulent scheme he ran for about a year and through which he had been able to misappropriate over $9 million from his advisory clients.

According to the claim brought by the SEC against him, Starr prior to his arrest managed over $700 million through Starr Investment Advisors LLC on behalf of around thirty high net worth clients.

The scheme was made possible since Starr had power of attorney or signatory authority over many banks and investment accounts belonging to his clients. Furthermore, Starr had custody of some of his clients’ assets also he was not a qualified custodian. Moreover, certain clients’ assets were held in a physical form in a safe at Starr’s office.

In order to avoid detection of the misappropriation scheme, Starr has been able to rely on the complicity of Jonathan Star Bristol (another star!!!), an attorney at an international law firm, who allows him, from November 2008, to funnel some of his clients’ assets through his attorney trust accounts. Bristol was the sole owner of those accounts. Bristol would then send the money deposited on his accounts to Starr related parties also he knew that it was belonging to Starr clients.

According to the SEC’s complain, the scheme started in August 2009 and comprise many illegal transfers from clients’ money. It culminated in April 2010, with the transfer of $7 million from three different client’s accounts to found Starr’s purchase of a luxury Manhattan apartment.

Also some of the clients noticed the illegal transfers from their accounts and Starr had to return some of the stolen money, he still had been able to perpetrate the scheme for almost a year and to steal several millions for his own personal use.

If investors needed a reminder, this case highlights again the danger of self-custody of clients’ assets by an asset manager. The SEC stressed in his complain that in order to hold assets a custodian need, among other obligations, to be registered and to engage an independent public accountant to perform surprise examination of its clients’ accounts. Furthermore, if an advisor is not an authorized custodian, he has the fiduciary duty to deposit his clients’ assets with authorized parties.

Managed accounts are providing extra security versus a fund structure only if those accounts are structured properly and monitored by the clients. Attorney power should never be granted to the investment manager and transfers over a certain amount have to be authorized by the account owner. Furthermore, the client need the skills and tools to monitor the account, the era of blind trust is over today you need to “trust but verify”. It should be stressed that complicity is very difficult to detect and has been unfortunately used in several other fraud cases. Thorough due diligence is a must but you should also remember the wise advise of not putting all your eggs in the same basket.

Source:
SEC Press release:http://sec.gov/news/press/2010/2010-248.htm
SEC Complain: http://sec.gov/litigation/complaints/2010/comp21782.pdf

What does volatility teach us about mean deviation?

2010-12-18T14:24:00.000-08:00

If you think, like many, that “an instrument that has a daily standard deviation of 1% should move 1% a day on average", you should read the following article:

Goldstein, Daniel G. and Taleb, Nassim Nicholas, We Don't Quite Know What We are Talking About When We Talk About Volatility (March 28, 2007). Journal of Portfolio Management, Vol. 33, No. 4, 2007. Available at SSRN: http://ssrn.com/abstract=970480

The due diligence process according to John Mauldin

2010-12-18T14:12:00.000-08:00

John Mauldin is among other things a serial writer and an acute investment professional. I enjoy very much reading his Thoughts from the Frontline e-letter or the various articles he features in his outside the box letter.

He has posted a draft chapter of his new upcoming book about Absolute returns on his website (http://www.accreditedinvestor.ws/downloads/Due_Diligence.pdf). The name of the chapter is "Evaluating Hedge Funds" and describes his approach to due diligence.

Also it is quite challenging to describe a due diligence process in only 22 pages, I noticed a few ideas which are worth considering in your analysis of an hedge fund:

• Some hedge fund managers are good and some are just lucky. You do not want to invest in the lucky one, as luck always run out, typically just after you invest.

• The business side of the fund is as important as the investment side.

• The most important thing to understand about a fund is "Why" it makes money. If you cannot understand the "Why" of a fund, you should not be investing.

• A brilliant manager who can't follow through on the paperwork is a disaster in the making.

• Second level references are far more informative that the given references

Hedge Fund Appraisal annonces the launch of the Research Gateway

2010-12-08T12:01:00.001-08:00

Learn how it works by watching our multimedia presentation

The research gateway presentation

View more webinars from hfappraisal.

Cost of information is a barrier to self-regulation

2010-07-06T06:40:00.000-07:00

The graph below is from a survey conducted in 2009 by Ernst & Young named Global Hedge Fund Survey: Weathering the storm published in November 2009. It is not a surprise that the 100 hedge funds surveyed prefer an investor driven change rather than a costly and efficiently questionable regulation.

I agree that investors should be more demanding from their hedge fund managers in terms of transparency. However, the only way for the industry to be effectively "policed" by its investors is to lower the cost of information.

In a paper, Board Structure and Price Informativeness, forthcoming in the Journal of Financial Economics, The authors find evidence that stock market monitoring is a substitute for board monitoring. Access to reliable information at a reasonable cost is what makes it possible.

The day when investors will be able to compare hedge funds on an apple to apple basis, the industry will be a safer place to invest.

Reducing insider trading risks at hedge fund advisers

2010-07-05T04:27:00.000-07:00

Andrew Vollmer, a partner in the Securities Litigation and Enforcement Group at Wilmer Cutler Pickering Hale and Dorr LLP published “How hedge fund advisers can reduce insider trading risk,” in the Journal of Securities Law, Regulation & Compliance, Vol. 3, No. 2 (2010).

The article discusses some of the approaches that hedge fund managers use to prevent insider trading violations. They include avoiding agreements to keep information confidential and giving heightened attention to business communications between hedge fund personnel and close family members or personal friends. The article also describes the many legitimate reasons that analysts at money managers have to communicate in private with senior management of public companies and ways hedge fund advisers can police the insider trading risks associated with those communications.

The author has covered the topic from a legal perspective describing methods used to avoid being "brought behind the wall" unintentionally. However, the article does not discussed the way to avoid the intentional insider trading practices revealed recently at some well known hedge funds. As discussed, recently in my blog, the identification of fraudulent practices at hedge fund advisers is an arduous task. A dedicated compliance/legal department and pre-trading systematic compliance checks are good safeguards to avoid insider trading.

Administrators become transparency providers

2010-07-02T04:12:00.000-07:00

Hedge Fund managers are usually very cautious regarding the level of transparency they provide to their funds' shareholders. The reasons invoked by the managers for such secrety are usually their fear to see their investment strategy reverse engineered or other investors betting against them. Even if the managers provide investors with some granular information about the fund's portfolio, this information partiality can be questioned.

However, their is one person for whom the hedge fund manager has no secret.This is the fund's administrator. In order to perform its duties, the administrator needs to have access to detailed information about the fund's portfolio. In most cases the information is gathered directly from the fund's counterparties.

Following investors' demand for more transparency, some administrators understood, that they were in the best position to provide this additional disclosure in an independent manner. Today, at least three of them (Citco, Morgan Stanley and Globop), are proposing transparency reports to investors for funds which have elected to propose this service to their shareholders. The managers can decide which level of transparency they want to provide.

A common layer of transparency proposed by the three administrators is a report providing information about the NAV calculation process. The information included in those reports can cover pricing sources, position reconciliations, fund assets and liabilities, counterparty risk concentration, portfolio liquidity and where assets are held in custody.

According to the Q4 2009 HFN Administrator Survey, the three above mentioned administrator had assets under administration at the end of 2009 totalling $582.44billion which represents approximately 25% of the total hedge funds assets.

The tools for more transparency into the opaque hedge fund industry are available, investors need now to use them and put pressure and their managers and the fund's administrator for a broader generalization of those practices.

Related links
http://www.morganstanley.com/about/press/articles/9bcef2d6-5463-11de-96f6-3f25a44c9933.html
http://www.globeop.com/globeop/proserv/fund_administration/fund_performance_reporting/
http://www.citco.com/Divisions_Transparency_Platform.jsp

The financial crisis’s “Ponzi schemes” blowing effect

2010-07-01T06:17:00.001-07:00

Image via Wikipedia

(Photo:Ponzi aka "Charles Bianchi" under arrest circa 1910)

The last financial crisis has had a stunning side effect in uncovering "Ponzi schemes".

In fact, in order to keep a "ponzi scheme" going, the investment "fraudster" needs only one thing: liquidity. As long as the amounts subscribed into the fund exceed the amounts withdrawn, the credulous investors will probably feel confident that they made a good investment decision. The liquidity crisis engendered by the financial crisis had the effect of destabilizing the good operation of some Ponzi schemes especially the ones who were offering short liquidity terms.

A search on the SEC website for the word "Ponzi" returned 294 litigation matches for the period between September 1^st 2008 and June 30^th 2010 compared to 144 matches for the preceding 20 months period. The matches do not always represent separate cases but the difference between the two numbers unquestionably demonstrates the positive effect of a liquidity crisis in blowing up "Ponzi schemes".

The last complaint of the SEC against an alleged ponzi schemer was filed on June 17^th 2010 against Daniel Spitzer and the investment companies and funds he controlled (click here to read the full text of the complaint). It is worth noting that once again the victims are individual US citizens invested in an LP vehicle with no third party administration. The complaint does not explain why the different entities involved in managing the funds were not registered as investment advisers with the SEC despite the fact that they were supposedly managing around $100ml for 400 investors.

We are now 20 months after the collapse of Lehman Brothers which triggered the huge run to the bank experienced by so many "liquid" funds; it is fair to assume that most of the pure "historical Ponzi schemes" have now been uncovered. However, investors beware not to become too complaisant as fraudsters are always waiting for the right moment to catch you off-guard.

Conflict of interest versus independence: the board of directors’ dilemma

2010-06-30T08:19:00.001-07:00

If you are not yet convinced about the damages that a conflicted board of directors can cause to investors, I suggest you read the article "The Other Offshore Disaster" published in the New York Times.
The author comes back on some of the circumstances that led to the loss of around $1.6 billion in 2007 by investors in the Bear Stearns's hedge funds.
He demonstrates that the existing conflict of interest due to the tight working relationship between Walkers Global and Bear Stearns led the two "independent directors" of the fund to take wrong decisions at the detriment of the funds' investors.
The article also demonstrates the failure of Bear Stearns to spot unlawful trading by the portfolio manager which probably contributed to the massive loss.
The quality of the board of directors should be a top priority for hedge fund investors as I have already advocated numerous time in my blog. Directors are potentially in a privileged position to spot problems that investors will only be able to catch after it is too late.
The needed change in hedge funds corporate governance needs to be investors led, so please before you invest looks who are the individuals who may be the last rampart to keep you investment safe.
To read the New York Times Articles click here.

Mickey in Insider Trading Land or How the good regulators can help the poor investors

2010-06-07T06:05:00.000-07:00

The regulators are not only enacting new laws but they are also looking for way to better enforce existing ones.

The New York Times published an article at the end of May about possible new steps in the U.S. government fight against Wall Street uses of non public information to trade.

From an investor due diligence stand point, identifying insider trading is certainly an issue for several reasons. First, you need to have transparency into the fund’s portfolio at the position level, something that is usually possible only with several months lag. Once you get the portfolio from a trusted and independent source you need to analyze the positions the transactions in order to identify an unusual move or gain. In the case, you are able to spot a questionable investment you are not done because the investment manager may have had a good theory behind buying or selling the specific investment. At the end of the day, you spent a lot of time negotiating access to the portfolio, analyzing the data, questioning the investment manager on probable misconduct and finally you will usually end up with a very weak case to prove insider trading and the investment manager will be angry at you.

Investors need to make their best effort to identify misconduct as part of their due diligence but they also have to be conscious of their limits. If the regulators are able to give a hand in identifying insider trading practices it will certainly be welcomed by investors.

The Next Step in Catching Insider Trading?

The arrest of an assistant to a Walt Disney Company executive and her companion on insider trading charges reflects what seems to be a common perception about the ethics of these investors – even if most ply their trade legally…

Click here to read the article.

The brokers’ sword of Damocles over hedge funds’ heads

2010-06-07T01:46:00.001-07:00

A very interesting article published by Hedgefund.net from Devi Koya, a partner at the law firm of Baker & McKenzie.

A decline in asset under management at a hedge fund has multiple consequences not only on the manager's revenue but also on its creditworthiness. Since hedge funds are using leverage extensively in their investment strategies, through cash borrowing or derivatives, their capacity to meet their liabilities is of the highest importance for their trading counterparties. The first mechanism of protection for brokers is their ability to call for additional margin or collateral to reduce their credit exposure to a fund. The other protecting clauses in the brokerage contracts are the Additional Termination Events clauses or "ATE". For example, if the funds breaches some predefine threshold is terms of assets under management, key man departure … the broker has the right to call for additional margin or collateral. The next step after an ATE occurrence will be the termination of the relationship by the broker and the liquidation of the fund's positions usually at fire sale prices.

Hedge fund's CFO should be very careful in negotiating their prime brokerage and ISDA agreements especially in regards to ATE. Furthermore, they need to obtained waivers from their brokers, after the occurrence of an ATE, to avoid being at the mercy of their counterparties during the next adverse market event (which will no doubt occurs sometimes in the future).

Competent legal, compliance and operations teams are no longer a luxury for hedge fund but a requirement in an environment where everyone try to pass the "hot potato" to its neighbor.

Devi's Corner: When the Banks Won't Call You Back - NAV Triggers' Effects on Hedge Funds
Between 2007 and 2009, many hedge funds declined in size due to investor redemptions and/or performance declines. These same hedge funds trade derivative agreements under an ISDA Master Agreement that typically contain provisions defined as Additional Terminations Events ("ATE") which can be triggered by the decline of a fund's net asset value...
Click here to read the article

Money protection rules: A false sense of confidence

2010-06-04T05:26:00.001-07:00

The announcement yesterday by the FSA of its fine against J P Morgan Securities Ltd. has sent a strong signal to UK's financial institutions authorized to hold client money and assets.

The FSA rule seems to provide good protection for clients but this is without considering the option available in the law to opt-out from the client money rules. Amongst hedge funds, it is not uncommon for managers to choose this option since they usually get a better interest income for their cash.

At the end of the day, it is very good for regulator to enforce the rules but it also gives a false sense of protection to investors who don't always understand all the subtleties of the law.

Conclusion: Don't take money protection for granted. Ask you manager the right questions!!

The Financial Services Authority (FSA) has fined J P Morgan Securities Ltd (JPMSL) £33.32 million for failing to protect client money by segregating it appropriately.
Under the FSA's client money rules, firms are required to keep client money separate from the firm's money in segregated accounts with trust status. This helps to protect client money in the event of the firm's insolvency….
Click here to read the FSA's announcement.

The small guys’ magnifying mirror

2010-06-04T03:56:00.001-07:00

HedgeFund.Net published yesterday a very interesting article about the challenge for small hedge fund managers in implementing "institutional" like operational best practices.

The article covers a lot of subject including investors due diligence, oversight of service providers, compliance, systems, competencies …

The "institutionalization" of the hedge fund industry is certainly good news for investors. However, this trend has its setback as witnessed by the opening by the FSA of an investigation on Gartmore on what it looks like an internal control overreach.

Devi's Corner: 'Institutional' When AUM is Less Than $500M
by Devi Koya, Baker & McKenzie LLP , June 3, 2010
The buzzword when investors are conducting due diligence on a hedge fund today is "Institutional." ….
Click here to read the article.

Will the new regulations make hedge fund investing safer?

2010-06-01T01:03:00.000-07:00

In the last edition of our Due Diligence Bulletin, we cover the recent regulatory developments on both sides of the Atlantic. The main challenge of those new rules will be to avoid regulatory arbitrage. The real benefit of a new regulations are usually visible only after several years, however the investment managers will have to bear the extra compliance costs upfront. Investors should be conscious that no matter the regulations that will be enacted the only real protection is a proper due diligence before investing.

Read the latest HFDD Bulltetin here.

Change to US GAAP may be costly for investors

2010-04-30T04:48:00.001-07:00

The recent application of the new Interpretation No 48 (FIN 48) to US GAAP related to Accounting for uncertain tax positions may push some managers to revise their fund's NAV.
In fact, FIN 48 clarifies the accounting for uncertainty in income taxes recognized which may trigger adjustments to provisions made for tax uncertainties in the financial statements.
According to our information, hedge funds which made profit by investing in the Spanish equity market, in the last four years, may have to take a provision under FIN 48 to account for capital gains tax. The Spanish government reduced the tax for foreign entities to 18% in 2006 to bring it in line with local investor taxation. Other jurisdictions may be concerned (for example, Ireland has since 2009 a 25% capital gains tax).
It looks like funds reporting under IFRS standards are not concerned by those adjustments.
For a complete review of the differences in accounting for uncertain tax positions under IFRS and US GAAP, I recommend the following article:
http://www.internationaltaxreview.com/includes/magazine/PRINT.asp?SID=689631&ISS=23993&PUBID=35

What type of due diligence for your “Newcits”?

2010-04-12T07:03:00.001-07:00

UCITS structure is bringing onshore in a regulated framework hedge fund strategies which were previously available offshore and only to "accredited investors".

The UCITS directive is providing guidelines for mitigating some of the risks linked to the fund's operations and investment strategy.

The effectiveness of those protections is being tested in the case of the UCITS funds invested with Bernard Madoff.

It is broadly recognized that the UCITS structure is providing some extra level of protection to investors but at which cost!!!

Learn more by reading Hedge Fund Appraisal last monthly Bulletin. Click here to open.

Directors’ pedigree as a red flag

2010-03-18T03:10:00.001-07:00

On February 17^th, a US federal judge has ruled, in the Lake Shore Asset Management case, that investors will get back 40% of the $268ml losses they claimed.

Lake Shore was shut down in 2007 after federal authorities charged that it concealed $30 million in trading losses.

The fund claimed it lost around $130 million in the bankruptcy of Sentinel Management Group Inc.

The former chairman of Lake Shore is Laurence Rosenberg, who was chairman of the Chicago Mercantile Exchange from 1977 to 1979.

This story remembers me another hedge fund fraud case back in 2005, the name of the manager was Paul Estace and the fund was called Philadelphia or PAAM (not link to PAAMCO!).

The analogy between the two cases does not stop with their common strategy, commodity trading, or the type of fraud, concealment of trading losses. Both companies had also as director a former chairman of an exchange.

Laurence Rosenberg who was chairman of the Chicago Mercantile Exchange from 1977 to 1979, was a director at Lake Shore and John Wallace, who was the vice-chairman of the Philadelphia Stock Exchange, served on the board of PAAM.

In both cases, it is worth noting that investors recovered around 40% of their assets.

All too often Hedge Fund managers seek to attract investors' interest by having the "Hall of fame" sitting on their board. Investors should be conscious that the experience without the involvement is not even worth the few thousands dollar paid to a board member.

So please, new time you do a due diligence on a fund don't stop with the directors' pedigree but try to understand what they really do.

Now you know that investing in a fund which has a former chairman of an exchange on its board will not protect you from fraud but at least you will recover something!!!

Hedge Funds exempted from the new SEC Custody Rule

2010-01-12T02:32:00.000-08:00

The Securities and Exchange Commission (SEC) has issued amendments to Rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and related amendments to Form ADV Part 1 and Rule 204-2 on recordkeeping.

The purpose of the custody rule amendments is to impose additional controls on registered advisers that have access to client funds or securities. The primary tool for this is independent verification of the assets. The form of such verification varies depending on the nature of the adviser’s access to or control over the assets.

The custody rule will now require an adviser with custody:
• to undergo an annual surprise examination by an independent public accountant registered with the Public Accounting Oversight Board (PCAOB) to verify client assets;
• to have a reasonable belief after due inquiry that any qualified custodian maintaining client assets sends account statements directly to advisory clients; and
• if the adviser or a related person acts as “qualified custodian” of client assets, to obtain or receive from the related person, a report on internal controls relating to the custody of client assets prepared by an independent PCAOB-registered public accountant.
All SEC-registered investment advisers will be required to comply with the enhanced custody rules. The amendments will be effective March 12, 2010, and registered advisers must comply with the new rules as of that date, except in certain cases where other compliance dates are specified.

Unfortunately, every rule has its exemptions and hedge funds will likely be eligible for such exemption.

In fact, an investment adviser to a pooled investment vehicle that is subject to an annual financial statement audit and distributes the audited financial statements (prepared in accordance with U.S. GAAP) to the pool’s investors is deemed to have satisfied the annual surprise examination requirement. The audit must be performed by an independent PCAOB-registered accountant and the financial statements must be distributed to investors within 120 days of the end of the pooled investment vehicle’s fiscal year end (or 180 days for a fund of funds). In addition, if a pooled investment vehicle is liquidated, it must be audited upon liquidation and the audited financial statements distributed to all investors “promptly” after completion of the audit.

The SEC noted that under the amended rule, an adviser to a pooled investment vehicle that satisfies reporting obligations by delivering audited financial statements to investors is not required to have a reasonable belief that the qualified custodian delivers account statements to investors. The SEC has directed its staff to explore ways in which additional protections may be afforded to investors in such vehicles.

For further reading and sources, I recommend the bulletin on the subject published by Katten Muchin Rosenman. You can find the document at the following address:
http://www.kattenlaw.com/sec-adopts-custody-rule-changes/

Hedge Fund shareholder activism: Is it really worth the game? The Dynamic Decisions case.

2009-11-20T01:42:00.000-08:00

On November 12th, 2009, the U.K.’s Serious Fraud Office (“SFO”), an independent government department that investigates and prosecutes fraud and corruption cases, announced that it is probing the London-based, Dynamic Decisions Capital Management Ltd., after the matter was referred to it by the Financial Services Authority.
The SFO’s investigation is the last act in a death spiral scenario that started in March 2009 before the Grand Court of the Cayman Islands. Because of the lack of transparency of the administrative processes (or probes) used by the U.K and Cayman Islands authorities, in comparison to what can be achieved from the U.S. authorities, it is difficult to acquire details on what really happened. Thus, the apparent lack of information surrounding this case is fuelling speculation about what really happened and numerous are those who already want to see Alberto Micalizzi, Dynamic’s founder, join the hedge fund fraudster Hall of Shame. Alberto is denying all allegations and believes that investors will recover 100% of their money.
At HF Appraisal, we have a different outlook on the events which led to the involvement of the SFO in Dynamic’s story, and we will try to extrapolate on what really happened since mid-December 2008. The current case will also allow us to illustrate the funds’ shareholders legal strategy to force the winding up of the fund.
In order to understand the story, we need first to analyze the chronology of the events.
February 20th, 2009: Micalizzi sent a letter to the investors explaining that the firm scaled back its equity and options holdings in December and bought “fixed income instruments backed by solid assets”. According to the letter, settlement of those purchases would be delayed until February because of “credit market conditions”,
Last week of February 2009: Two investors complained to the fund, and the board hired the law firm Dechert LLP for an opinion on the oil-backed bond transaction.
February 27th, 2009: In another letter to the investors, the investment manager announced that investors’ withdrawals would be suspended and that Micalizzi resigned from the board of the master fund to avoid a conflict of interest. According to the investment manager, Micalizzi was barred by the board to speak to the investors thereafter.
March 13th, 2009: A conference call was organized between the funds’ shareholders and the board of directors. In this call, Humphrey Polanen, a former director of the funds, relayed Micalizzi’s message to investors that the fund had “substantial” losses last year and assets may have fallen to as low as $20 million, excluding illiquid assets according to a court document.
March 23rd, 2009: A petition was submitted by Zolfo Cooper, a restructuring firm, appointed by two investors in the two feeders funds, Strathmore Capital LLP, based in London, and Cadogan Management LLC of New York. The shareholders won their petitions for the nomination of a provisional liquidator on the feeder funds, but Dynamic Decisions investment manager opposed the request on the master fund.
March 26th, 2009: Humphrey Polanen resigned as a director.
April 2009: Grant Thornton LLP is named provisional liquidator.
May 22nd, 2009: Hugh Dickson and Stephen Akers, partners at Grant Thornton LLP, were named the fund’s official liquidators by the Grand court of Cayman Islands. The liquidators said they expect to organize a meeting of creditors within the next 28 days to report on their findings.
November 12th, 2009: The fund’s liquidators, Grant Thornton LLP, said they were investigating corporate bonds the fund bought late last year. On the same day, the SFO announced its investigation.
In the Cayman Islands, which are British territories, companies can be liquidated, according to the UK Government’s Insolvency Service, for the following reasons:
Members' voluntary liquidation (or members' voluntary winding up). This is done when the shareholders of a company decide to put the company into liquidation, and there are sufficient assets to pay all the debts of the company, i.e. the company is solvent.

Creditors' voluntary liquidation (or creditors' voluntary winding up). This is done when the shareholders of a company decide to put the company into liquidation, but there are not sufficient assets to pay all the creditors, i.e. the company is insolvent.

Compulsory liquidation (or compulsory winding up). This is done when the court makes an order for the company to be wound up (a “winding-up order”) on the petition of an appropriate person. If there is more than one director, all the directors must jointly present the winding-up petition. A single director cannot present a winding-up petition.
If you are a director or a shareholder and you are also a creditor of your company, you may wish to present a winding-up petition on the grounds that the company cannot pay its debts.
In a fund structure, shareholders become creditors of the fund has soon as they submit a redemption request and that the fund accepts this withdrawal. We can safely assume that the two investors, Strathmore and Cadogan, placed redemption orders and received confirmation, from the fund’s administrator PNC, before the fund announced on February 27th that redemptions were suspended. The fact that the two shareholders became creditors on that day and, in the eventuality of a liquidation (i.e. “winding-up”) of the company, they would have been placed in a preferential position, in the scheme of collocation, with respect to the other investors. In other words, being preferred to other claimants (i.e. investors), Strathmore and Cadogan would have a higher chance of receiving any payment from the proceeds of sale (i.e. liquidation of the fund).
One of the remaining conditions to wind-up a company is for a claimant to demonstrate that the fund was insolvent. In this connection, Strathmore and Cadogan alleged, in their petition, that the “[…] board had little information concerning the investment in bonds, and were not even sure if the bond were genuine”. The two investors also claimed that there was “[…] gross mismanagement and misfeasance”; thereby leaving the judge almost no choice but to appoint a provisional liquidator. The petition was further supported by a Dechert LLP report which cited “[…] vague concerns about one of the potential buyers [for the bonds] on the table”.
The resignation announcement of March 26th by Humphrey Polanen from the fund’s board is also puzzling since he is the one that indirectly triggered the liquidation process after his phone call with the fund’s investors on March 13th.
Thus, in April 2009, the Grand Court of the Cayman Islands appointed Grant Thornton as the provisional liquidator. The role of the firm, at this point, was to investigate the business to discover, protect and recover assets as well as produce a report to the court, which then decides whether or not to liquidate the company. In a statement dated May 25th, Grant Thornton announced that “[…] a number of allegations have been made as to the remaining asset value and the nature of the assets held, and the master fund has been unable to pay a number of large redemption requests”. Apparently, this statement does not bring anything new to the table, as the Grand Court had already decided on May 22nd to call for the liquidation of the funds and appoint the provisional liquidator for the task.
Today, almost 9 months after the suspension of the redemptions by the fund, the liquidator is still investigating the purchase of the oil-linked bonds and the investors are still waiting to see how much they will recover from their investments in the funds. Moreover, the existence of the fraud is yet to be demonstrated.
In sum, it appears that the forced liquidation strategy adopted by Strathmore and Cadogan is a good one, as it may enable them, as creditor, to recover their investments, especially if the fund has sufficient assets and the legal requirements of a winding-up order are satisfied. However, it seems that the investors’ action in court has not helped speed up the asset recovery process. We are surprised not to see more investors in the Hedge Fund industry use this legal action (or mechanism), especially following the wave of redemption suspensions announced at the beginning of the year.
The role of the board of directors in this kind of process will have to be investigated to see if they understand the implications of liquidation and if they took the proper decisions in either accepting or contesting a petition for liquidation.
No matter the issue, the Dynamic story appears to be strong testimony for implementing a board of directors with the necessary skills, experience and involvement to choose the best alternatives during a crisis and for the ultimate benefit of the shareholders. It appears, in the present case that all the processes seem to have escalated beyond anyone’s control and not necessarily for the benefit of the shareholders. We will have to wait longer to find out the outcome of this story, but for the time being the Dynamic case has assuredly, and perhaps unnecessarily, tarnished the already fragile reputation of the hedge fund industry.

Disclaimer: Hedge Fund Appraisal has not performed any due diligence on the funds mentioned in this article. All the information was collected from public sources, which have not been verified. Nor does this article constitute a legal opinion.