A number of hedge funds with December year ends should be in the throes of audit work and investors should be beginning to see a trickle of audited financial statements coming through. It is a good idea for investors to begin to track the inflow of these documents – some funds will be bound by deadlines imposed by their listing authorities – others may be taking their time for a host of reasons. It is a good time to keep a weather eye on these invaluable documents.
This year they deserve particular attention as there should be an interesting story to read and digest in each of these sets of audited financial statements. It has been an eventful time for all funds.
For those of you who simply look to see whether the audit report is qualified or unqualified – a word of warning – a clean audit report does not imply that there are no problems – it simply implies that the material information has been presented in a true and fair manner. In order to understand the issues there is still a requirement to review the document to understand what it has to say to you. By way of illustration the vast majority of companies that I dealt with in my days as an insolvency practitioner had unqualified audit reports in their financial statements and there was often surprise that the report had not been a sufficient prophylactic in preventing the insolvency followed by accusations of auditor negligence. You only have to look at what is happening today on Lehmans and the examination of Ernst & Young’s work as auditor as a typical example.
Hedge fund accounts are not that complicated a document to review. There is the audit report (which generally comes in three broad variations) a director’s report and an investment manager’s report, the accounts themselves comprising four major accounting documents – an operating statement (or profit and loss account) a statement of assets and liabilities (or balance sheet) a statement of change in net assets (or movement in shareholders interests) and a cash flow statement (or flow of funds) – with accompanying disclosures in the form of notes to the accounts.
They are each in their own right important. They are each worth reviewing. They each have a story to tell.
But what are the main features worth looking out for in the latest crop of financials given what has happened over the last eighteen months?
- Check the disclosure on assets – do they remain in line with the investment strategy or have they acquired large positions in securities that are out of character for the fund whether due to concentration or other reasons;
- Look for special purpose vehicles and other wholly owned subsidiaries that may hold assets, check whether you understand the reasons for their existence and the nature of the relationships they have in the overall organisation of master and feeder vehicles and any legal issues on ownership or restrictions on ability to deal with the assets;
- Check the changes in capital through shareholder activity in the statement of changes in net assets to identify what has caused the changes the fund is affected by. For example is relative stability in fund size masking huge inflows and outflows during the year;
- See what the investment manager and directors have said in their reports about the activities of the fund and is it consistent with the numbers;
- Check whether the fund has changed its accounting policies and whether there are material differences between the Net Asset Value in the financials and the Net Asset Value at which dealing took place at the year end;
- Have a very close look to establish what you can learn about the liquidity of the fund and how it has managed redemptions. Identify if possible illiquid side pockets or securities with the potential for problems. If FAS 157 has been applied look at the increase in level 2 and 3 assets. There is important information in those changes that really ought to be understood by an investor;
- Look at the risk disclosures and identify new disclosures added – they are not always standard disclosures;
- Look for disclosures on liabilities – actual and contingent, cross guarantees and granting of collateral and indemnities and assess the changes from the previous year and the nature of the changes. Do you as an investor have a good understanding of the funds collateral management procedures;
- Look in the notes to the financial statements for disclosure on off balance sheet items – don’t ignore the disclosures on derivatives and the notional value of exposures. If there are deliverable transactions assess how the fund is organised to cope with these. Look at what hedging the fund employs and whether the margin requirements of the hedge give rise to liquidity issues (this was a serious problem for hedge funds and fund of hedge funds particularly in the absence of appropriate credit lines). Do you as an investor understand the accounting and disclosure methodologies adopted if disclosed. e.g the use of so called ‘Repo 105’ transactions to take liabilities off balance sheet on Lehmans;
- Look at how the fund has disclosed any tax matters and if any provisions have been made in line with the latest requirements – do make sure you understand what these are – tax drives hedge fund structures;
- Compare the disclosed expenses with the previous year – in particular look at changes in remuneration for administrators, accountants and lawyers as these are often symptomatic of underlying problems – whether litigation or major changes in documentation or structure or other problems. Managers are generally reluctant spenders of money on these types of services. Whilst it can be difficult to derive a total expenses ratio on a hedge fund particularly given the practice of brokerage costs being rolled into the cost of investment, it is still worth devising your own system to track how these add up year on year;
- Look at any disclosed financing costs and look at them in relation to the assets under management; and
- Finally do ensure that you read the notes to the financial statements – there are often gems worth prospecting hidden away as formal disclosures.
These steps will help in doing a meaningful review of the financial statements of funds you are invested in.
©Jaitly LLP