Reality checking

FTfm on the 7th of March had an interesting report by Chris Flood on research done by Cerulli headed “Absolute return funds ‘a myth’”.  What grabbed my attention though was the comment that absolute return UCITS III funds launched by hedge funds needed a “reality check”.

They really do.  

The push towards UCITS has been fuelled by the AIFMD.  Investors view UCITS vehicles as safer because of the regulatory requirements such as the need to provide valuations and liquidity.  I wrote about these concerns last year in October – “Making sense of it all – Newcits”.

As an investment objective absolute returns are supposed to be one of the characteristics that supposedly differentiate hedge funds from other mutual fund structures that do not  normally charge performance fees.  The concept of absolute returns is closely aligned with one of the overriding principles that a hedge fund should have – that of the preservation of capital.  But it is not just investment strategy that needs to be geared to the preservation of capital – the structure needs to be suitable too for the risk taking that is proposed.  Here too reality checks are necessary.

One area where the need for reality checks is essential in a structure is in relation to the safe custody of assets.  It is not enough to have a big name custodian – which until you understand the basis may just be a Fig leaf.  It is essential to understand what proportion of assets will be held by prime brokers to the fund as collateral for financing, what proportion of unencumbered assets will be held by the custodian, what proportion of the assets can the prime broker require to be transferred as collateral and whether there are sub custodial arrangements and how they will operate.  Investing in emerging markets create their own twists which must be properly understood.

The custodian is there to protect the funds interests in the legal title the fund has to assets and how they are used – the custodian controls the assets and only releases them from its safekeeping in accordance with agreed procedures.  It is important to understand what those procedures are.

AIFMD will introduce some new requirements making the custodian role one where the custodian (referred to as a depositary) will need to assume more liability than it it has previously been prepared to accept.    There will be a requirement to ensure that cash flows are properly monitored and payments made by or on behalf of investors upon the subscription of shares or units of a fund have been received and that all cash has been booked in accounts in the name of the fund or the manager or the depositary on behalf of the fund.  These are activities that a fund administrator would typically perform and fund administrators have set up subsidiaries providing depositary functions for funds that their groups administer.

AIFMD as it currently stands means that in Europe funds will either be governed by the UCITS or the AIFMD regimes.  Both regimes will need investors to perform reality checks.

Investors need to understand where their assets will be held.  For example if there are master feeder structures – then it is the depositary of the master fund structure that is going to require more examination.  Establish who holds the voting shares or controls the structure and what the conflicts of interest might be with those who safe keep the assets – if you find that it is the same entity that does so then how are potential conflicts of interest managed?   If there are umbrella structures make sure that you understand whether there is cross umbrella protection through segregated pools of assets for each different fund – it may have been set up purely for the fund managers convenience and may afford little protection to the investor if something was to go wrong.

Regulatory regimes for all the well meant protection they are designed to provide are still no substitute for investors rolling up their sleeves for a bit of reality checking.

©Jaitly LLP

The AIFMD merry go round

Still not too much excitement on the Alternative Investment Fund Managers Directive (AIFMD) – the general view seems to be that there is still plenty of time before implementation will be necessary and of course given that we are at Level 1 at this stage and the real negotiations will only begin as Level 2 gets worked out there seems to be no sense of urgency.

A strength of most alternative firms of course is that they do have the ability to adapt rapidly to market changes so the lack of urgency itself gives no real cause for alarm.  When they have to change – they will. 

But it is the sense of business as usual that is more of a cause for concern and so one hopes that the Level 2 negotiations to work out the operationalisation of the AIFMD will result in some sensible thinking to make the AIFMD a vehicle for good rather than a regulatory stone around industry’s neck.  

One can only hope that this is not the beginning of another round of regulatory arbitrage.

The year end was a busy one for a number of reasons – now it is time to analyse the detail of the AIFMD to properly understand its implications for hedge fund management and hedge fund investors.

©Jaitly LLP

Investors in the cockpit

The theory is that shareholders as owners of the business determine who manages a business for them.  The reality often is that boards choose the people who serve, influenced by the choices of a handful of directors or a dominant shareholder interest.

As I have written before governance on investment fund vehicles is largely influenced by the investment manager that sets up the fund.  Of course a large shareholder can influence choices on the board but it is rare for investors to get involved other than perhaps to avoid investing if they are uncomfortable about the composition of a board or to insist on the existence of at least one independent director – although that ‘independent’ director is generally still anointed by the investment manager.

So it was with interest that I had my attention drawn to s.971 of the Dodds Frank Wall Street Financial and Consumer Reform Act under subtitle G – Strengthening Corporate Governance. (Thank you James!)

This section amends section 14(a) of the Securities Exchange Act of 1934 to give the SEC power to prescribe rules and regulations to require that a solicitation of proxy, consent, or authorisation by or on behalf of an issuer include a nominee submitted by a shareholder to serve on the board of directors of the issuer.  This will be done under such terms and conditions as the SEC determines are in the interests of shareholders and for the protection of investors.  The SEC can exempt an issuer or class of issuers from the requirements taking into account whether it disproportionately burdens small issuers.

Why is this section of interest?  Simply because it serves to indicate that there is increasing recognition that investors interests may need protecting and this could be a small step in adjusting the balance of power that exists on company boards.  

Investors in funds need to be adopting a similar approach by nominating to boards those with the knowledge and willingness to give primacy to their interests.  The lessons of 2008 clearly indicate that due diligence on its own is insufficient.  Involvement in governance on an ongoing basis  is necessary to ensure that the investment fund tracks the course that investors should expect of it.  That will only be possible when investors begin to require their nominees to be represented on boards of vehicles they invest in. 

Section 954 on clawbacks in the same Act is for another day – however in the meantime investors should be considering providing their own co-pilots to make decisions in the cockpit.

©Jaitly LLP

Fixing the light at the end of the tunnel.

So the draft final judgement has been prepared, Goldman’s consent has been signed and the press conference held.  Time for a collective sigh of relief to put it all behind and move on.  The light at the end of the tunnel has been switched on again – but be careful because those lights are glowing red.

What was predicted has come to pass.  The institution has acknowledged that its marketing material was ‘incomplete,’ agreed to undertakings over the next three years to do things it could not possibly refuse to do as it should always have been doing them anyway.  The SEC has $300m in fines in the bank and Deutsche Industriebank AG and the Royal Bank of Scotland N.V. will receive $150m and $100m respectively in compensation and the share price has recovered sufficiently for the fine not to cause too large a dent.  

So the institution dusts itself off with a fine that is simply a cost of doing business in the area – nothing really changes and we can all get back to the serious business of making money.  Whether you take the view that the SEC had a weak case because of industry practice in making its largest ever fine or whether what Goldmans did was wrong is to some extent immaterial – it is now unlikely that we will ever know the full extent of the story – but it is the outcome and its underlying message that is so serious.  

Breaking rules or acting unethically do not result in large institutional businesses being closed down.  The litigation is of course still not over but it is against an individual that is not going to put up a fight the way the institution would so Fabrice Tourre for now remains on the hook.  There is something about that result which seems inherently unfair and unjust.

Those who enforce rules must be proportional in their actions but markers set by fines do not prevent large institutions from breaking rules in the pursuit of profits – many of these arise from failures of supervision but there is also little incentive because institutional memory can be notoriously short.  The argument that is usually used is that reputations are tarnished by the imposition of these regulatory fines.  Are they really?   A brief review of the form ADV and the disclosures on regulatory actions of the large firms clearly demonstrate that these breaches are not unusual.  The impact of regulatory action should be to prevent the recurrence of breaches by changing behaviour rather than simply imposing token punishment.  The disclosures made on the form ADVs suggest that it is very much business as usual as the long list of disclosures on regulatory actions against firms to date should have tarnished these reputations irreparably.

Indeed if regulatory actions were a criteria for not doing business with firms it would not be possible to deal with most major firms.  So if it is the intention of the SEC to set markers and change behaviour through its regulatory actions what is the real purpose of entering into these consent orders when regulatory breaches occur?    

Is that reason enough to make a case for re-examining that light at the end of the tunnel?

©Jaitly LLP

Shedding light on Regulation

As regulators scamper to introduce regulation into the world of alternatives one cannot help but wonder whether another opportunity is about to be lost.

The problem with regulation is that it is often a political knee jerk reaction to events.  I had for example viewed with some excitement the opportunity the FSA had with the consultations on side letters to address some of the issues that gave rise to the need for such agreements – but the result was a disappointment of weak compromise and the current  European regulatory effort seems destined to a similar fate.

Regulation will never save investors from themselves.  Investors will forgive almost anything with performance.  So what should regulation be designed to address?  I prefer a variation to the FSA’s eleven principles as my starting point:

  • Integrity
  • Fairness
  • Transparency
  • Appropriate business structures and governance
  • Balance of interests
  • Protection of interests
  • Verifiability
  • Skill and due care

How would these apply to the world of alternatives?  I believe it is possible to have a regulatory framework that does not stifle the investment manager but has sufficient clout to bring a manager to heel or to its knees if it misuses the privileges granted to it.

Integrity is a broad over arching starting point and does not require much discussion.  Skill and due care whilst clearly important are intentionally placed last on my list – what chance for example does a regulator or an investor have when market participants/managers themselves have no idea of the effects of re-hypothecation in financing transactions – and that is not to condone any of the three groups for that lack of knowledge.

Fairness is central to any financial services transaction – whether in relation to investment terms, fees, manager’s intellectual property or otherwise.  When one looks at existing terms and risks that could at least technically be mitigated such as in relation to cross class liability between classes and different levels of leverage then I don’t believe that enough is done by managers to protect investors.  I don’t think it is enough simply to disclose the existence of cross class liability – I think the manager needs to be obliged to justify why maintaining that risk is fair to investors.  The manager’s argument is that once disclosed it is a matter for investors to determine whether the risk is an acceptable one that of itself is not an unreasonable position until one looks at the rationale applied and the level of due diligence really done by investors.  However applying the concept of fairness the manager would need to have taken reasonable steps to protect the classes from cross class liability rather than simply disclosing the existence of the risk and will have explained to the investor why from their point of view the existence of such a risk is fair to the different classes of investors.   This argument is important as it is often confused with the principle of transparency – it is never enough in my view simply to disclose – although disclosure is an important step.  To go back to my example of re-hypothecation – this was clearly disclosed to those who bothered to read the contractual terms – but its impact was assumed to be known which it clearly was not.   I am not advocating that the investment manager needs to become nanny to the investor but I think disclosure needs to go beyond the familiar generic risks that one sees spouted with such regularity in any prospectus that one might care to pick up.

The business and governance structures too are generally constructed from the managers point of view.  Managed accounts are often created to address specific issues – whether it is in relation to ownership and control of assets or transparency to trades.   Managers could do much more to protect the interests of investors – but lawyers are remunerated to protect managers – as is so clearly set out in the disclaimers in the prospectus.  The obligations in that respect need to be balanced and that can only be done by an independent party making sure that there is a proper balance of interests – which should protect the manager as much as the investor.

Whose interests need protection?  Everyone has a stake – the manager its intellectual property and investment edge, the investor its capital, the service provider protection of its profits and reputation.  The balance of interests and the protection of interests is very skewed in favour of the manager – that needs to change as it is linked to bringing fairness back into the balance without destroying commercial opportunities.

There is no investment house today that does not proclaim its adherence to best practice.  Unique selling points gradually blur as everyone claims to adopt practices of virtue – operational due diligence being no exception to such claims.  The reality however is quite different – few do so properly whilst many play at the periphery of what should be best practice.  This is what makes verifiability so important – whether it is in relation to best execution, due diligence or risk management.  If it is possible to verify the claims of an investment house whether through ISO standards, SAS70/FRAG21 reports or independent valuation reviews  and where such information is provided to investors – then that would make a significant change to the investment landscape that we currently observe.

Principle based regulation that addresses the roots of the problems that we have experienced in the industry in the last decade would go a long way to rebuilding foundations of trust – but in finding the appropriate balance to encourage the industry to flourish is an opportunity that would be a great pity to miss.

©Jaitly LLP

The Emperor’s new clothes – the myth continues…..

As we come up to the anniversary of the Lehman Bank failure and the purported start of the current economic debacle it is interesting to see what lessons if any have been learnt in the field of asset management.  It appears that in some quarters at least the Emperor’s new clothes remain fashionable.

I was interested to read for example about the survey results in FTfm that investors were far more interested in performance rather than standards.  It is a familiar bell with resonance in many areas.  It is also interesting to see that little has really changed in due diligence methodology since the events of last year.

As a risk manager meeting clients to describe and reassure them about the risk processes used by my team I was always struck by the approach different types of investors took to the concept of risk management.   

The private investor would always appear to focus on performance provided there was no immediate risk to capital.  My sessions on risk with private clients were invariably short with most of the time being spent on how investment ideas were generated and where the next generators of performance were going to come from.

The institutional client was quite a different animal – here invariably the sense one often got was that the focus was ‘career risk management’.  Would you get fired for having invested with a big name?  The chances were that losses emanating from an investment in a big name were far safer from a career perspective provided a few boxes could be safely ticked.  Talking of boxes – the miracle black box process still has formidable powers of seduction – particularly when a big name is involved.  I remember the justification used to override a concern I had on a regulatory fine on a well known firm that eventually failed  – that if that was the standard that was to be applied it would be impossible to employ any of the major brokerage firms as they had all at some stage been fined for  regulatory infringements.

Of course in defence of the investor is it ever possible to do an effective due diligence review of a big investment house through the process of a meeting lasting a couple of hours?  Is there a realistic practical alternative?  There are assumptions made on teams, structures, evaluation processes and competence that are almost impossible to verify through the normal meeting process of due diligence in relation to a large organisation.  Yet that is the process that continues to be employed in making an assessment and is clearly insufficient.

When I evaluate risk in an organisation my view is that some of the greatest business and operational risks that exist – lurk in large organisations and the impact of these are almost always significant – Barings, Lehman Brothers, Enron to name a few.  The smaller failures that occur at the start of the journey towards disaster are easily disguised and the rot that sets in as a consequence are rarely recognised.

Very small organisations have different risks to contend with – based on keyman issues and lack of infrastructural depth – but these are assessable – because size permits it.

This is not to advocate that only medium sized structures are the safest investment vehicles  to place your money with  although they recommend themselves to being reviewable, having sufficient infrastructure for questions to be raised about practices that may arise or develop and yet being small enough for small failures to have catastrophic consequences for the business thereby creating incentives to implement better more permanent fixes than the papering over that can occur in much larger organisations.

What I do advocate is that there is an optimum size to an asset manager from a risk management perspective and the big names can create myths of reliability around their existence.  Some of the most inconsistent service that I have ever received both as an individual and as a professional have been from large well established organisations.

Due diligence requires more verification work throughout the life of an investment and the status quo on process needs to change.  It is in this blind faith in the miracle black box process and the grandeur of the large unverifiable organisation that the myth of the Emperor’s new clothes continues to thrive. 

©Jaitly LLP

Liquidity Management – new fad or back to basics….?

Ever wondered how a fund or a fund of funds manages liquidity?

Offering documents can include an arsenal of provisions for the moment when things go wrong – redemption gates, side pockets, suspension of NAV calculations, suspension of redemptions, revaluation of assets, creation of provisions and reserves, payment of redemptions in specie and the creation of separate classes with differing liquidity.

But these are all cures for the malady  once management has to face up to a liquidity problem – what is far more interesting is the approach to prevention.

The spectre of the liquidity axe always hangs in the air – however well managed a fund – because if, for example, you take the case of a fund of funds with quarterly liquidity which only invests in funds with monthly liquidity you still have to manage for the prospect of the fund you wish to redeem from, suspending its normal redemption processes thereby impeding the liquidity flow on your investment.  All funds will retain some form of rights and discretion to delay redeeming and paying out to an investor.

The obvious starting point will always be to try to ensure that the liquidity of your vehicle at least matches the liquidity of the underlying investments.   

Is this always practical given lock up periods of 6 months to 6 years upon subscription?  Some funds will try and cater for this issue by creating lock up periods for their own investment vehicles and by imposing charges for any financing they might need so as not to affect the portfolio as a consequence of a redemption – but that is not so easily done – sometimes because of the push back from the sales personnel linked to selling these funds to investors.

So what are some of the practical things that can be done?

  • Ensure you have a liquidity profile for your portfolio which shows the time taken and the cash flows for the portfolio to go wholly in to cash by taking into account lock ups in force, notice periods, compulsory gates and any penalty charges that may be imposed
  • Always maintain a cash buffer to meet ongoing expenses and to meet margin calls – a number of funds faced extreme liquidity constraints in 2008 in the absence of credit facilities because they were not prepared for the Euro/Dollar exchange rate movements for their currency hedges
  • Ensure that your credit facilities will enable you to meet redemption calls equivalent to the proportion of your longest locked up investment outside the liquidity range of your own investment vehicle.
  • Avoid investing in investment vehicles or investments  that have liquidity mismatches with your investment vehicle.
  • Ensure that you have given no covenants to your own providers of finance that could place your investments in jeopardy because “they would never happen” – do you know for example what cross default provisions there are in your financing agreements and what percentage reduction in assets triggers a default?

The best liquidity management is done from the perspective of decisions made on the assumption that the fund will need to go wholly into cash and ensuring that any borrowings and requirements for return of capital are properly catered for in the offering documents of your own investment vehicle for such an eventuality.  

In order to do it well – assume that the worst will happen – that is the best form of liquidity management.

©Jaitly LLP

The “Expenses” Debate – worth examining?

The current media interest on UK parliamentary expenses is a good moment to take stock of what constitutes a reasonable expense for an investment manager to charge a fund as opposed to a cost that it should bear itself.  

I have always found it very interesting to see what an investment manager will charge as an expense to a fund it manages.  Practice varies enormously.  Some managers will charge bonuses payable to their traders as a fund expense, others research related travel or the costs of information technology and risk management systems.

Received wisdom in the alternatives industry justifies a two tiered fee structure on the basis that the management fee charged – typically on a monthly basis – covers the running costs of the investment manager including staff, systems and premises.  The performance fee is the reward that the investment manager receives for generating the risk adjusted returns for which he is appointed.

The fund itself bears its own direct costs such as the costs of trading, audit, service provider fees (including those of the investment manager), direct legal costs and director’s fees.

Soft commissions or bundled commissions are another way for an investment manager and the fund it manages to receive additional benefits that the fund indirectly pays for through the commissions it is charged for trading.  These are considered acceptable expenses where the investment manager receives benefits which may for example be research related such as the provision of Bloomberg terminals for the investment manager.  The benefits become more nebulous when they relate to travel and accommodation or entertainment.  Different regulatory systems may also specify what is permissible or not for investment managers regulated by them.

Where an investment manager starts to charge expenses to the fund that would typically be investment manager costs such as trader bonuses and information technology – it raises a basic philosophic question as to what the management fee is supposed to represent?  Is it no longer representative of the investment manager’s running costs or is it to be viewed as a monthly premium for the privilege of having the investment manager manage the fund?  Is it reasonable for the investment manager to charge a pure fixed profit element in the form of these fees if running costs are also to be charged to the fund as additional expenses?

Who for example should bear the costs of the investment manager and its staff having to travel to research investment opportunities used for trading the fund’s portfolio?  Are these exclusively for the benefit of the fund or are there other clients of the investment manager who receive a free benefit as a consequence?  Is it not this very expertise for which the investment manager is appointed and if so are you as an investor paying twice for it?

Investors will often accept the status quo based on the investment manager ‘s success but it is essential that investors understand what they will eventually be picking up the costs for – and whether this was something acceptable or that they were prepared to accept.  Success generally keeps these issues at the bottom of the pile.

A careful fund investor should understand the expense profile of the fund.  A good investment manager should be able to justify the management fee it charges based on properly budgeted staffing, research costs, premises and systems so that the management fee is what it is described to be – a fee for managing the fund’s portfolio.  Where the costs of an investment manager and the management fee it receives begin to diverge – then this should be the catalyst for a review and a discussion between the investment manager and the investors in the fund.   

©Jaitly LLP

The “independent” administrator…….

The “independent” administrator……….

As reports come in about the appointment of independent administrators it is perhaps worth adding a note of caution to the panacea that such an appointment suggests.  As ever, the devil is in the detail and the appointment of an independent administrator on its own may be insufficient.  

Why is that?

The appointment of an independent administrator is an indicator that there may have been a change in mind set by fund managers whether driven by investor demand or by market best practice.  That is a good thing – but how good it is, depends on the contractual terms that have been agreed between the administrator and the fund to which it has been appointed.  It also depends on the administrator’s experience  and infrastructure as to whether the agreed services can be provided to an adequate standard.

It is possible to find independent administrators to funds who in fact provide nothing more than what the industry calls a NAV lite service or who simply provide transfer agency services.  There is absolutely nothing wrong in the provision of these services – it is simply important to understand that the service provided is limited to that service alone.  

Tread cautiously too where independent valuation services are provided as they may not always be as independent as you might presume.

It is not uncommon to find wording in the offering memoranda of funds where an independent administrator is responsible for verifying the valuations used by the fund to state that where it is not possible to obtain independent verification then the values used will be those provided by the board of directors or the investment manager to the fund.  From the administrator’s point of view this is perfectly reasonable and is important in managing their own risks in providing such services to the fund.  But where does this leave the investor who believes that the net asset value that they have received from the administrator comprises prices fully verified by the administrator?  Because this wording is so common I generally try to insist that an obligation is created whether by side letter or by amending the fund’s documentation that the administrator or the manager is obliged to inform my investor where the net asset value comprises non independently verified prices (or prices provided by the directors and managers) which form say more than 5% of the net asset value.   This is essential so that the investor is able to form a better view of the values that comprise the net asset value being reported to them.

It is also not uncommon to find that the contractual terms for the provision of price verification are drafted in such a way that the administrator is protected if they rely on prices provided by the manager or directors of the fund and so there is little obligation contractually to seek out independent verification where current publicly traded price information is not available.  When one starts to look at the contractual documentation of a fund – because everyone is so concerned about managing the risks that may attach to them – it is sometimes difficult to see who if anyone is contractually responsible for the valuation of a fund.  

Investors need to insist that contractual obligations are created so that there is proper independent verification of prices used for a net asset value – if necessary as ‘agreed upon procedures’ if the uncertainties in valuation are so inherently risky.   There is nothing wrong in a fund investing in securities that have inherent uncertainties around their valuation – what is important in such instances is that there is a clear and replicatable set of steps and processes that would enable an independent third party to apply them and reach the same price/value – and that these steps and processes are reviewed and checked as being applied by an independent party.

So what should an investor look for in an independent administrator?   Here are some basic questions and issues to consider:

  • Is the administrator’s business  sufficiently diversified so as not to be dependent on the fund manager’s business?
  • Does the administrator have the capacity and infrastructure to deal with the investment strategies of the fund (don’t necessarily be seduced by a big name – get to know the team that will service the fund – there can be infinite variety between teams)  Can they meet the necessary deadlines?  Administrators can grow too quickly and lack safe capacity.  Does the administrator understand the fund’s strategy and have teams with the requisite experience to deal with it.  e.g. appropriate valuation teams?
  • Does the administrator have robust quality control procedures and a good supervisory and training environment?
  • Do the contractual arrangements create a real responsibility to provide a “Full Service Net Asset Value and Transfer Agency Service” to the fund and its investors?
  • Is there a mechanism in place to inform investors if the net asset value includes non independently verified prices over an agreed threshold and whose responsibility is it to report it?
  • What history does the administrator have with previously reported problems on funds?  Is there any litigation that you should be aware of and consider?
  • Have you done any due diligence on the administrator and the team that will service the fund you are investing in?
  • Who owns the administrator?  Is the administrator able to invest in the funds it services – and does it?  Are there any other conflicts of interest that need to be considered?

If you can get suitable comfort on these issues then indeed you will have an independent administrator worthy of that name on the fund you are about to invest in.

©Jaitly LLP

The Paper Trail

I was at a briefing on Friday – where Insolvency Practitioners were talking about their experiences on the Lehman Administration.  

Over the last 9 years I have been warning investment professionals not to ignore the terms which they have signed up to in contracts and pointed out to them the dangers of what they were agreeing to.  The response has always been that it was not something to worry about because it would never happen.   Lehman has brought home to everyone that not only do these things happen but they have specifically been contemplated for by the lawyers drafting these terms.  Accepting these terms has in some instances laid managers open to accusations of dereliction of duty to their investors.

Some in the industry seem to have forgotten that its creation and development was to endeavour towards capital preservation far more than performance.  That requires attention to detail and careful consideration of the contractual terms being signed up to.  A principle which seems to have been lost along the way by some because of the powerful temptations that performance brought with it.  It is only by refocussing on capital preservation with attention being given to the accompanying paperwork that alternatives managers can begin to rebuild the shaken faith of their investors.

©Jaitly LLP