Category: Operational Due Diligence

November has presented many opportunities for reflection what with the European Directive for Alternative Investment Managers, the insider trading actions by regulators in the US and UK, the reported inflows into hedge funds, the drama around the departure of key personnel on the fortunes of investment managers and much more.  I think there is more to be played out on all of these so I thought I would address something different – an area which is the subject of much received wisdom in our industry.

I read an interesting report recently on developments in operational due diligence and one of the areas it covered was the power of veto.  I have always been fascinated by how investors approach this issue at due diligence meetings because the existence of or even lack of a power of veto is not enough of a safety or warning mechanism on its own even though investors seem to set great store by it.

The exercise of a power of veto by an operational due diligence team is seen as a positive by most investors – an indication of independence of function – and indeed that is exactly how it should be – at least theoretically.  

But that focus on its own would be insufficient.  The reason for this is quite simple – if those doing operational due diligence need to exercise a power of veto then it is generally an indication of two things, both of which can have extremely serious consequences:  The first is a misalignment in the interests and motivations of the investment and risk teams and the second a polarisation in positions that indicates that there could be no meeting of minds.  The occurrence of either is corrosive in a team.

In my case, the lack of veto powers lead to my having to resign from an otherwise extremely interesting job and having veto powers (and exercising them) caused my being fired from another!   There was clearly a misalignment in our approaches but mercifully history proved my position in both to be right.  How should investors have reacted in each instance?  The circumstances of each departure would have given a clear indication of the concerns that they ought to have had.  It is the misalignments resulting in the departures that should have been the subject of examination in determining whether the case for investment remained.

The most successful outcomes in due diligence processes are iterative interactions between investment and due diligence teams.  This requires the tabling of issues, a discussion on the range of outcomes and a meeting of minds on the best approach to be adopted.  In such an ideal world there would be no need to exercise a power of veto as there would be agreement on the moment to walk away and where there was no clear agreement the concerns of the due diligence team would be respected rather than a veto having to be tabled. After all an exercise of a power of veto would be a statement that the investment team needed saving from themselves – that should not be viewed as a positive – why would investors really want to place money with such an investment team?  

It is worth noting that in the long run investment teams wield far more influence as they are regarded as the rain makers – due diligence teams are simply the brakes – and brakes can be and are replaced.  

It is therefore the processes around the decision making process that are of much greater importance than the presence or absence of veto powers.

But that does not mean that I do not advocate the power of veto for a due diligence team – simply that its exercise should be viewed as a warning sign rather than an indicator of a healthy investment approach and an absence of exercise should result in much greater scrutiny of the investment decision making process.

©Jaitly LLP

Mention derivatives and even the financially literate quiver with fear.  Yet these instruments (increasingly standardised) are no more than creatures of contract where a few fundamentals and a lack of fear of jargon will always hold you in good stead.  There has been much in the news about derivatives.  The European Union is seeking to reform regulation for example on central clearing parties and in the US there are similar moves afoot.

But a few fundamentals will always hold you in good stead when looking at these instruments:

Know your counterparty:

Whether your trade is cleared centrally reducing counterparty risk or whether you are directly exposed to counterparty risk is a fundamental starting point.  If you have a portfolio of these instruments then you have the added dimension of portfolio risk in relation to your counterparty exposure.  It is worth spending time on this as part of your due diligence.  These trades often unravel due to actions taken by a counterparty so it is important to understand who they are and what pressures they may be susceptible to. 

Who owns the assets and liabilities in the contract:

Derivatives are often described as zero sum games  – there is a winner and a loser – and the accounting to determine who is which depends on where the assets and liabilities in a trade sit – who owns the assets and liabilities and how they are determined and payable need to be clear.  

Cash Flows:

Ignore these at your peril – delays in payments can have devastating consequences – triggering default clauses and even ruining reputations.  I have written before about the consequences of illiquidity on foreign exchange hedging – these contracts are simple over the counter derivatives but an inability to meet calls on margin due to illiquidity can have serious consequences.  You need to understand how the cash flows will operate – a good understanding will highlight the weak points of the trade and where your investment could potentially go wrong.  The profit and loss accounting cannot be done without understanding these flows properly.  These flows determine when trades become profitable and will influence the decisions that are taken on the trade – such as exercising an option, taking delivery of a future or closing out a trade

Collateral and Margining:

Derivatives are generally geared transactions.  What this means is that your exposure on a contract can be a multiple of what you actually pay out and so the consequences of a trade  can be much higher than the money put down to enter the trade.  When there is borrowing or financing involved the party lending the money will always want some form of security or collateral.   It is therefore important to understand what amount is put down as initial margin, what constitutes variation margin and what sort of haircuts (fees) are taken on each tranche of a trade.  Margins are essentially a partial payment of collateral as insurance if there is a default on a contract.  There will be rules as to how these are calculated and when and to whom they are paid.  A good indicator as to how a counterparty views risk on a transaction is to look at the amount of margin they require the other side to put up.  The greater the proportion of margin required the higher the perception of risk.  It is no surprise that investment managers can be cagey about disclosing this information as it gives a good view on how the counterparty views them as a risk.

Valuation Methodologies:

It is essential that you understand these – they will determine the profit and loss on the trade and the gains that you report/account for and form the basis on which the cash flows occur.  Mistakes can happen and it is important to apply the methodologies to double check what you are being told about your assets, liabilities and cash flows.  Derivatives can be priced using models – referred to as synthetic prices – but you should still conduct “reality checks” on these prices both for calculation and for checking in the market that you are within acceptable parameters. 

Crystallisation & Default events:

Make sure you know how the contract will crystallise or close out and what the options are to close out the transaction and how this would be done.  As important is the need to understand what constitutes a default and what that implies – generally the rights over collateral will get exercised and there will be further liability/penalties to be addressed.  The strength of the counterparty is relevant because a weaker counterparty may not be interested in helping you weather a temporary problem or it may be the weakness that triggers issues for you in the way the contract is serviced.

Definitions:

Make sure you understand how terms are defined – even if the references are to standard ISDA terms make sure you understand what they mean and their effects.  Even professionals make assumptions on terms which can turn out to be incorrect – question jargon – people often use it without really understanding what they mean when they use it.  It can be an expensive legal exercise to unravel what was meant when a transaction goes wrong.

These seven simple steps will ensure that the basics are at least understood and they will enable you to have better clarity on the derivative trades that your investment manager may be using and give you a clearer view on the risks of that investment strategy.

©Jaitly LLP

Market conditions today are very similar to those that investment professionals managing funds found themselves dealing with during 2008 :

• the re-emergence of rumbles of uncertainty  and instability in relation to the banking system and 
  
• a Euro falling in value against the US dollar.

When investors look at funds of hedge funds they often forget that discussions on liquidity should not simply focus on the liquidity of underlying fund investments but also on credit facility management and the pressures put on the currency hedging that the fund needs to do.

Fund of hedge funds like their underlying investments need to provide collateral to obtain financing.  In addition on hedging transactions cash margin needs to be posted.  It is not unknown for a fund of hedge fund to move an investment from one portfolio to another simply for the expediency of being able to raise some money for the margin calls required for a currency hedge that has gone the wrong way.  And right now Euro denominated funds investing in US Dollar denominated underlying assets will be feeling some liquidity pain.

How does this work?  Lets say a manager has two funds A and B.  Fund A receives a $100 worth of subscriptions.  Fund B has no subscriptions and all its assets are under a 12 month lock.  Let us also assume that the buffer of cash for the currency hedge has been exceeded on both funds so there is a requirement to raise additional funds of $50 to post margin on both funds.  Where does the investment manager raise the $50 in relation to Fund B?  If he has exceeded his buffer calculation for the hedge he is in trouble because his funds are under lock so he cannot get to them.  In this scenario he readjusts his portfolios – he finds an asset   held by Fund B which because of the way the investment’s ownership is recorded in the underlying funds books can be moved to Fund A without triggering the lock provisions because there is no record of a change in beneficial owner as the owners reference is just the common custodian reference that the investment manager uses for all his funds.  A very common practice among managers with several funds.

In this way Fund A receives $50 worth of assets and Fund B receives $50 of cash which it is then able to post as margin.

Surely there is nothing wrong with that?  On the face of it there may not be – Fund B clearly needs to raise margin and  has achieved its objective.  Fund A may have wanted that particular investment and the $50 has been utilised appropriately to get exposure to that particular strategy.  There is nothing sinister in the shadows and the compliance officer is happy that all is well in the garden.

But what if the receipt of the $50 worth of investments in Fund A was not appropriate to its strategy?  What if the benefits to Fund A of receiving those investments is not all that clear cut – or even has an impact on its performance?  Well then surely the transfers have only been for the benefit of Fund B?  Surely the investors in Fund A (unbeknownst to them) are bailing out the investors in Fund B facing a major liquidity issue if they are going to remain hedged in relation to their currency risk?  If investors were to start examining the internal transfers of assets that occur within the fund portfolios of an investment manager they may find that a story unravels which whilst it keeps the investment manager’s portfolios squared up is not necessarily strictly in the interests of both the receiving and transferring fund.  Can proof for such accusations be found?  It would take examination and the evidence may be circumstantial but investment managers would begin to find explaining some of these transfers quite difficult other than for the expediency of managing liquidity in one or the other of their funds.

Given current market conditions investors doing due diligence on hedge funds would be well advised to look at the extent to which there have been internal portfolio purchases and sales as that is likely to give them a far better insight into how portfolio liquidity is being managed than any marketing presentation on the seriousness with which they take liquidity issues on a fund.  It would have the makings of an interesting conversation and draw away from the shadows a practice by fund managers that should be capable of scrutiny.

©Jaitly LLP

Customary practice is sometimes used as a reason for not providing transparency. Lack of transparency makes the management of conflicts of interest almost impossible and it is particularly dangerous for employees if they question established customs and practices.   The market makers defence in the Goldmans case is an example of what appears to have become customary.  Custom and practice don’t make an action right but they make it very difficult to question what can sometimes be glaringly obvious problems.

Money feeds greed and that is why transparency must be an all important principle in managing conflicts of interest.  Ah! but what about commercially confidential information such as might be in the possession of the market maker?  Transparency forces the re-examination of the status quo and reduces the potential for howls of protest when things go seriously wrong.  What of unintended consequences?  They too can be managed in a culture of openness and transparency.  It is not idealistic piffle – it is essential for fair dealing.

The central tenet of the charge against Goldmans is that there was no transparency because of the lack of disclosure on conflicts of interest.  These related to how the Abacus portfolio was chosen and the failure to correct the assumptions made on the positions being taken on the securities.  Goldman’s defence appears to be that there was no requirement for such transparency as they were simply market maker to the transaction and did not need to disclose their knowledge of the conflicts that existed.  I suspect we will never know the court’s view on the charges or the validity of the defence, as the prospect of a settlement through the payment of a fine seems the likely course that events will take, if history is anything to go by.  The financial establishment understands the well trodden path these allegations take – ‘a cost of being in the business’ is how I once heard it described by a former boss – and that is why lessons are never really learnt because the precedents are few and far between and rarely affect the individuals at the helm of the business.  It leads to the turning of a blind eye in favour of the potential for monetary success and reward.   

As the chief operating officer of a funds business I fought a hopeless battle over the pricing of a security which was priced differently in two funds we managed.  The principle that it could not be right to have different prices for the same security was not considered relevant  – it was not deemed necessary to adjust the price because the impact on the net asset value was not considered material.  I argued that pricing should be based on the principle that a security at a valuation point should bear the same price across all the funds in the range or be disclosed but this was considered to be unnecessarily pedantic and not required by the rules.   Would transparency and disclosure have made a difference in the absence of a uniform price?  To my mind they would have because the investor would have been in a position to form their own view on the matter.  It should not have mattered whether the difference was material or not.  Disclosures in our current environment are often done reluctantly and  when made are viewed with suspicion – sometimes because of their rarity  and often because they are made under compulsion and lead to questions of what else should be known.  In large organisations people do not like to admit to mistakes – the blame cultures that exist are career limiting and the structures can themselves give rise to conflicts of interest and lead to horrible failures of supervision.  In an organisation with deep pockets – you pay the fine in settlement without admission of guilt and move on – and corporate memories being notoriously short – mean that expediency and greed often cause history to repeat itself.

Criminal charges can of course alter the landscape as happened with Andersens over Enron (even though that charge was subsequently reversed on appeal) but this needs to be driven by the need to enforce regulations rather than to make political capital.

It all serves to highlight how difficult it can sometimes be to challenge the status quo and why transparency on conflicts is so important to fairness in financial market operations.

©Jaitly LLP

Corporate governance on offshore funds is worth re-examining as investors continue their search for reliable investment structures.

It has always been the case that the investment manager as the sponsor of a fund has determined whom to appoint as the service providers to the fund, the level of charges and the terms of appointment.  Fund directors are no different in the manner in which they are appointed.  

Shareholders are normally unable to vote a director off a fund board as they generally hold non voting shares to avoid issues of control and either the investment manager or a trust managed by the fund administrator will hold the voting or management shares.  

Investors can, of course influence those decisions and often do – either through quiet diplomacy or by voting with their feet.  The directors have fiduciary responsibilities to discharge in relation to the fund regardless of whom they are appointed by, but the perceptions at least, do linger that they are in effect the  investment manager’s men (and women) given the provenance of their appointment and who would generally control their removal. 

Perhaps this perception is also fuelled by the limited involvement of the director because of the non executive nature of the appointment or perhaps it is because there is a significant expectation gap between the duties investors expect to see performed by such directors and those actually seen to be  performed.  There are of course many excellent fund directors who do all that might be expected of them and more but because investors often know little about these activities – the perceptions remain.  There are also others who fuel these perceptions by doing very little!   Investor due diligence is increasingly being directed towards directors because of this and that has helped shed some light on what they do.

The slight unease with which the offshore fund directors role is viewed by some investors suggests that it is time for greater clarity on all sides on what can reasonably be expected of a director in a non executive role.

Investors themselves are not entirely guiltless;  I have often heard investment managers complain about the difficulties of getting investor responses to corporate actions on the funds.   Which is the reason given for investors being required to give an automatic proxy to the administrator in subscription documents so that fund administration and corporate actions can remain uncomplicated by a typical lack of investor response.  The accepted view is that if investors are getting ‘reasonable performance’ they don’t want to be bothered by administrative matters.

A starting point might be greater engagement with investors on the potential appointments to the board (these without doubt already take place at an informal level and should be part of an investor’s due diligence process through which indirect approval is, in any event, given) It is however rare for directors to proactively engage with investors in a fund even though there are a few good exceptions.  

The private equity industry has for sometime nominated their own directors on the boards of investments.  Their reasons for doing so may be worth examination as hedge fund investments do share similarities.

What are the potential pitfalls of such appointments?  To start with it would require the buy in of the investment manager.  That will never be a done deal – whether on grounds of cost, confidentiality, objections from other investors or differences in view of what is required of the role.  The residence status of a wider universe of directors also has the potential to impact the fund’s tax status.  Clarification would be required on the role of an investor nominated director and in what respect it might differ from other directors on the fund.  In theory of course there should be no difference whatsoever but investors may require greater engagement with them to be kept informed of developments on the fund.  Conflicts of interests between investors themselves could also be a significant consideration.  Investors often underestimate co-investor risk which can be significant to the health of a fund.

An investor nominated director that was subject to a service agreement that specified say a requirement to review fund documentation, to visit the fund managers operations, participate in fund board activities, engage with investors on fund related matters and meet the service providers of the fund would set a minimum standard of corporate governance.  Good directors in the industry may already perform many of these functions and more as part of their roles but there are also many who do not.    

Of course a list of activities such as this begs the question as to whether this can be done for the usual standard cost of an offshore director – which may explain why there can be a gap between between investors expectations and what actually happens.  To some extent investors get what they pay for, in some cases they get great value for money where there is a good director who will do it all for the standard fee, but if greater engagement with them is something the investor seeks then there will be a cost attached to it.

Perhaps investor nominated director appointments with service agreements are worth consideration as a way to at least narrow and manage the perception gap that currently exists.

©Jaitly LLP

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