Reflections – Page 3

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

Safe as Houses – Protecting Assets

This month I thought it would be appropriate to focus on the issues of asset protection that are necessary when considering fund investments. The AIFMD has approached this issue by requiring funds to have a depositary. The Pensions Regulator in the UK issued a discussion document at the end of January dealing with issues around asset protection in Defined Contribution Schemes in which a principal of Jaitly LLP played a role.

Of course alternatives and hedge funds in particular are becoming an important aspect of pension investment strategies as trustees and consultants consider greater exposure to these types of investments to manage their investment portfolios.

Asset protection means different things to different people – the AIFMD takes a relatively narrow approach requiring a depositary with risk management and liquidity requirements as part of the operating conditions for the manager. The UK Pensions Regulator in its discussion document recognises a much broader approach by considering the impact of wider issues such as fees, administration and record keeping, valuation methods, insurance, compensation schemes and security lending all of which can have just as significant an impact on the protection of investor assets as might the use of a custodian.

Hedge Funds can be viewed by some as riskier investments – but depending on the investment strategy they need not be. Indeed as absolute return vehicles one of the underlying principles of a hedge fund investment should be the preservation of capital and hence the protection of assets.

The analogy to houses in this month’s title is apt because of the use of leverage in investment strategies and their impact on asset protection. It is a concept that needs to be understood far better by investors. As with a house – financiers provide funds which are secured against the value of the house. This leads to financiers introducing margins of safety in case the value of the house should fall by requiring that amounts lent should not exceed say 70% of the current value of the property (a concept ignored by sub-prime lenders). With a business that borrows money – the principle is no different and the lending is secured by taking out fixed and floating charges on the assets of the business which the financiers assess as giving them a margin of safety in the event of a default.

In a hedge fund too the principle is similar but the nature of leverage and the deal that is negotiated with the financiers – the prime brokers – is important to understand, as that will have a significant impact on the safety of those assets for investors.

So lets take a simple long short equity fund that states that its gross exposure will normally not exceed 130%. Note this is only an intention – it does not prevent the fund from going beyond this limit. What does that mean? It means that the sum of its long and short exposures will not normally exceed 130% – but it could. For example its investments held long could be 100% of the value of the fund and its short exposures 30% or other combinations totalling 130%. It is able to do this by borrowing 30% of the value of its assets. Funds with little negotiating power may agree to the prime broker securing the value of all the assets against the borrowing. If the fund deals in risky transactions the prime broker may require wider margins of safety to take into account difficulties in asset valuation or fluctuating asset values. Others may negotiate that the assets secured cannot exceed say 140% of the level of borrowing. Others may provide for assets up to 200% of the borrowing and so on. The assets secured in this manner are referred to as encumbered or collateralised assets.

The prime brokers can then re-hypothecate the encumbered assets – this enables them to borrow from third parties and to put up the re-hypothecated assets as security for that borrowing as if it was their own asset. This is what caused such problems for funds that were financed by Lehmans because collateralised assets had been re-hypothecated and were being retained by counterparties when Lehman had defaulted on its obligations. Where the assets collateralised had no limits – i.e the prime broker treated all the funds assets as collateralised then the problem was exacerbated even further – and then there was of course the problems with record keeping that meant that tracing and differentiating between encumbered and unencumbered assets became a major problem.

How this will operate in relation to the depositary requirements of the AIFMD needs to be fleshed out by the EU and ESMA in accordance with Chapter III and Article 18 (a) 16 of the directive. The UK Pensions Regulator is also consulting on the issue through its discussion document. Both are also looking at risk management and liquidity.

It does seem therefore that there is a real need for certain basic principles to be clearly articulated so that investors interests are protected in relation to leverage:

a requirement for disclosure of how leverage will operate on a fund and what impact this will have on liquidity and risk management
a requirement to disclose what the manager of the fund will and will not be permitted to do in relation to leverage and what protections and controls will operate to ensure that the manager does not breach these parameters
a requirement to provide an explanation of the circumstances in which rights against collateralised assets can be exercised by financiers and how collateralised security shall be managed
a requirement to explain the types of recourse available (if any) to investors in the event that assets are lost
a requirement to disclose how assets will be custodied, including sub custodial arrangements
a requirement for custodians and depositaries to be adequately capitalised and to carry appropriate insurance or bonding in relation to those assets and possible loss
a requirement for custodians and depositaries to segregate the assets from their own with adequate record keeping and regular disclosure .

It is only then that the regulatory environment within which investors make investment decisions will operate to protect investors assets and enable investors to make informed decisions relating to risks around leverage.

©Jaitly LLP

End of an era – Ramesh Jaitly

On the 18th of December 2010 the senior partner of Jaitly LLP passed away suddenly in New Delhi en route to the UK.

He was a man of many parts – soldier, pilot, tea planter, advocate, columnist, lecturer. He was a well known figure in industrial relations relating to the tea plantations in North East India where the plantation labour respectfully referred to him as the ‘Hakim Sahib’ (‘the judge’).

His wisdom and his experience as an advocate and mentor will be sorely missed.

©Jaitly LLP

Making sense of it all – Newcits

It has been a period with conflicting news stories – first there were the stories about hedge fund managers who had failed to achieve the promised distribution by launching UCITS funds (referred to as Newcits). Then there was the story of a survey, that contrary to expectations, showed that Newcits had outperformed their hedge fund counterparts and now there are reports of a major hedge fund closing its UCIT structure and returning capital to its investors because reports suggest that the tracking error was widening.

Newcits were supposed to be the hedge fund managers insurance policy against the AIFMD and the way to get distribution in Europe. They have been marketed as better regulated, less risky and more liquid products than their hedge fund equivalents.

These claims need to be treated with some caution because it is distribution and regulatory arbitrage with the AIFMD that are the real drivers that attempt to make a virtue of the Newcit.

I have heard many cite the example of the UCIT structure used as a feeder fund to invest in Madoff, others cite the trade off they are prepared to pay for in the form of lower returns in return for reduced volatility and the enhanced liquidity of these products.

The great danger with Newcits is that marketing spin would have you believe that through the use of these structures investment risk can be replaced with improved liquidity risk. It cannot. An illiquid investment remains an illiquid investment regardless of whether it is housed in a Newcit or a hedge fund. Just because NAVs are prepared fortnightly do not make the product more liquid – the manager still makes judgements on the amount of liquidity that will be necessary and it will still be the more liquid part of the portfolio that will be realised first in the event of redemption notices. It may be true that regulatory requirements force more of a focus on liquidity requirements and indeed valuations – but it is investment strategy and markets that determine liquidity and not choices of investment vehicles and domicile. UCITS can gate redemptions and managers still need to manage liquidity by realising investments.

In so far as the claim goes that these products are less risky – one needs to ask what makes them less risky? Is it the counterparty concentration risk limits? The use of VAR as a risk assessment methodology? Valuation requirements? Restrictions on the use of derivatives limiting exposure to the net asset value? The nature of financing that may be permissible? Of themselves these strands are all good things to have – and many hedge funds have claimed the use of these for many years – Irish listed hedge funds have had similar counterparty exposure limits, many hedge funds claim to use VAR methodology (for what its worth) – so I am not altogether convinced about the significant improvements that Newcits provide – sure the requirements need to be adhered to and yes they do move towards a better framework for risk but they do not necessarily offer significant improvements on what hedge funds claim apart from being mandatory requirements.

How about better regulation? Unarguably there is more to deal with and monitor – but does this necessarily mean that it is better? I have visited enough investment managers in my time and observed large tomes of compliance manuals gathering dust on shelves. I have also as a chief operating officer been party to discussions on how to get around regulatory requirements that did not quite suit the hour of the day. It is the application of joined up proactive regulation that would be meaningful if it is done within a culture of real risk management – but that does not need rules – it needs attitude.

So what is it that you need in order to make sense of investments in Newcits? Everything. The due diligence needs to be as detailed as it should be for a hedge fund. The hurdles the Newcits must go through to comply, set, just that, hurdles. The investor must still complete its due diligence on both investment and operational aspects because structure and hurdles not withstanding the risk management, the liquidity and valuation claims, the investment strategy all still need thorough examination.

And if you remember that investment risk cannot be converted into reduced liquidity risk by changing the wrapper into a Newcit then you are streets ahead of some investors in Newcits and you may even be beginning to make sense of it all.

©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

The puzzle about insider dealing

Pick up a newspaper these days and there is plenty to read about enforcement actions on insider dealing. In fact as I write I have just received an email newsletter from a leading law firm in the U.S. on the very subject.

Developments on the enforcement of insider dealing offences are interesting but even more intriguing are the way enforcements are being implemented and why more obvious enforcement actions are not happening. Some of it is fairly obvious – what constitutes dealing on market sensitive information or material non public information can be difficult to prove and to bring a legal action can be costly both in terms of money and reputation for the regulatory authority although there is clearly a much greater appetite developing.

The way U.S. enforcement actions work – whilst a pragmatic way of getting results – are to my mind no more than a tax on wrongdoing through the use of consent orders and it is unfortunate that the FSA appear to be taking a leaf out of that book. What this means (and I have seen this thinking operate in practice) is that the ends justify the means and the end is always profitability – the measure of success in our business. This is the wrong approach to adopt for regulation – the regulator should not get fixated on the statistics of enforcement but on formulating a clear framework of what is acceptable and unacceptable and then taking a zero tolerance approach to what is unacceptable. Is this too idealistic? In the current framework of course it is, but with an election looming and the future of the FSA hanging in the balance – now is the right time to be taking stock on being an effective and fair regulator. The FSA may have a good reputation with those it regulates but its current approach erodes its principles based foundations.

When one looks at the US model of regulation I am puzzled by what it appears to condone. On the one hand we have press reports of zealous efforts with wire tapping on Galleon and on the other the existence of funds that raise questions by their very structure. Everyone knows that effective trading is dependant on the analysis of flows of information and it is clear that investors look to tap into that analytical prowess. Yet if a fund can exist that invests primarily in a single security and where the investment manager sits on the board of the company issuing the securities in which investments are made, are you only tapping into analytical ability? Even if trading occurs only outside closed periods how much knowledge can be imputed to unpublished market sensitive information? None it would appear. Difficult to prove one way or the other? Perhaps – but intuitively what conclusions might one reach even if intuition alone is insufficient? Yet I am not aware of any regulatory interest in funds of this nature. Perhaps there is some technical loophole in the rule based regulatory system that permits their existence – but if there is – what has been done to address it? I am not necessarily implying wrongdoing either, wilful or otherwise – it is well known and understandable that investors like to appoint directors on boards to protect their interests. The director has an immediate conflict between the fiduciary duties owed to the company to which he is appointed and the investors who have appointed him and upon whom they may rely in making investment decisions.

These can be difficult issues and can result in grey regulatory boundaries. Yet when a regulator takes enforcement action – should it be a reprimand that in effect is nothing more than a token fine for the institution?

We all know that regulatory boundaries are constantly being tested – so when one reads that a big name house has paid a regulatory fine with reductions to that fine for cooperation – the message delivered should not be seen to be simply yet another tax on the institutions profitability, because it got caught.

From a due diligence perspective it is often said that if an organisation has a history of regulatory fines it is best avoided – yet if one looks at a number of institutional grade houses there would be few that have unblemished records. But there is no sign of investors rushing to the exits because of the existence of such fines – is it because the investor’s focus is on the results rather than how they are obtained? Is it because they believe there has been a mending of ways? Is it because investors do not see the reasons for the fines to be matters for concern? Perhaps investors consider the pushing of boundaries on insider dealing and other regulatory issues to be to their advantage because they do not carry any direct risk from the manager’s actions? Does it mean that the regulators concerns are not aligned with those of the investors? Should they be?

It can be a puzzle.

©Jaitly LLP

Fund of Hedge Funds – What the future holds

I am often asked what the future of Fund of Hedge Funds is. This Monday was no different when as a guest of Resonance 104.4 FM’s Naked Short Club I was asked whether there was a role for Fund of Hedge Funds in the future.

My view is that there will always be a role for Fund of Hedge Funds.

Fund of Hedge Funds fulfil a variety of needs for investors. There are those investors who are unsure of their own expertise and ability to invest in alternative investments, there are others that simply do not possess the resource to conduct the detailed due diligence that should be an essential part of investing in alternatives, there are others who would prefer to leave the monitoring of such investments to those specialising in the area. Other investors view Fund of Hedge Funds as a way of dipping their toes into the world of alternative investments and learning about them as an investment tool, as a way of getting access to investment talent that they may not otherwise be able to invest with or as a way of getting sufficient diversification because of the size of their investments.

Another area that is developing appears to be the appetite for niche Fund of Hedge Funds – specialising in geographical areas or ethical investments. As countries that signed up to the Ottawa convention start to implement versions of their promises – these may provide an impetus for specialised ethical investing that Fund of Funds may be well placed to provide.

Interestingly, more public money seems to be heading into alternatives too as evidenced by tender invitations by national pension schemes for advice on investing in alternatives. Much has been made in the press recently about pension funds acquiring professionals with appropriate experience as trustees of pension schemes and this need becomes ever more important as pension funds consider exposure to alternative investments and look to Fund of Hedge Funds to give them this exposure.

A lot has been written in the press for the need for Fund of Hedge Funds to change to meet investor needs and to allay investors fears on the weaknesses that were self evident in the last 18 months. Alarmingly I see very little evidence of change in the methods used by Fund of Hedge Funds. There is plenty of talk about the changes required: transparency, evidence of process, enhanced due diligence, improved risk management, improved monitoring and reporting, better liquidity management – but scratch beneath the surface of that talk and you will find that little has changed. That is such a missed opportunity – given the role that Fund of Hedge Funds need to play. There is a real need for them. But they need to do more to build the trust of their investors. What I find disturbing is that commercial logic would dictate that they did actively address these issues because ultimately it would stand them in good stead. Yet it does not appear to be happening?

In my view the blame for that lies primarily with the organisational structures employed by the businesses that own these investment managers and the way they are compensated. These encourage a ‘star culture’ around which myths develop, where the focus is more on asset gathering rather than capital preservation. A case where perception becomes far more important than reality.

But blame also needs to be directed at investors who often tend to approach investment with a Fund of Hedge Fund manager passively. When a Fund of Hedge Fund manager talks about their state of the art due diligence process – apply that same process to the Fund of Hedge Fund manager and see if they pass muster. Is there an alignment of interests, are they prepared to provide evidence of what they say they do, do they segregate investment, risk and operational functions, what contingency planning do they have in place when key staff are unavailable and perhaps more importantly do they really have the staff numbers and depth to meaningfully provide the services they are selling. Look for evidence of the risk teams exercising their powers of veto, look at turnover on their various teams and talk to people who have left . Things are rarely as rosy as the marketing people would have you believe.

But for those managers that do get it right. For those that are prepared to be honest about what they can and cannot do and who are prepared to invest in resources that will help them deliver a meaningful service to their clients and who take seriously the delivery of the promises they make – for them there is a future in the long term. For the others, they will get away with what they can in the short term until ‘after the event’ regulation and investor losses result in the imposition of even greater and sometimes pointless costs which will affect everyone in the industry and its reputation. There is a lot to be said for the industry setting high standards that others feel commercially obliged to adopt.

In the meantime the future for Fund of Hedge Funds promises to be interesting.

©Jaitly LLP

Training in Operational Risk

If you want an investment professional to understand the niceties of operational risk there can be no better training opportunity than to send them to attend a meeting of creditors and investors convened by the liquidator of an offshore fund that has gone wrong.

I attended such a meeting last Thursday. There were a number of things that struck me about it.

Firstly only a handful of investors attended the meeting – some joined the meeting by phone but very few had made arrangements to attend or be represented at the meeting. Was it concerns over publicity, costs – throwing good money after bad, an assessment of the hopelessness of the situation? It is difficult to say.

Meetings of this nature are designed to impart information to those affected by the events in the Fund – and there are significant costs attached to doing so. These costs are inevitable and inevitably they eat into the pot available for recovery. Is there a case to insist on some mechanism such as insurance to cover such eventualities on investments in future?

The nature of the classifications into investor and creditor claims and the priorities given to each type of claim throw into sharp relief what remedies are available to those who stand to lose money from the collapse of such a fund. Who recovers what ahead of whom, where there are funds to distribute to such claimants, can then become significant issues – the difference between getting some recovery or none at all. It also highlights what a fine balance there can sometimes be between a fund being classified as solvent or insolvent based on how a claim may be classified.

Despite the wonderful clarity of vision 20/20 hindsight brings with it – and whether or not there were tell tale signs before the allegations of potential negligence and wrong doing arose – what is instructive about such a meeting is for investment professionals to consider ahead of an investment the sort of things that they may need to deal with in the event an investment of theirs goes wrong…….

What avenues are available to them to recover their investment if things went wrong
Do they really understand how their assets will be held and how they can be dealt with
The nature of claims that could arise and the priority in which they would be paid
The expenses involved in recovering what is left of an investment and who should bear them or whether it is worth paying for insurance to cover such eventualities
What justifications would there be for the investment if the disclosed risks actually came to pass
Can service providers to a fund be properly held to account for their actions or inactions in relation to the fund and to what extent is it reasonable to rely on them in making such an investment.

Where there is fraud – no amount of prior work may necessarily unearth the issues and however good ones risk management – controls can always be overridden. But what is important from a training perspective is to bring home the reality that these things do happen and the only way to emphasise to investment professionals the complications in unravelling such matters is in my view by making them attend these types of meetings – so that they understand first hand what happens when a fund ‘blows up’ and that it is not simply a theoretical risk.